Commentary | 07 August 2015

Time for Europe to take Greek lessons from Asia

Time for Europe to take Greek lessons from Asia

Stephen Grenville

Nikkei Report

7 August 2015

Click here for the online text.

  • Stephen Grenville

Time for Europe to take Greek lessons from Asia

Stephen Grenville

Nikkei Report

7 August 2015

Click here for the online text.

  • Stephen Grenville

Executive Summary

Having teetered on the brink of exit from the euro in July, the Greek government has agreed with its creditors to negotiate a rescue package worth 86 billion euros ($94 billion) that would keep Greece afloat for the coming three years in return for painful economic reforms. The agreement is due to be finalized in mid-August.

No one disputes the judgment of the International Monetary Fund that Greece's existing debt burden, equal to about 200% of gross domestic product, is "unsustainable," but the reforms demanded by the creditors will delay economic recovery. A fresh start is needed that separates the debt hangover from the structural reforms, and Asian history can provide the model for this.

In 1966, the Indonesian economy had collapsed, with rampant hyperinflation, a valueless currency and an unpayable foreign debt burden resulting largely from purchases of Russian military hardware. Debt payments due in 1966 (including arrears from the previous year) amounted to 130% of the value of exports. Politics was in fragile transition from one autocratic leader -- Sukarno -- to another -- Suharto, who finally assumed the presidency in 1967. It is hard to imagine bleaker economic prospects.

Despite this seemingly hopeless outlook, Western creditors and Japan met in Tokyo to chart a way forward for the old debt and for new aid. In the Cold War era, problems like this were seen by the Western allies in geopolitical terms, as opportunities to influence global events. This provided a breadth of vision that we have since lost.

The debt negotiations were mediated by Hermann Abs, Germany's most experienced banker. He knew about unsustainable sovereign debt from personal experience: He had led the German delegation at the 1953 London Debt Conference, which slashed Germany's debt and laid the foundations for the country's extraordinary post-war revival.

The agreement that was eventually reached rescheduled the Sukarno debt to spread repayments over 30 years, interest free, and with the possibility of postponing the first eight years of repayment. There was no reduction in the nominal value of the outstanding debt, but the delay in repayment and the zero interest rate dramatically reduced the real value of the debt, making repayment feasible, provided the Indonesian economy recovered.

There were no conditions of the kind that are being required of Greece. Nothing was done to supervise Indonesian domestic policy, beyond making available sympathetic guidance from the IMF and the World Bank. Those who argued in 1966 for this kind of conditions-free debt forgiveness took a bold gamble that an unknown army general and a small group of academic economists (later dubbed the "Berkeley Mafia") with no practical policy-making experience could get Indonesia's economy working normally again. The gamble paid off. It was the watershed that put Indonesia on the road to three decades of 7% annual growth under Suharto.

In the ensuing years, this simple model of debt-forgiveness has been forgotten. It is not as if the problem has gone away or a better method of sovereign debt resolution has been invented. There is still no sovereign equivalent of domestic private-sector bankruptcy procedures, which would trim the debt to fit the diminished repayment capacity of the debtor, thus allowing the debtor to resume normal activity. Argentina in 2001, Iceland in 2007, the European Union's peripheral states (Spain, Ireland and Portugal, as well as Greece) in 2010 and more recently Ukraine -- all illustrate the impasse into which sovereign debt rescheduling has fallen.

The political power of the creditors has delayed or prevented quick acceptance of the inevitable -- the realization that the debt could not be repaid in accordance with the initial terms. Creditors have used all forms of pressure, some akin to blackmail, in pursuing their own interests -- as is being demonstrated with Argentina's current debt problems. Sometimes this heavy-handedness works for the creditors. In 2010, fraught financial markets convinced the authorities (including the IMF) that if Greece defaulted, there would be a run on the other EU peripheral countries and a second-round global crisis.

Haircut

In response, the IMF broke its long-standing rule that it lends only when there are good prospects that the debtor will be able to repay. This was clearly not the case for Greece in 2010. By 2012 a second round of debt deliberations was needed. By this stage, many of the private sector creditors had been repaid. The others were offered repayment with a "haircut" -- a reduction in capital repayments -- that subsequent events have shown was not deep enough. The remaining Greek debt is still unpayable.

Over the past decade the IMF has made several valiant efforts to put in place more sensible sovereign debt restructuring procedures and principles, but it has always been thwarted by intense lobbying by the financial sector, which hopes to avoid having to incur the full cost of its careless lending.

When the latest Greek program fails (as it inevitably will), what about using Indonesia's 1966 experience as the basis for a fresh start? Negotiators could even take an element from the 1953 German debt treaty, in which it was recognized that repayments should be linked to repayment capacity. The quicker Greece becomes a healthy economy, the more likely it is to repay its debts. This gives everyone an interest in a Greek recovery.

The missing element in the negotiations to date is a recognition that the debt overhang needs to be dealt with definitively so that it no longer weighs down the prospects for recovery, acting as a wet blanket on any prospective investment and preventing a return to economic normality. The 1966 Abs model achieves this objective.

Rescheduling over 30 years with no interest payments reduces the present value of the debt so much that it makes repayment credible. Providing the option of delaying the first eight years of payments gives the debtor breathing space to regain normality. Leaving the face value of the debt unchanged (no "haircut") lets the creditors continue with the fiction that the value of their debt is unaffected. This makes the settlement more palatable politically and creditors' balance sheets can remain unadjusted.

In 1966 Indonesia was not given a long list of challenging externally supervised conditions to fulfill, and yet the economy revived dramatically. Nor was Germany in 1953, when its debts were halved and the way was open for its rapid post-war revival. To weigh the agreement down with a Brussels-formulated wish list of non-essential structural reforms such as deregulating trading hours is reminiscent of the IMF's conditionality in Indonesia in 1998, in the wake of the 1997-98 Asian financial crisis, when conditions extended to a requirement to dismantle the country's clove trading monopoly. This kind of detailed intervention does not work. Greece has already labored mightily on its budget, which is now in near-balance (excluding debt repayments). Fixing the tax system will take longer, but unrealistic targets are no help.

Greece's creditors need a new approach. To find it, they should look at Asia's recent history.

 

Stephen Grenville, a former deputy governor and board member of the Reserve Bank of Australia, is a visiting fellow at the Lowy Institute for International Policy in Sydney and a consultant on East Asian financial issues.