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Greece must restructure its debt or face a messy default

By George Irvin, Special to CNN
  • Greece is due to repay over half of its outstanding €330 billion in debt by 2015
  • Irvin: More austerity will cause GDP to contract even faster
  • Greece must insist on a sensible restructuring, says Irvin

Editor's note: George Irvin is Professorial Research Fellow at the University of London's School of Oriental and African Studies (SOAS). He is author of Regaining Europe: an economic agenda for the 21st Century, London: Federal Trust, 2007.

(CNN) -- The question of whether Greece should restructure its debt has acquired a rhetorical ring -- the country has few options left. Greece is due to repay over half of its outstanding €330 billion in debt by 2015 -- that compares to its earnings (gross domestic product) of just €210 billion a year in 2011, with an economy which is contracting and a workforce which is going on strike.

Furthermore, for Greece to return to a sustainable path given current market interest rates would mean doubling taxes or cutting government spending by 75%, so the country is being supported by its eurozone peers and the International Monetary Fund, because the numbers don't stack up.

The fact that Mr Papandreou's new government has managed to survive a vote of confidence and now seems likely to drive through parliament the new round of cuts demanded by Brussels hardly matters. More austerity and misery will merely cause GDP to contract even faster, thus making it impossible for Greece to lower its debt to GDP ratio and budget deficit in the medium term.

I'll spare you the detailed numbers: Martin Wolf of the Financial Times has argued the case convincingly. A more sensible question is whether a managed default on that debt -- in other words, paying back less than what was borrowed with the assent of its creditors -- can be arranged? Or will Greece be forced to default without the support of its peers in the eurozone?

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A managed default is one that does not destroy the country's banking system, paralyze production, produce wage cuts far deeper than imposed by bailout conditionality and spread serious contagion.

Proposals exist for creating a European mechanism for restructuring sovereign debt. In the Greek case, much depends on timing since the next tranche (worth €12 billion) of the current EU/IMF loan is due in late July. If eurozone (EZ) ministers continue to disagree about terms for this disbursement, or more generally on a new Greek loan programme between now and their next meeting on 11 July, not only could political pressures in Greece lead to an uncontrolled unilateral default -- euphemistically termed a "credit event" -- but the effects of default could well spill over into Spain, Italy and even Belgium.

How would a managed default work? The Greek banking system (including the Greek Central Bank) holds about 40% of domestically-issued Greek sovereign debt and 60% is held by the ECB and multitude of private banks, chiefly in France and Germany.

The actual figure held by private banks may be smaller since they have been reducing their exposure while the ECB takes up the slack. Critically, eurozone ministers and the ECB would need to agree on a package of debt restructuring. In order not to trigger a "credit event," such debt restructuring would be "voluntary" and involve exchanging the old debt for new debt that has the same face value but much longer maturity and lower interest rates. This is the preferred outcome of many economists.

Suppose that the repayment date on sovereign debt were increased to 20 years and the coupon reduced to a near-German level of 3% (the current averages are 7.5 years and 4.5%). Greece would be better off in that it could obtain new EU finance, and its required budget surplus needed to service debt interest would fall significantly.

More austerity and misery will merely cause GDP to contract even faster, thus making it impossible for Greece to lower its debt to GDP ratio and budget deficit in the medium term
--George Irvin

How does the above scenario compare with total default? Total sovereign debt repudiation -- followed almost certainly by Greece's immediate exit from the euro -- may have considerable emotional appeal, but it would not lead quickly to the country's solvency. A "new drachma," even ignoring the administrative and legal difficulties of its rapid introduction, would have a market value far below that of the euro. Because the assets of the Greek banking system are denominated in euro, a return to the drachma would require massive bank recapitalization. Household debt, such as credit cards and mortgages, would need to be paid back at a higher drachma price.

Moreover, although a large drachma devaluation would make exports far cheaper, necessary imports would be far dearer, resulting in serious inflation.

If the government froze nominal wages, the real wage would fall leading to further political unrest. In the short term at least Greece would find it almost impossible to borrow. Uncontrolled default combined with a euro-exit would not be pretty.

The irony of the current situation is that EZ finance ministers appear more likely to try to muddle through -- awaiting 2013 when the new bailout fund, known as the European Stability Fund (ESF) emerges -- rather than to opt for a controlled default now of the sort outlined above. But muddling through will simply reinforce the view of the financial markets that sooner or later Greece, and perhaps Ireland and Portugal too, must default unilaterally. Eurozone ministers are playing a very dangerous game; Greece must insist on a sensible restructuring.

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