The Cost of a Haircut: Greece, Eurozone, IMF

NEW YORK (TheStreet) -- Earlier, I noted there were two parts to the International Monetary Fund Stand-By Program for Greece: austerity and increasing its competitiveness. However, by the beginning of 2012, the IMF had concluded that the austerity part of its plan for Greece had failed. Why?

Because:
  • the austerity measures were so extreme that initial efforts to implement them made things worse (slower growth, shrinking government revenues, and higher unemployment); and,
  • the measures were politically impossible to implement -- instead, governments fell and there were riots in the streets.
  • On July 4, the IMF estimated that GDP would decline by 4% in 2011 and by 1% in 2012. Six months later, the IMF concluded GDP would fall 6% in 2011 and another 4% in 2012.

    IMF estimates were wildly optimistic on unemployment as well. Last July, it projected unemployment at 16% in both 2011 and 2012. Six months later, the fund raised the projection to 18% in 2011 and 20% the following year.

    To its credit, the fund saw what was happening and gave up on austerity measures. Its Stand-By Program was ended early, and its new Extended Fund Facility Program emphasizes labor market reforms and other measures to make Greece "competitive."

    Germany continues to have a different perspective: more austerity. And to that end, it forced other euro countries to accept a European Union treaty amendment: Government deficits should be no more than 1% of GDP. Because the IMF (at least for now) has given up on austerity while Germany and other strong euro countries still promote it, a rift between the IMF staff and euro countries has developed. But while the euro countries are more supportive for Greece, the IMF remains in control of what gets done: it set the conditions for disbursements and it polices them.

    Old and New Programs

    The first bailout program for Greece was 110 billion euros, with the IMF Stand-By providing 30 billion euros (27%) and euro countries providing 80 billion euros (73%). Table 1 provides details on disbursements and cancellations.

    Table 1. -- Original Greek Bailout Funds
    (in billions of euros)

    Table 2 projects disbursements under the IMF's new Extended Fund Facility and eurozone support. The fund has agreed to quarterly payments of 6.2 billion euros, provided Greece achieves numerous qualitative and quantitative performance targets. The euro countries have promised 144.1 billion euros for the 2012-to-2014 period. That will make its share somewhat larger than in the first program.

    Table 2. -- Second Greek Bailout Program

    The Private Sector Initiative (PSI)

    According to the Greek Invitation to Participate, the Greek government will exchange each 1,000 euros of existing debt for 315 euros face amount of new bonds plus 315 euros notional amount of GDP-linked securities plus 150 euros aggregate face amount of PSI payment notes. What is the real value of this exchange? Who knows? Who cares?

    Banks and other financial institutions will have a great time packaging and reselling this stuff. The Greek Invitation indicates that approximately 197 billion euros of securities qualify for the exchange, but for various reasons, the amount exchanged will be less. Does the size of the haircut really matter? In the short run, it matters to banks and other financial institutions taking the haircut. In the long run, for reasons discussed later, probably not so important.

    Most important in the PSI agreement are its grace period and its low interest rates.

    For PSI subscribers, there will be no principal or interest payments for 11 years. Interest will accrue, but at low rates: 2% in 2013 to 2015, 3% in 2016 to 2020, 3.65% in 2021, and 4.3% in 2022 and thereafter. But no principal or interest payments on the exchanged debt before 2023! Think about that, 11 years. And a lot can change in 11 years.

    Financing Needs

    Greece has two financing needs -- the government and its balance of payments deficits. Consider first the government deficit. The IMF's estimates are presented in Table 3.

    Table 3. -- Greece: Government Financing Needs, 2010-2016

    With the PSI amortization, the gap looks reasonable. More of the euro support can be used in 2012 when the financing gap is the worst. The bottom line in Table 3 gives debt obligations not part of the PSI. These must still be paid.

    The IMF's projections for 2013 and on? Based on its track record, it is reasonable to assume they are too optimistic. But who really knows? There will be new elections, a new government, more riots in the street and higher unemployment (the IMF is projecting 19.4% for 2013 -- I will give you odds that it will be higher).

    Competitiveness: The Long-Term Problem

    So far, the focus has been on Greece's immediate financing needs and the IMF/euro efforts to ensure they are covered. But what is the real problem? Greece cannot compete with the strong euro countries. The IMF knows this, and in developing its programs for Greece, the fund was cognizant of that fact. The evidence for this comes from efforts to determine exchange rates at which countries' balance of payments will be in equilibrium. The results are far from certain, but the IMF estimates that Greece has an 11% competitiveness gap (and it might be as high as 33%). This means production costs in Greece are too high for its balance of payments to be in equilibrium.

    There are two ways such imbalances are reduced in most countries:
  • Wages and other costs fall as a country loses jobs to foreign producers, and
  • a country's currency loses value relative to other currencies.
  • The U.S. is a good example. Back in the 1980's, Japan became extremely competitive as an export nation. Just as today with China, Japan was then an "Asian tiger." In 1985, a U.S. dollar would buy 239 yen. Today, a dollar only buys 83 yen. That exchange rate adjustment helped with the U.S. competitiveness adjustment.

    The problem with Greece is that as long as it is in the eurozone, none of the competitiveness adjustment can come through the exchange rate. It must all come through lower production costs from costs and other internal efficiency adjustments in Greece.

    So the IMF's latest program is intended to make Greece competitive with Germany. This is not something the IMF is normally asked to do. Is it possible? I doubt it. How about Italy, Portugal, and Spain? Will they ever be able to compete with Germany? Probably not.

    This lack of competitiveness manifests itself in Greece's current account balance. More specifically, the problem is that Greece imports more goods than it exports (Table 4).

    Table 4. -- Greece: Selected Balance of Payments Items

    Note one other troubling feature here. The Greek unemployment rate is almost 20%. If and when Greece recovers, the demand for foreign goods will increase . . . .

    Eleven years is a long time. Will the size of the haircut really matter? It should be interesting.

    Elliott Morss is an economic consultant and an individual investor in developing countries. He has taught at the University of Michigan, Harvard University, Boston University, among other schools. Morss worked at the International Monetary Fund and helped establish Development Alternatives Inc. He has co-written six books and published more than four dozen articles in professional journals.

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