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ViewpointsJuly 2011

How to Orchestrate an Orderly and Credible Restructuring of Greece’s Debt

Myles E. Bradshaw, CFA Senior Vice President, Portfolio Manager Mr. Bradshaw is a senior vice president and portfolio manager in the London office, focusing on U.K. portfolios and pan-European strategy. Prior to joining PIMCO in 2007, he worked at Threadneedle Investment Managers for six years, managing global and sterling bond portfolios. Mr. Bradshaw started his career as an economist at HM Treasury, where he worked for three years. He has 12 years of investment experience and holds an undergraduate degree from Oxford University.

Ahead of the European Union summit on Thursday, markets are bracing themselves for a restructuring of Greek debt. I don’t want to dwell on the various reasons for this, but suffice it to say that we don’t expect Greece to issue bonds as planned in 2012. Political support for additional loans to Greece without any bondholder bail-in is low, especially from Germany and other core eurozone countries. Instead, I want to discuss what a Greek restructuring could look like – and now that the contagion has reached Italy – what can be done to contain contagion risks. While the question of when Greece should restructure its debt is mainly a political decision – though it increasingly looks like it could happen this year – how it should restructure its debt remains an open question. Any eventual restructuring plan would also be decided by politicians, but its impact would be influenced by a range of reactions. Before speaking to this, it is important to identify the objectives of a “relatively orderly” restructuring: 1. To provide debt reduction and solvency relief for Greece – but it is important to note

that a potential debt restructuring would not necessarily remove the need for fiscal austerity and structural reform, as both these are necessary to achieve a primary surplus and recover competitiveness – nevertheless, it can reduce the execution risks.

2. Win political support in creditor European Union (EU) countries – particularly in Germany, Netherlands and Finland – and with the International Monetary Fund (IMF) for continued financial support for Greece.

3. Identify the unintended consequences of restructuring, namely potential contagion and the accompanying policy measures that could counter a disorderly process.

Solvency Relief for Greece Identifying how much solvency relief Greece needs is complicated, not least because there is no magic debt ratio that is sustainable. Debt “sustainability” is often defined as a function of a sovereign’s debt load, nominal interest rates, the primary surplus (i.e., fiscal balance before interest payments) and nominal GDP growth. A restructuring must either reduce the debt load and/or lower the interest rate. This serves to lower the primary surplus that Greece must achieve in order to stabilize its debt over time. And fortunately for Greece, the austerity measures that can be scrapped would be a multiple of this change in the fiscal target. That’s because by taking less money out of the economy, growth should be stronger, tax revenues higher and public finances healthier (this is the so-called fiscal multiplier). Lower interest payments should also serve to reduce Greece’s

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ViewpointsJuly 2011

financing needs and help buy political support in Germany and elsewhere. Restructuring therefore reduces execution risk and increases the political viability of the plan from the perspective of both Greece and the EU. For example, Figure 1 shows how a hypothetical 1% interest rate cut and €30 billion debt write-off –possibly via debt buybacks financed by the European Financial Stability Fund – would change the primary surplus target for Greece, reduce the austerity required (after taking account of the fiscal multiplier), and show the impact it would have on annual financing needs in the form of interest payments saved. As context, the new IMF program anticipates austerity measures worth 10.4% GDP in total to target a primary surplus of 6.4% GDP in 2014. In other words, to make a difference, debt worth more than €30 billion (the target figure set by EU ministers) has to be restructured.

Fiscal Savings from 1% Cut in Interest Rates  and €30 Billion Reduction in Debt Stock 

Debt stock (€ billions)

Change in primary surplus required to

stabilize debt in 2011 ¹

Fiscal austerity avoided due to solvency relief ²

Interest savings (€ billions)

Cut rate on all debt (end 2011) 373 1.50% 2.3% 3.7 Cut rate on all European Financial Stability Facility (EFSF) loans until 2012 80 0.30% 0.5% 0.8 Cut rate on all private debt (end 2011) 317 1.30% 2.0% 3.3 Cut rate on €30 billion private debt (end 2011) 30 0.01% 0.0% 0.0 €30 billion reduction in debt outstanding (end 2011) 30 0.10% 0.2% 1.5

Hypothetical example for illustrative purposes only.

¹ Debt stabilizing primary balance using IMF June forecasts and derived as [(r - p(1+g) - g)/(1+g+p+gp)] times previous period debt ratio, with r = interest rate; p = growth rate of GDP deflator; g = real GDP growth rate ² Assumes a fiscal multiplier of 0.67 (simple average of estimates from March 2009 economic outlook) and 0.5 elasticity of fiscal deficit to GDP growth Sources: PIMCO, IMF. As of 30 June 2011

Figure 1

 Extending the maturity of debt is important but on its own it is insufficient. A maturity extension of short-term bonds may reduce Greece’s refinancing needs and therefore make the sovereign less vulnerable to a change in creditor sentiment. But it may only improve debt sustainability if Greece can raise GDP growth in the interim. Winning Political Support from Creditor Countries and the IMF Identifying how much political capital might be bought in EU creditor countries and beyond is more straightforward. If we include the very optimistic (€32 billion) privatization receipts, Greece needs an additional €105 billion of funding between 2011–2014. Based on our forecasts, if this all came from the official sector it would lift the share of debt owed by the official sector, the European Central Bank (ECB,) and domestic financial institutions to 81% by 2014. This means that the official sector would bear the brunt of any subsequent restructuring after 2014 (see Figure 2). The extent to which a debt

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restructuring hinders additional official sector support will signal how politically viable any eventual restructuring plan is likely to be.

Official Sector Ownership of Greek Debt  Assuming No Private Sector Participation up to 2014 1 

-

50

100

150

200

250

300

350

400

450

2010 2011 2012 2013 2014

€ (b

illio

ns)

EU/IMF loans Eurosytem Domestic Greek Institutions/Investors Non-Greek Institutions/Investors

1 Assumes no return to private bond markets in 2012. Official sector fills financing gap without any private sector involvement. Sources: PIMCO, IMF, Bank of Greece. Forecasts as of 30 June 2011

Figure 2 Contagion Risks and the Necessary Policy Response Contagion risks are positively correlated with any benefits Greece might experience from a potential restructuring and are likely to arrive through three main channels: the Greek banking system, the European banking system and the payments and settlement system, and the European sovereign market. 1. Greek Banks

The Greek banking system would be the most affected by any restructuring because of its large holding of Greek government debt. According to the Bank of Greece, Greek banks held €47 billion in Greek government securities in May 2011 compared to only €28 billion of capital and reserves (excluding bad loan provisions). The first problem for Greek banks is the ECB’s insistence that Greek bonds would be ineligible as collateral in a repo transaction if downgraded to a “selective default.” This is a big deal as Greek banks currently borrow €98 billion, mainly backed by Greek government bonds or government-guaranteed paper. A withdrawal of ECB liquidity would therefore trigger a bank run in Greece and raise the odds of something similar occurring in Ireland and Portugal. But the policy response here is relatively straightforward. If the ECB refuses to waive its collateral standards for regular open market operations, it could provide liquidity for other non-government collateral, such as loans, through the Emergency

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Liquidity Assistance (ELA) program. This is currently being used in Ireland where Irish banks are receiving Eurosystem funding via the Irish Central Bank for assets that are not eligible for regular ECB open market operations. The second issue is a recapitalization of the Greek banking system. Regulatory forbearance means that Greek banks are not marking Greek government bonds to market and hence retain the fiction of healthy regulatory capital. This could continue after a restructuring but it would prevent Greek banks from returning to the market and means that the Greek international trade would be constrained by the increasingly worthless letters of credit from Greek banks. It also means that the steady depositor outflows would continue, draining the system’s lending capacity and creating the risk of a sudden loss of confidence and a bank run. The ideal policy response would be a recapitalization of the Greek banking system alongside a sovereign debt restructuring. Ideally, the capital will be invested directly in the banks by an EU entity, such as the European Financial Stability Facility (EFSF), as lending money to the government to invest in banks will increase sovereign solvency pressures.

2. European Banks and the Payments and Settlement System

The direct exposure of the European banking system to Greece appears manageable and the detailed data in the bank stress tests should allow investors to precisely identify the potential direct losses and related capital raise. European banks have reduced their exposure to the Greek government and banks over the last year (see Figure 3). Aside from Germany, the total exposure of the main European banking systems to Greece, Ireland and Portugal is now well below 10% of capital. However, contagion is often more about risk aversion in the face of what is not known rather than what is known. As such, we would expect investors to hoard liquidity both in euros and in the USD funding markets. Some banks may need to raise more capital to reassure investors. Cross‐Border Bank Exposures to Euro Periphery Governments and Banks 

Greece Ireland Portugal

(in % of GDP)(in % of capital and reserves) 1

France 13 (-23%) 9 (-52%) 11 (-31%) 32 (-36%) 1.7% 7%Germany 19 (-9%) 24 (-45%) 18 (-20%) 60 (-30%) 2.4% 16%Italy 2 (-44%) 2 (-23%) 2 (-45%) 6 (-38%) 0.4% 2%Spain 0 (25%) 1 (-80%) 12 (-13%) 13 (-29%) 1.2% 5%UK 4 (10%) 16 (-47%) 5 (-24%) 25 (-38%) 1.5% 8%

Total exposure to GIP (in € billions as of yearend 2010;

percent changes from March 2010 in brackets)

1 For UK, in percent of capital of four largest banks. Sources: PIMCO, BIS, ECB. As on 31 December 2010

Figure 3

The policy response to a liquidity crisis is now well established following the failure of Lehman Brothers in 2008. It typically involves unlimited liquidity,

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loosening of central bank collateral standards and a reutilization of the Fed-USD swap lines. Some banks may be able to raise equity from private markets but for banks that are forced to turn to their governments for their funding needs, the ideal vehicle would be a Europe-wide bank recapitalization fund. With a small change in its terms and conditions this function could be performed by the EFSF. A Europe-wide bank recapitalization fund would avoid a repeat of the Irish problem, where the cost of recapitalizing the banks raised doubts about the sovereign’s solvency, ultimately raising the cost of credit and resulting in the loss of market access for the whole economy. Finally, to reduce the risk of bank runs in case of future sovereign crises, a Europe-wide deposit insurance scheme backed by a single European regulator and guaranteed by all eurozone governments should be introduced. Without such a deposit insurance scheme the cost of credit to eurozone households and corporations will vary from country to country, thereby placing at odds with the single monetary policy set by the ECB. This would also help reduce the counterparty credit risk in the payments and settlement system.

3. European Sovereigns Contagion to other European markets will be the most politically challenging channel to contain. Repeating the policy prescription for Greece, Ireland and Portugal (i.e., combining fiscal austerity with liquidity support) will not restore confidence and overlooks the problem with increasing the size of the EFSF to fund Italy. Instead, European leaders need to take steps toward greater fiscal integration. The obvious example is the proposal for a common eurozone bond, but less radical measures include making the EFSF a joint and several liability system where the liability is shared between member states, increasing its size substantially and allowing it to buy bonds without the sovereign necessarily being on an IMF program (i.e., a flexible credit line). Alternatively, governments could guarantee other sovereigns’ debt issuance in a way similar to the post-Lehman government guaranteed bank issuance schemes. The objective has to be to ensure that higher rates and volatility associated with a liquidity crisis do not create self-fulfilling prophecies and trigger solvency crises. Clearly there has to be political compromise. In return for fiscal union, governments will also have to accept limits on their own fiscal sovereignty. Such pooling of sovereignty will take time to legislate and in the interim the ECB is the only institution with the size and credibility to contain the crisis by executing a large-scale asset purchase program in a similar fashion to the Federal Reserve, Bank of England and the Bank of Japan.

Bottom Line There is no guarantee that Greece will pull off an orderly restructuring, but early attention to the above cited factors would increase the probability of this happening.

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ViewpointsJuly 2011

This material contains the opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. There is no guarantee that results will be achieved. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Pacific Investment Management Company LLC, 840 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. ©2011, PIMCO.