Is the Greek PSI Sweetener Enough?

By Marc Chandler

The private sector involvement to reduce Greece’s debt burden remain unresolved. Officials continue to talk as if it will still be any day now. Some observers attribute the euro’s firmer tone today to greater confidence now that a new twist has been added.

Essentially, what is being proposed to entice participation and allow a reduction in the anticipated coupon of the new bond is a warrant (option) that is tied to the performance of the economy. The better the Greek economy does the greater the value of the warrant. The early indication is that this is being suggested to be worth 0.5%-3.0% (depending).

Fitch is still warning that Greece will default on the March 20 bond maturity. However, the apparent new twist is that it does not expect it to leave the monetary union. Many observers still expect (and believe) Greece and the euro zone would be better if it left monetary union.

We have argued the opposite: that the euro area would not stabilize as the risk of others being forced out increases; that Greece’s woes would intensify and that whatever competitive gain it enjoys by a weaker currency is more than offset by higher inflation.

The economic contraction, in its fifth year, would be considerably deeper and it does not have the industrial capacity to boost exports significantly in the short-run. It is counter-intuitive that the an economy in such a slump continues to run a substantial current account deficit. Once a PSI agreement is struck, attention will shift to three other key issues. First, is the participation rate sufficient?

Second, even if the private sector participation sufficiently high, will it be enough to put Greece’s debt on a sustainable path? This seems unlikely and there is increasing risk that the ECB forgoes getting anything but its initial investment back (estimated savings for Greece is around 10 bln euros, assuming the ECB holds a conservative 40 bln euros of Greek bonds, acquired at a 25% discount). As we have suggested, the national central banks may take a larger haircut on their Greek bond holdings.

Third, the second aid package for Greece may have to be larger than the 130 bln already mooted. The creditors, including Germany, seem reluctant at this stage to pony up more.

While European officials do not seem to tire of claiming that Greece is unique, many, if not most, investors are unconvinced. Not only does Greece offer a precedent for other troubled euro zone countries, but some of its policy response by also have wider application. For example, the pro-cyclical nature of the fiscal policy in Europe needs to be broken. The GDP-linked warrants ("the sweetener") are scalable and ought to be explored by other countries.

We have also suggested that Greece and other peripheral countries should explore issuing samurai bonds under a Japanese Bank of International Cooperation program that insures part for the bond. We have suggested that Greece cuts its defense expenditures, which run close to twice other euro zone members as a percentage of GDP. We have suggested that Greece take a closer look at the World Bank’s "Doing Business" and recognize a number of low cost measures to boost entrepreneurship. It currently is among the least competitive economies in the world.