The Troika vs Greece

By Felix Salmon
January 30, 2012

Are you worried about Greece failing to come to some kind of agreement with its bondholders? If so, you’re far behind the curve. Because the new big worry is that Greece will fail to come to some kind of agreement with the Troika — the official-sector entities which are going to fund its deficits for the foreseeable future.

To understand what’s going on here, you really need to read two different things. The first is the latest paper from Mitu Gulati and Jeromin Zettelmeyer, entitled “Engineering an Orderly Greek Debt Restructuring”. It’s clear, it’s clever, and it explains exactly what Greece’s options are. The second is the leaked document from Germany, which has effective veto control over the Troika, laying out proposed conditions under which it’s willing to continue to fund Greece.

The mechanics of a Greek debt restructuring, as laid out by Gulati and Zettelmeyer, are absolutely fascinating to a sovereign-restructuring geek like me. But I’m not going to get into the details here. Suffice to say that in order for the restructuring to work, the Greek bonds currently held by the ECB need to be tendered into the exchange, somehow. There are various ways that this can happen: the ECB can tender its bonds directly; it can sell them to the EFSF, which would then tender them; or it could even sell them to Greece, which would tender them. But what it can’t do is sit back and continue to collect interest on those bonds while expecting all the private-sector bondholders to voluntarily take a massive haircut. Too many hedge funds own Greek debt now; if the old bonds continue to get paid out, then the hedge funds will simply refuse to tender, and the exchange offer will fail.

The point here is that the Greek bond exchange has to be worked out in very granular detail with the Troika, because the ECB is going to have to play a central role in making it work. If the markets think for one minute that the ECB’s bonds won’t be tendered into the exchange, the deal is almost certain to fail. On the other hand, as Gulati and Zettelmeyer explain, if the ECB’s bonds are certain to be tendered into the exchange, then Greece can structure a deal where it makes no sense to hold out at all, since holdouts would end up with illiquid and hair-cut Greek-law bonds, while anybody tendering would end up with English-law bonds which had much stronger bondholder protections and much greater liquidity.

So, what’s the Troika going to demand, in return for cooperating with the exchange and helping to ensure its success? More of a fiscal union, that’s for sure — which means real European control over how and where Greece spends its money. As the leaked document explains, “Greece has most likely missed key programme objectives again in 2011,” and “will have to significantly improve programme compliance in the future”, by “shifting budgetary sovereignty to the European level for a certain period of time”. That’s the reality of how bankruptcy works: if you run out of money, then anybody willing to lend you money can generally call whatever shots they want. And the fact is that monetary union, as we’ve seen, simply can’t work if there’s no fiscal union, with Europe having some kind of fiscal control over its member states.

The big problem with the leaked document is not the violation of Greek sovereignty, then. Rather, it’s the manner in which Greece’s new fiscal overlords are intending to treat the country’s debt burden. “Greece has to legally commit itself to giving absolute priority to future debt service”, it says, which is fair enough — California does something similar. Some bondholders like such things. But they don’t mean much to me: as I said in the Californian context, if you can break your promise when you default, you can break your promise to privilege bonded debt over other obligations, as well.

But the document goes significantly further than just giving Europe a say in Greece’s fiscal decision-making and asking for largely-meaningless promises from Greece. Check this out:

De facto elimination of the possibility of a default would make the threat of a non-disbursement of a GRC II tranche much more credible. If a future tranche is not disbursed, Greece can not threaten its lenders with a default, but will instead have to accept further cuts in primary expenditures as the only possible consequence of any non-disbursement.

In English, what this means is that Greece has to open itself up to a double fiscal whammy. Greece is going to be running deficits for the foreseeable future, and needs to get the money to cover those deficits from the Troika. Now, what happens in future, post-restructuring, if Greece gets into a fight with the Troika, and the Troika doesn’t give Greece the money it needs? As things stand, that would be a very bad outcome indeed. Greece could default on all its debt obligations, but it’s still running a primary deficit, so it would need to make even bigger fiscal cuts, or try to raise taxes even more, in order to bring its budget into balance. The result would be worse austerity, and an even deeper recession.

Under the German proposal, things get significantly worse than that, for Greece. Essentially, if the Troika cuts off funding, then Greece still needs to make all of its debt payments, on top of its primary deficit. The resulting austerity would be devastating — as Germany, of all countries, should know. After all, the burden of crushing German obligations after the Great War was largely responsible for the rise of… OK, enough. I’m not going Godwin here. But the point is that Germany is trying to take away Greece’s option to default. Interfering with Greece’s fiscal sovereignty is one thing, but this goes way too far.

I can see how Europe might want to give itself some kind of control over total expenditures and revenues in Greece. But the relative priority of expenditures — whether Greece wants to spend its tax revenues on debt repayment or on hospitals, for instance — must be left to the Greeks.

The reason all of this is going on, of course, is that the Troika’s interests and Greece’s are far from aligned. The Troika wants to stop having to fund Greece, and therefore wants Greece to regain access to private markets as soon as possible. Greece, on the other hand, is more interested in domestic growth at this point, so long as the Troika will continue to provide funding while private markets are closed. At the margin, then, the Troika wants more fiscal constraints (and hoped-for access to bond markets in future), while Greece just wants to get out of recession and start seeing some kind of light at the end of the tunnel.

Or, put it another way. Greece wants long-term debt sustainability, which means growth. The Troika, on the other hand, is less interested in the long term: it just wants the private sector to take over in terms of funding Greece as soon as possible. And the private sector, while it does care about long-term debt-sustainability calculations, also cares about many other things, like governing law and the constitutionality of default and the probability that Greece will continue making bond payments even if Troika funding dries up.

All of which means, weirdly, that bondholders would be better off lobbying the Troika than they are negotiating directly with Greece. After all, the Troika is really calling the shots here. And the Troika wants bondholders treated extremely well — after the restructuring. So if bondholders want things like English-law bonds and constitutional amendments, they should probably be asking the Troika for them, rather than Greece. Greece has no real reason to give them such things. But it can easily be forced to, if that’s what the Troika demands.

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