The last few weeks have seen the market increasingly price in the probability of a Greek debt buyback. Following this week's 'failed' Eurogroup meeting that chance has risen even more as leaked details suggest a debt-buyback is becoming the corner-piece of the 'new' deal. The leaking of details (and anticipation by the market) has driven GGB prices up and reduced much of the benefit of the buyback 'boondoggle' and as Barclays notes, "even if the debt buyback enables the IMF and EU leaders to come to an agreement, leading to a Greek resolution in the near term, in the medium-to-long-term Greek debt is not sustainable on realistic macroeconomic assumptions without notable outright haircuts on official EU loans to Greece. Therefore, a successful debt buyback might resolve the Greek debt sustainability issue on paper in the troika report but it will most likely not resolve it in investors’ minds." While there are 'optical' advantages to the buyback, the four main disadvantages outlined below should be irksome to the Greeks - which is critical since, as ekathermini notes, a senior finance minister commented "God forbid we should not be close to an agreement on Monday."
The full piece is worth a read (and Bulo/Rogoff's details on sovereign debt buybacks) but for those pressed for time between holiday shopping stores - read sections 4, 6 (Optics), 7 (The Disadvantages) & 8 (Reality).
1. Why has the buyback programme gained traction recently?
There have been months of discussion between Greece and the ‘troika’ (the European Commission, IMF and ECB), aimed at adjusting the current Greek programme such that the next €44bn disbursement could occur. Furthermore, all of the troika’s additional reform requests have been approved by the Greek parliament. As such, the focus is no longer on the relationship between Greece and the troika, but rather, it has shifted to disputes within the troika, between the IMF and European leaders, on how to fill the financing and more importantly the debt sustainability (DSA) gap. A debt buyback is now expected to form an important part of the latter.
2. What progress is being made on the dispute between the IMF and European leaders?
The primary disagreement between the IMF and European leaders is on how to fill the DSA gap. Under the new 2y extended Greek programme, the IMF still wanted to see Greek debt reduced to 120%, with additional adjustments from 144% of GDP in 2020 without any adjustments. In the absence of outright haircuts on EU loans to Greece, this is a very difficult task to achieve. However, European leaders, particularly in Germany, insist that politically and legally, outright haircuts are impossible to accept at this stage. After this week’s troika meetings, it seems that the dispute between the IMF and EU leaders has eased somewhat. Reuters reported on Friday morning that the IMF has increased its debt-to-GDP target for Greece to 124% by 2020. Moreover, recent comments from Schaeuble and Weidmann have not ruled out future compromise in the form of haircuts on EU loans, depending on the progress of the Greek government reform implementation. In the meantime, EU leaders are aiming to hit the new IMF DSA target level by 2020 with a mix of measures, such as the ECB giving up profits on its SMP and investment portfolio holdings, reduced interest on EU bilateral loans to Greece and a debt buyback programme. We summarise in Figure 1 our best estimates of how the troika is expecting to fill the financing and DSA gaps under the new Greek programme. Note that some DSA gap still remains to be filled, according to our estimates.
3. What size of buyback programme is under consideration?
This week’s Eurogroup meeting on Greece implied that Europe is willing to contribute a further €10bn from the EFSF to the extended Greek programme. And the cash needed for the buyback is planned to be the same amount. This suggests to us that this new EFSF money will most likely be used for the buyback execution. While these new funds should constitute the bulk of the buyback cash needed, some of the ECB profits can also be used to contribute too. The outstanding size of the post PSI bonds is €63bn. An average purchase price of 25, 35 and 50 cents on the euro implies €40bn, €29bn and €20bn of nominal purchases with 15pp, 9pp, and 5pp of GDP debt reduction, respectively.
4. What form will the buyback take, and is it feasible to accept a 10pp of GDP debt reduction from it?
So far, there has been no official information on the debt buyback. It could be a fixed price offer or a competitive reverse auction. The fixed price offer should give all investors the same price on a voluntary basis. In order to achieve a reasonable level of debt relief, we think this price should be no more than 35cents on the euro. Currently, we estimate around €20bn of the €63bn outstanding post PSI Greek bonds are held by the Greek banks and other domestics. These domestic investors, particularly the banks, will most likely have an agreement with the government and fully participate. The rest of the Greek bondholders are probably international investors such as banks, hedge funds, real money managers, insurance and pension funds. The current Greek strip average price is 28. While some hedge funds might still not find a 35cent fixed price deal attractive, as long as domestic investors fully participate, it is quite possible that nominal purchases ultimately come close to €30bn.
Alternatively, the Greek Treasury might hold a reverse competitive auction, in which domestic investors and banks are indirectly encouraged to accept a 30cent price whilst international investors would sell their holdings of up to €10bn at prices up to 45cents on the euro, which can still achieve an average purchase price of 35cents on the whole auction.
However, we think this competitive reverse auction might lead to political issues later on, as there could be questions asked over fair treatment, in the sense that domestic private investors would have to compromise to the benefit of other investor groups, As such, we believe the probability of a competitive reverse auction is very low, making the former fixed price option much more likely.
5. Can the collective action clauses (CACs) be used as part of the buyback?
With the aim of achieving the highest possible debt relief for Greece, it seems that politicians have also discussed using CACs as part of the buyback offer to force a low price deal on all private investors. Given the PSI involving private investors early in the year, we believe a second coercive debt buyback could have a very negative impact on sentiment. Indeed, this option seems to have quickly lost favour with officials. As such, we see the probability of coercive debt buyback via usage of CACs as very low. In any case, a credible threat from using CACs will be much lower now as the PSI bonds are under international law, whilst pre-PSI bonds were under domestic Greek law.
6. What are the benefits of the debt buyback?
Optically, the debt buyback provides debt relief, in the order of 10pp of GDP if an average purchase price of 30cents on the euro can be achieved. It will also provide very limited financing relief of €2.4bn over the new programme period (until end of 2016) via the interest payment cancellation on the potential €30bn nominal debt bought (the coupon on this debt is 2% flat across the Greek strip). Most importantly, if executed successfully it will most likely help to form some common ground between EU leaders and the IMF to move on with the Greek issue in the near term.
7. What are the disadvantages?
Previous debt buybacks show that secondary market prices rally significantly up to the actual debt buyback offer. As a result, by the time the buyback occurs, debt relief due to price action is much lower than originally expected. As such, we think a large part of the rally in Greek bonds that has occurred since the end of the summer is due to debt buyback anticipation-related buying, which resulted in average Greek strip price appreciation of 75% since mid August. The average market value of €63bn of Greek debt was €10.2bn in mid August; however, at 35cents on the euro, the post debt buyback market value of €30bn of nominal debt will still be around €10.5bn. Therefore, this typical price appreciation in anticipation of the debt buybacks in most cases makes debt buybacks a creditor-subsidising experience.
Secondly, even if an average 35cent purchase price is achieved in the debt buyback operation, as we mentioned above, up to €20bn of the participation has to come from domestic banks, which would mean up to €15bn recapitalisation needs for the Greek banking system, which has to come from EU loans. Unless officials have a way to handle additional recapitalisation needs of the Greek banking system as a result of the buyback, the optical debt relief might even be cut further.
Third, as highlighted in “The Buyback Boondoggle” by Bulow and Rogoff, when a corporate spends resources on a buyback operation, it typically uses assets that otherwise could be seized in the event of default, which makes the deal more attractive to the borrower. However, €10bn of money that will be used by Greece for the buyback could otherwise be used for investment and other growth-generating measures, which might well have been more helpful for Greece in the medium to long term.
Lastly, even if the debt buyback enables the IMF and EU leaders to come to an agreement, leading to a Greek resolution in the near term, in the medium to long term Greek debt is not sustainable on realistic macroeconomic assumptions without notable outright haircuts on official EU loans to Greece. Therefore, a successful debt buyback might resolve the Greek debt sustainability issue on paper in the troika report but it will most likely not resolve it in investors’ minds.
8. Where does the debt buyback leave Greece and Europe from a medium- to long-term perspective?
A successful debt buyback will most likely pave the way for a resolution of the disputes within the troika and lead to the disbursement of the next tranche of around €44bn. However, as mentioned in the previous answer, even a successful Greek debt buyback wouldn’t come close to achieving a sustainable Greek debt position. And, as long as the debt sustainability issue remains outstanding, private investment will be limited, and the tax evasion and capital outflow situations are unlikely to improve. All of which will have negative growth implications. The longer growth remains weak, the more fiscal consolidation will probably be demanded of Greece by EU leaders, which might at some stage lead to further social unrest, potentially even followed by collapse of the already troubled existing government. While Germany’s plan is probably to delay any outright haircut on loans until after German elections in 2013, delaying to deal properly with Greek debt sustainability might create the above mentioned scenario before then. Therefore, it is even questionable whether the debt buyback would even buy the time that European politicians are hoping for before deciding on the end-game for Greece.