Many investors wish to wave a final goodbye to the disruption the Greek debt crisis has had on market valuations. Meanwhile, European policymakers are already trying to move away from the dramas on the periphery and focus on restoring growth in Europe. Both impulses are understandable. Unfortunately, they are premature.
The debt reduction agreement put in place last week is the biggest sovereign restructuring so far. Yet it goes only part of the way in helping Greece overcome its core problem of too much debt and too little growth. And it won’t be long before this latest deal also comes under pressure. So here is what to look for and what to do about it.
With debt reduction only one of three components of the recent €130bn bailout, expect more details this week on the other two. On Tuesday and Thursday we will find out how much money the European Union and the International Monetary Fund are willing to release to Athens upfront. Markets are hoping for heavily front-loaded payments, while official creditors prefer them to be more back-loaded.
This difference relates to Greece’s ability to deliver on its part of the bargain – particularly an additional dose of heavy austerity at a time when youth unemployment is already 51 per cent and the economy is contracting at a rate of seven per cent a year. Even if socially and technically feasible, the upcoming elections in Greece will introduce yet another element of complexity.
Going beyond the next few weeks, it is highly likely that the Greek bailout will again be found wanting. Were it to be fully implemented – highly unlikely – the result would still be an unsustainable debt stock of 120 per cent of gross domestic product in 2020. With such a prospect, new private capital will not engage in Greece, robbing the country of the oxygen needed for investment, growth, competitiveness and jobs.
No wonder markets are already pricing in a significant probability that Greece will have to again restructure its debt. And the next round is likely to be a lot messier. Talk about “PSI 2” is already accompanied by growing awareness of “exit risk” (the possibility that Greece will have no choice but to exit the eurozone to restore competitiveness and growth).
Whenever it occurs, PSI 2 will be a very tricky affair because of what Greece has just agreed to. By shifting the legal jurisdiction governing most of its outstanding bonds from Greek to UK law, the country is giving up significant flexibility and narrowing its range of options. It is also exposed to a lot more risk in the event of a future restructuring. Finally, the overwhelming majority of new loans comes from the official sector. With this large accumulation of liabilities to “senior creditors”, any disruption in payments could quickly spiral out of control.
Already official holders of Greek bonds, such as the European Central Bank and European Investment Bank, refused to participate in last week’s restructuring deal. If Greece were to default on such creditors, let alone on the IMF, it would undermine the one source of new financing that is still available.
Finally, Greece cannot – and should not – rely on its European partners and the IMF to maintain indefinitely an approach that repeatedly fails to deliver. With a referendum in Ireland and presidential elections in France (held against the background of seven governments having lost office in Europe since 2010) we should expect many more calls for a fundamental redesign of the eurozone. Few will favour more exceptional large-scale financing for Greece.
What last week’s debt reduction deal really delivers is a bit more time for others to reposition for the next, more disruptive, act in this unfolding Greek drama. For European policymakers, this means even more urgent building of firewalls to protect countries such as Italy and Spain, continuing to strengthen the core through better fiscal and political integration and forcing banks to raise capital. For investors, it is about reducing their exposure not only to another default by Greece, but also the risk of the country’s exit from the euro.
If this were to happen, the latest agreement would end up being characterised in history books as more than just a costly failure.
The writer is the chief executive and co-chief investment officer of Pimco