A New Phase in Euro-Zone Crisis – Zero Coupon Perpetuities for Greece?

I don’t have an enormous amount of time to consider the implications of the Greek election yesterday in a tremendous amount of detail. So the following are my thoughts, disorganised and potentially incoherent.

Syriza and the Independent Greeks are forming a coalition. The Independent Greeks are not an extremist party (despite the warnings that the flash news report from some excited news agency on my iphone said). They both want to renegotiate the debt.

Greek 2015 election results

This was inevitable. You can’t live the way Greece was living forever. Eventually the political system adjusts and voter allegiances change. Ultimately, it is not so much a matter of the fact that it did happen, more that it took this long (sources here and here). The fate of PASOK is a fascinating example in voter repositioning and the cost of inertia, lasting bad governance and bad luck in the face of crisis. Exactly the same could have happened had New Democracy not lost that fateful election in 2009.

Greek polling

Renegotiating the debt is a good idea, and really an inevitable step, the alternative to which is a disorderly default. The underlying assumptions necessary to make debt sustainability possible are, in my opinion, unrealistic. The figure below shows some of the assumptions underlying the DSA conducted by Darvas, Sapir and Wolff (2014), as well as their results:

Darvas, Sapir and Wolff (2014) - Greek DSA by Brugel

 

The optimism is patent in the comparison of the above yield curve (Figure 4) with 10yr rates over the last 12 months.

Greece 10yr govvies _ 2014-15

Given the inevitability of this development in Greece and perhaps other European countries, it is in the interest of all parties concerned to actively and credibly engage in any further negotiations. A disorderly default would be bad for Greeks, whose central bank is holding on to about 10% of most of the bonds that will be defaulted on and whose financial system might collapse. It would also be bad for its European partners who are holding on to around over half of the country’s debt, worth EUR187bn.

So what would a renegotiation look like? – In my opinion it would fit somewhere between debt forgiveness a la Paris Club, an agreement for (the ECB and) the EFSF to exchange their holdings for zero coupon perpetuities (which would allow Greece to just phase out the pricipal over the coming centuries.) or a full fledged default. I’m on the side of zero-coupon perpetuities (in a sense it’s a more extreme version of what happened to the USA), but it has to only apply to ESM-held bonds. The ECB would not be able to participate, but in principle, it could sell his holdings to the ESM, let the ESM do the exchange and then repurchase them as zero-coupons(or not).

Finally, watch closely. Whatever happens in Greece will be a template for renegotiations with other peripheral coubntries like Portugal and Cyprus.

Syriza has now established itself as a credible interlocutor. Sure, it has crazy voices from within and it has a coalition partner that has on more than one occasion demanded that Germany pay WWII reparations. However, assuming that Tsirpas can maintain party discipline, which is a big IF, he may just have the necessary bargaining power to renegotiate Greece’s debt. He is not a messiah and his the utopian among his jubilant supporters will inevitably be disappointed. But he may just have enough credibility to get something from his partners. They should seek to make a deal with him. If a deal is not reached, a disorderly default will definitely follow. However, in my view the worst thing is that if Tsirpas failed, Greece may shift to the other extreme and the fellows at Golden Dawn seem much less pleasant…

 

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