29 June 2015

The seven stages of Greece’s debt tragedy

Jason Manolopoulos

How did we get here, and why is it lasting so long? Here is how the drama has being playing out between Athens and Brussels

Different cycles influence a country’s economy: the business cycle, the credit cycle, the regulatory cycle, the moral cycle. One that is seldom talked about is the debtor-creditor cycle. George Soros deftly describes the relationship between creditors and debtors as “the collective system of lending” in Alchemy of Finance.

In Greece’s case this cycle is of particular importance, as Greece needs a significant debt haircut in order for the economic cycle to restart. While that is not the only prerequisite, it is still essential.

The drama that has been playing out between Brussels and Athens is part of the debtor-creditor cycle, the various phases of which can be broadly summarised as follows:

1. Willing debtors – willing creditors

For the past three decades Greece enjoyed, to its later regret, a massive credit boom. For its citizens, this led to a short-term increase in wealth, as households borrowed more and the state received significant subsidies from EU aid funds for poorer regions.

On the other hand, Greece’s competitiveness was rapidly declining; higher wage costs made industry less profitable and exports less competitive. At the same time, ominously, productivity was deteriorating. This stage ended back in 2009.

2. Debt crisis and ‘rescue’ packages

The cycle inevitably turns and debtors have to either restructure or default on their obligations. Creditors usually form a consortium in order to protect their initial investment. This is formed on the fictional belief that outstanding loans will not be impaired. New cash is injected by the consortium to the debtor; in return for austerity measures.

On the debtors’ side, the main objective is to keep access to funding without lowering their standard of living. With the consortium’s attempt to share the burden of the effort, debtors and creditors feel equally discontent: in this case, Germany and other “core” countries resent contributing to bailouts, as their taxpayers must continue to “throw good money after bad”. Greece unwillingly agrees to austerity measures, while promising to keep new borrowings at a minimum. The definition of minimum is open to interpretation and gives rise to much angst, as we can see.

3. Austerity and recession

Austerity measures in Greece resulted in a sharp decrease in domestic consumption that further prolonged the recession. Debt servicing costs remained high, but a small relief was accomplished. Minor improvements in the trade balance were considered inadequate and some discussions towards a restructuring of the public debt commences. Greece went through this phase in the winter of 2012.

4. The deadlock

Although both parties would be better off striking a deal, each acts in its own interest; the result is both are worse off. Funds gathered by the creditors are limited; intensifying pressures on the debtors. Creditors continue to receive interest payments, while the debtors’ living standards collapse. The stalemate holds only through the mutual threat of a complete breakdown. In the past five months Greece has been dangling in the precarious deadlock phase again and again.

Interestingly, Greece’s case shares striking similarities with Latin America’s troubles in the 1980s. In 1982, Mexico warned about its inability to service its debts. Repeated rounds of restructurings offered no viable solution. Only after a devastation of local incomes, a collapse in the currency and the standard of living did a consensus emerge on debt relief. Confidence was restored, growth resumed and Mexico regained access to capital markets.

Hopes have risen of a debt haircut for the official sector, as creditors are now discussing it

5. Adjustment begins, leniency returns

At a certain point, the economy readjusts and competitiveness returns. Eventually creditors become more lenient and provisions are booked against future losses. It typically takes five to 10 years for lenders to accept these impairments. We are now in year five since Greece’s initial bailout.

6. Increase in economic activity

By 2014, Greece was expected to have regained the loss in competitiveness it experienced from 1995 to 2010. However, this does not mean a better standard of living for the Greeks, as surpluses are funneled to debt servicing. Growing inequalities appear and may result in rising extremism. In this phase, the discontent among citizens could lead to “accidents” – reversing the recovery process. Greece was transitioning out of this phase when the snap Greek elections were held.

7. Sustainable recovery

Exports rise at a faster pace while domestic demand picks up. As growth reappears, debt servicing costs come down and the rising tide lifts the wider society.

Prior to January’s elections, Greece oscillated but progressed between stage 3 and 6. Economic data indicated that a slow recovery was underway. However an austerity-fatigued electorate combined with the creditors’ unwillingness to grant concessions led to a victory for the Syriza party. These prolonged negotiations have had a direct impact on the economy, halting the recovery process. Greece now has to implement more austerity to regain confidence and close the budget gap.

On the other hand, hopes have risen of a debt haircut for the official sector, as creditors are now discussing it. Judging from the above, growth might still be elusive or just around the corner – it all depends on whether Greece and its creditors are willing to face reality.

There are more stages to go before any hope that Greece can permanently exit this crisis.

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