It’s Time to Break the Never-Ending Cycle of Crisis in Greece

Citi GPS Opinion Article

5 July 2015 – The principle of effective solidarity between Greece and its creditors has failed miserably to solve the Greek crisis. The decisive NO vote in the Greek referendum was a rejection of the status quo and a vote for hope, even if the Greek government probably gave its population a false hope that it could have its cake and eat it too.

Sadly, the prospects for a resolution of the crisis and for an improvement in the living standards of ordinary Greeks are worse than they were before the referendum was called. Trust has all but vanished on both sides and the capital controls and deposit withdrawal limits that were imposed on Greek banks will be difficult to lift anytime soon: some households and businesses that could not access their deposits will likely withdraw their money from the banks at the first opportunity.

The prospect of a viable and sustainable solution to Greece’s and the Eurozone’s problems remains nowhere to be seen. If another agreement is reached, it will likely be a slightly revamped re-run of the programs that have failed since May 2010. The can will be kicked down the road, with a partial implementation by Greece of further fiscal austerity measures and minimal implementation of the structural reform components of the program.

The first/best solution remains a program of drastic structural reform, ‘owned’ by the Greek population and government, in return for continued funding and some debt relief by Greece’s official creditors. This does not currently seem politically feasible. In its stead, for the next agreement between Greece and its creditors to break the cycle of never-ending and mutually damaging brinkmanship, it needs to satisfy two essential conditions: first, to grant the Greeks their wish to be (or appear to be) masters of their own destiny; and second, to limit the exposure of the country’s creditors. This could be achieved in five steps:

First, as regards fiscal austerity and structural reforms, the Greek government should be told it is free to do as it pleases; any fiscal deficits will have to be funded in the markets. That way, any policies adopted will be nationally ‘owned’ rather than imposed by the institutions (or the quartet, that is, what used to be known as the troika plus the European Stability Mechanism (ESM)). The awkward and humiliating ritual of intrusive oversight by international institutions should end.

Second, the debts owed by the Greek state to the European Central Bank (ECB) (€27bn) and to the International Monetary Fund (IMF) (€21bn) should be effectively bought back by the ESM (should the ESM not be allowed to buy this debt directly, the buyback could be done via a loan from the ESM to the Greek government, on the same terms as the existing European Financial Stability Fund (EFSF) loans to Greece). The other official exposure to the Greek government (by the EFSF and under the bilateral Greek Loan Facility) will remain unaffected. It is highly concessional and subject to the 7 years remaining of a 10-year grace period granted in 2010. Debt service on this debt is minimal in the foreseeable future. The government could declare a moratorium on its publicly owned liabilities, its privately owned liabilities, both or neither. It could turn some or all of its liabilities into real GDP growth warrants or suspend debt service until real GDP reaches, say, a level 10 percent above its previous peak level (2007). That choice would be driven by the relative importance of future market access versus current debt service and austerity.

Third, international institutions would not lend the Greek state any more money in return for continued funding and some debt relief by Greece’s “official creditor’s”). The Greek government would be on its own financially. If the markets were to be willing to lend to the Greek sovereign, good luck to them.

Fourth, to prevent money from the institutions finding its way into Greek government coffers by the back door, the ECB would strictly enforce its risk-management framework, no longer accepting any new exposure of the ECB or the national central banks (NCBs) of the Eurosystem to Greece’s sovereign debt Such debt would be excluded from its public sector purchase program (public sector purchase program (PSPP)/quantitative easing (QE) program, the program of asset purchases launched earlier this year to provide a monetary stimulus to the Eurozone economy). Greek sovereign debt or financial instruments guaranteed by the Greek sovereign would no longer be accepted as collateral for lending to Eurozone banks, either in the course of routine funding operations or through emergency liquidity assistance (ELA) to banks facing liquidity problems. Greek government exposure could become eligible for ECB operations again in the future once it satisfies the ECB’s risk management rules (the conditions being the equivalent of becoming investment-grate-rated again and having had continuous market access for some time).

These actions by the ECB would result in many Greek banks being unable to fund themselves. ELA, provided by the Bank of Greece (the Greek central bank) at its own risk but subject to the approval of the Governing Council of the ECB, has been the only material source of funding for the Greek banks since February 2015. The total amount of ELA funding was capped on 28 June, even before the Greek government failed to pay the IMF the €1.5 billion that was due on 30 June. Greek banks hold a considerable amount of Greek sovereign debt (€13.6bn according to ECB data as of end-April, of which perhaps more than half would be bills) and Greek sovereign-guaranteed financial instruments (an amount of perhaps around €30bn). With no prospect of new funding by the creditor institutions (and having gone into arrears to the IMF), the value of the Greek sovereign and sovereign-guaranteed debt instruments held by the banks would fall markedly. Even if the ECB did not require the Greek ELA facility to be wound down, haircuts on the collateral offered by the banks would rise. Even if the Greek banks did not become insolvent immediately, they would be unable to roll over their maturing liabilities. So the fifth element of the plan would entail recapitalizing and restructuring these banks, to enable them to function without relying on Greek government-issued or government-guaranteed collateral. The need for additional collateral would be for potentially up to €45 billion, even though restructuring of the banks (potentially bailing in some time deposits in Greek banks) and higher collateral valuations than for the existing collateral could bring the total amount of capital needed from external sources down significantly.

The restructuring and recapitalization should be carried out by the European authorities, probably through the ESM, which would likely require a capital increase to make up for the increased exposure to Greece. The ESM would thus become the main (perhaps the only) shareholder in the Greek banks. These banks would continue to have access to routine ECB funding, and to ELA if necessary, provided they are deemed solvent and can offer adequate collateral, unrelated to the government. The ECB would bar Greek banks from making new loans to the state, or to provide new funding in any way; existing bank holdings of Treasury bills and other Greek sovereign debt and sovereign-guaranteed instruments would run off as they mature.

Any attempt by the state to extract additional money from the banks via a capital levy or other tax would be treated as a hostile act. Should the Greek authorities change the taxation of the Greek banks without the consent of the institutions, the official creditors would have the right to accelerate their own claims on the Greek sovereign. The ECB/SSM could also make it clear that such capital levies would drastically impair the ability of the Greek banks to lend to the Greek economy.

Our proposal returns ownership of Greek policies to the Greek population. It establishes a drastic form of banking union for Greece, making it possible to rescue the banks without rescuing the government. It reinforces the principle that monetary union is no obstacle to an orderly restructuring of the sovereign debt of one of its members. We hope it will motivate the creation of a sovereign debt restructuring mechanism (SDRM) for the Eurozone member states. This would be given the task of determining the debt sustainability of governments requesting financial support from the ESM. Such ESM funding would only be forthcoming if the sovereign in question is deemed to have debt sustainability with high probability. The ESM and the SDRM together would constitute the European Monetary Fund, or EMF. It would be an IMF with teeth. An independent body of experts would be charged with performing the debt sustainability exercise on behalf of the SDRM. Its findings, and the analysis supporting it, would be in the public domain. The creation of an SDRM permitting rapid and radical sovereign debt restructuring would fill a gaping hole in the architecture of the monetary union. Future sovereign insolvencies in the Eurozone would be handled swiftly and transparently, thus minimizing their adverse impact on the real economy.

Our proposal ends the soft bailouts of the Greek banks and government that have been conducted under the guise of liquidity assistance by the ECB and the Bank of Greece, thereby capping the damage done to the ECB’s credibility and also limiting the incessant rise of bailout fatigue and Euro-skepticism in the creditor countries. It also spares the IMF from throwing its principles overboard by again going along with lending to a patently insolvent sovereign. The distasteful situation where countries that are much poorer than any Eurozone state are put at financial risk to bail out Greece would be brought to an end.

Eurozone taxpayers would end up holding, via the ESM, a large number of Greek bonds bought from the ECB/Eurosystem – bonds that may never be repaid. But they already hold most of these bonds anyway, via Eurozone monetary authorities, the Eurosystem. The profit and loss-sharing arrangements across Eurozone member states for the ESM are identical to those for the ECB, and for the Eurosystem as a whole (except for losses on ELA, public sector debt purchases under the asset purchase program and some idiosyncratic collateral accepted by an individual NCB but not by the Eurosystem as a whole). The purchase of the SMP bonds from the Eurosystem by the ESM simply turns an obscure quasi-fiscal exposure of the Eurozone taxpayers into a transparent fiscal exposure.

The only additional outlay of any real significance that this plan requires is the recapitalization of the Greek banks. It is not immaterial, but it is in our view the price to pay for eliminating many of the distressing features of the Greek saga. It could in part be funded by some of the funds that expired unused in Greece’s 2nd program (including the more than €10bn of unused funds originally earmarked for bank recapitalization). Of course, both the buyout of the ECB/IMF debt and the bank recapitalization would require the usual approvals by the Eurogroup/ESM board as well as a number of national parliaments.

If this proposal works as expected, reforms are implemented in Greece, confidence is restored, growth resumes and the government regains market access — good for the institutions and for Greece. It would probably still take some time before capital controls and restrictions on bank withdrawals could be lifted entirely — trust in the soundness of the banks and the safety of one’s deposits once broken will take time to be restored — but if and when they are, at least the banks would be paying out in euros. Replication elsewhere is not likely, but not necessarily undesirable.

If our proposal fails to work (because the necessary reforms are not implemented and/or because confidence is not restored and domestic and external demand remain weak), the suffering of the Greek population continues. The banking system would likely continue to be under pressure, but at least it would, once the banks are rid of their direct exposure to the Greek government, have a lender of last resort in the Eurosystem and the ELA, even though a weakening real economy and declining government revenues would likely result in continued capital controls, deposit controls and external payment controls, while the state would issue scrip to pay its domestic bills.

Under our plan, a failing Greek government may still eventually resort to leaving the Eurozone. But there is no automatic link. Government default, on Greece’s private or official creditors, does not necessarily trigger a cutoff from ECB funding of Greek banks and a sudden forced exit from the currency union.

There is a variant of our proposal that could be implemented unilaterally by Greece, as it does not require any (voluntary) funding by the creditor institutions. We do not propose this and it has some important drawbacks compared to our proposal, but we want to point out some interesting parallels. It comes in six steps.

First, as before, as regards fiscal austerity and structural reforms, the Greek government again is free to do as it pleases.

Second, the Greek government announces a unilateral moratorium on the debt service (interest and repayment of principal) to all official creditors (EFSF, bilateral governments, ECB and IMF) and on as much of the privately held debt as is necessary to come as close as possible to a financeable general government deficit.

Third, as before, there would be no new funding of the Greek government by the creditor institutions. In view of the second step, this would not be hard to achieve.

Fourth, the banks (which would surely be insolvent and lose access to ELA) would be restructured and recapitalized by the Greek government, perhaps as new legal entities. They would therefore be nationalized. The banks would immediately stop servicing their debt to the ELA facility of the Bank of Greece and to the regular Eurosystem. This would most likely result in the technical insolvency of the Bank of Greece. The Greek government would not try to repair the insolvency of the Bank of Greece, which would likely find itself in negative equity. (It is not entirely clear what that would imply, but it is possible that the Bank of Greece would henceforth become an ineligible counterparty for the other members of the Eurosystem through Target 2.)

Fifth, strict controls on capital outflows would be enforced, but every effort would be made to keep internal payments as free as possible.

Sixth, if necessary for budgetary reasons and to recapitalize the banks (allowing them to open and for the payment system to operate internally), the government would issue scrip, a shadow or parallel currency, the New Drachma, say, issued perhaps through a shadow or parallel central bank. A

t any time, if an agreement could be reached with the creditor institutions (and if necessary with the private creditors), the unilateral version of our proposal could be turned into the original consensual version of our proposal by the ESM buying out ECB and the IMF and recapitalizing the banks and the Greek government gradually retiring the scrip. Should no agreement be forthcoming in finite time with positive probability, the unilateral version can relatively smoothly merge into a Grexit scenario.

From this description it is clear that the second set of actions is inferior to our proposal. In addition to the political difficulties that this scenario of unilateral default would create, Greek banks would still be hostage to the success of eventual negotiations with European creditors or would never open in euros again and the specter of Grexit would still hang over the Eurozone and Greece.

Almost five years into the Greek crisis, it is high time to put an end to it. New approaches are needed. Because of the blindfolds and mistrust restricting the vision of all parties involved in the bargaining, even the unilateral (inferior) version of our proposal is superior to anything likely to be negotiated or emerge following the referendum. It is said that insanity is doing the same thing and expecting different results. The insanity of trying the same thing over and over again and expecting different results must end.