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Beware Greek Debt Cut Figure
As we reported this morning, representatives of the Institute for International Finance put forward a new proposal to euro-zone governments last night in an effort to break the deadlock over Greece’s debt deal ahead of today’s European summit.
We couldn’t immediately learn the details, except for one snippet: The new proposal suggests a different discount rate being used to calculate the headline figure for the private sector contribution for the debt exchange.
So what? To explain, let’s back up a bit to the July 21 agreement by euro-zone leaders on a bond exchange that would reduce the net present value* of Greece’s debt by 21%–using an annual discount rate of 9%.
Since then, circumstances have changed. Germany has been seeking a 60% reduction. The International Monetary Fund has been arguing that even more is required to put Greece’s debt on a sustainable footing, a position which implies a forced debt restructuring.
The IIF has been nearer to 40%, and has been insisting it is voluntary. France, Spain, Italy, the European Central Bank and the European Commission, which would prefer a ‘voluntary’ deal which is difficult to make effective as the debt reductions get deeper.
But these debt-reduction numbers convey less meaning than they appear to, because they are very sensitive to the discount rate assumption. If the assumed discount rate is increased, you can also increase the headline debt reduction without changing the losses to bondholders.
So it’s likely that the IIF has shifted up the headline debt-reduction number, while also increasing its assumed discount rate. That would mean that the up-front hit to bondholders isn’t as great as the shift in the headline figure would suggest.
Given that the market yields on Greek bonds have risen significantly since July, the IIF has a point in suggesting a higher discount rate should be used for investors. Problem is that for Greece’s debt sustainability such a high discount rate is irrelevant: what’s relevant for Greece is its ability to pay its way—in other words, increases in nominal GDP**.
From this standpoint, given negative real growth, the appropriate discount rate from the Greek point of view is at most zero.
The assumed discount rate is also irrelevant to Germany and the other official creditors of Greece. German officials say their bottom line is to put in to Greece little more than the extra €109 billion that the official creditors signed up to in July. Thus, they are unlikely to be impressed by arguments about a higher discount rate, either.
There may not be any agreement today. But if there is, here’s the second cautionary note of the day following our earlier post about the size of the EFSF: Beware any headline numbers about Greek debt reduction.
* The net present value of a bond is calculated by adding together all the cash flows—each regular coupon payment followed by the final repayment of capital—with each bit of cash progressively reduced by the discount rate as each year passes.
** Nominal GDP=Real Growth + Inflation
