Although the Greek bond swap is still in progress, the expectation is that enough investors will tender their bonds for the deal to go ahead. One hurdle would be cleared. But would that dispel the uncertainty that hangs over the euro zone and clouds growth prospects? I suspect not.
Sovereign debt is different from the debts incurred by firms and individuals at the domestic level. It lacks what is euphemistically called 'enforcement technology' – that is to say, there is no court that will enforce a claim on a sovereign; and the concert of nations long ago gave up sending in gunships with marines to occupy the customs house.
Instead, a sovereign’s decision to repay its debt reflects a balancing of the discounted future costs of default (largely the impact of losing access to international capital markets and the disruption that entails) against the costs of making the debt payments (in terms of domestic adjustment that must be undertaken). In this approach, a number of factors determine the outcome: the rate of return on the investment that continued access to capital markets would provide, the rate at which the decision maker – the government – discounts the future, the potential economic and social costs from default, and so on.
As successive rounds of Argentine debt restructurings illustrate, however, it takes two to tango. Creditors also have a role. Private creditors that mark their assets to the market are motivated to negotiate with distressed sovereigns: They have an incentive to return value to paper they hold as soon as possible – an asset that is generating some return, even if it is less than the contractual term, has some value. In contrast, a loan in default is written off until such time as it is restructured. Of course, private creditors want to minimize the losses they suffer. So, they negotiate with the sovereign over the size of the “haircut” they are prepared to take. In this respect, the decisions of private creditors are also influenced by a range of factors – current and expected future interest rates, which determine the rate at which debt service payments are discounted, the expected economic prospects of the country, etc.
Official creditors, the European Union, say, in the case of Greece, are also involved in the process. Their objective, quite apart from some broader political objective of preserving the European project, is to limit the contagion that a default would have on their economies. The most worrisome channel of contagion is through the banking system. Creditor governments would therefore like to avoid default until such time as their banks are capable of withstanding the shock. (The IMF has a somewhat unique role, in that its objective is to assist its members strike the right balance between financing and adjustment, thereby promoting the public good of international financial stability and global growth.)
Put these elements together and you can assess the prospects for a Greek default. From the perspective of the Greek government, a key condition is achieving a primary surplus – the fiscal balance excluding interest payments. At that point, the government is generating enough tax revenue to cover its current expenditures; it no longer need to maintain access to credit markets to fund expenditures. Note, therefore, that Greece’s finance minister Evangelos Venizelos, has committed to a primary surplus in 2012. This could be a trigger point.
If Greece stood to benefit from continued access to capital markets, through higher investment, for example, it would still have an incentive to persevere on its current path. There is a problem here, though: Greece is grossly uncompetitive; yet, because it is locked into the euro, the only way it can regain competitiveness is to reduce wages and prices. This ‘internal devaluation’ strategy requires sustained high unemployment, which over time erodes social support and creates political fissures. In such conditions, decision makers become progressively more myopic – the long-term gains from sound policy are discounted, the near-term political costs are given extra weight.
What about the players? Private creditors have already received a substantial haircut and are largely out of the picture. Official EU creditors, however, remain an important player. Once their banks have adequately provisioned for potential losses, they may be less willing to countenance violations of key conditions on bailout packages. At that point, they may be prepared to see a default and a subsequent exit, particularly if it leads to a stronger, more cohesive 'core.'
Who knows what the future will bring. But it is possible to conceive of a situation in which there is a mutual parting of the ways between Greece and the euro zone: an “I” – ‘you’re fired’ – “quit” default and exit scenario.