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A default against official creditors only
A key assumption in my proposal for a Greek parallel currency to the euro, published in a CEPS paper last month, was that the Greek government would reach an agreement with its creditors in order to avoid a default. In the meantime, however, the options have narrowed: Either the creditors further water down their conditions for financial assistance to an extent that allows the Greek government to sign on to additional help without changing its position, or both sides stick to their positions and Greece will run out of money to make upcoming debt repayments. In this note, I assume the latter will happen.
In the intermediate future, sizeable debt repayments are due only to the International Monetary Fund and the European Central Bank. Debt servicing of the rescheduled private debt is moderate in the near-term, and repayments to the European Stability Mechanism do not begin before the end of this decade. Representatives of rating agencies have pointed out that it is not clear whether a default against the IMF and the ECB would lead to a default rating on Greek market debt. As long as Greece avoids default against the debt held by the private sector, it may escape a default rating and hence keep market access open for the future. This possibility lowers the costs of defaulting against the official creditors and makes default therefore more likely. However, escaping a default rating is not of material importance for the consequences of a default against the ‘institutions’ (the new label for the European Commission, the ECB and the IMF), which is discussed below.
Separating the Greek banking sector into a ‘good’ and a ‘bad’ bank
Should the Greek government decide to default against its official creditors, banks’ balance sheets would in a first step have to be temporarily frozen by introducing capital controls and restrictions to cash withdrawals from sight deposits. In a second step, however, it could restructure the banking sector into a ‘good bank’, which would retain the euro, and a ‘bad bank’, which would wind down non-performing assets against haircuts of liabilities of the bad bank to the Bank of Greece.
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A raw deal for creditors
The exercise looks fairly attractive on paper. In effect, it represents the ‘dollarisation’ of the Greek economy without the economic resource costs usually associated with such a move. However, it entails a seriously hostile act against the official creditors, in the case of the construction of the bad bank especially against the ECB. Depending on the recovery rate of the non-performing loans, claims by the Bank of Greece on the bad bank will have to be written off. Assuming a recovery rate of, say, 10%, assets of the bad bank could be reduced to
How to deter Greece from Grexit
Contrary to general belief, default, Grexit and the reintroduction of the euro as a foreign currency would probably be positive for the Greek economy. Confidence could come back as private and public excess debt would have been reduced at the expense of foreign creditors. The good bank would have a solid balance sheet with which to make new loans. In order to avoid the introduction of a new currency for the purpose of funding primary deficits, the government would have to achieve primary budget balance. But this has been the objective of the new government from the beginning. The good bank would lack a lender of last resort in the form of a central bank, but this would not need to be a serious disadvantage. Reserve requirements of 100% for sight deposits and a healthy equity cushion to protect longer-dated deposits from impairment through credit losses would make a central bank and government-backed deposits insurance scheme unnecessary.
On the other hand, creditors would be hard hit. Not only would they lose their €216 billion in financial assistance but they would also have to cover the losses of the ECB caused by the default on the Greek bonds in its portfolio (€17 billion) and the claims from the interbank payments system Target 2 (€99 billion as of end-April).4 The total loss (before recovery) of €332 billion could be a major political liability for many leading policy-makers in the creditor countries. It would therefore be rational for them to attach a high cost on a Greek default in order to deter, first, the Greeks from walking away from their debt, and second, other countries from imitating the Greek strategy.
One way of raising the costs of default would be to appeal to honesty and fairness. [...] Another way would be to threaten a cut-off from structural funds. However, Greece is set to get only a little more than €3 billion per year until the end of this decade. Debt relief is therefore worth 100 years of structural funds (even ignoring discounts for future receipts). Finally, the creditors could link the exit from EMU to a forced exit from the EU. The costs of leaving the EU and foregoing all privileges of a member of the club could be quite high and hence an effective deterrent. Yet, this is not very likely as the EU leaders will want to keep Greece in the EU for geopolitical reasons. In the event, the only viable strategy for the creditors would seem to be to give Greece the debt relief it can easily secure at moderate cost through unilateral default on the official creditors, ‘Grexit’ and the reintroduction of the euro as a foreign currency. But policy-makers in the creditor countries would have to disguise the debt relief from their electorates so as to avoid political punishment.