Cyprus Mail

From austerity to prosperity: chicken games and debt swaps

IMF director Christine Lagarde with German Finance Minister Wolfgang Schauble

By Theodore Panayotou

The Greek government, embolden by a fresh mandate from a desperate electorate crushed by austerity policies that failed to lead to the promised land of prosperity, is demanding a new deal, including debt swaps to lighten its debt burden of €315 billion, almost twice the country’s GNP. Greece’s European partners are sticking to their guns, demanding that the SYRIZA government abide by the austerity programme, signed by previous governments, thus reversing its promises to the electorate and its own raison d’être.

The two sides are on a collision course. Both have adopted maximalist positions and neither is willing to yield, even though both are offering a fig leaf if the other party agrees to yield. It’s a classic game of chicken.

Imagine two vehicles which are driving at great speed towards each other and are approaching a single-lane bridge. Unless one of the two drivers swerves, both of them will die in the crash. But if one swerves and the other doesn’t, the one who swerves is called a chicken, or coward; he loses and the other driver wins.

While the best collective outcome in a chicken game is if both swerve (a “cooperative” outcome in which there are no winners or losers), the worst possible outcome is the most likely: neither swerves – as each hopes the other guy swerves first – and both end up dying in the inevitable crash (a lose-lose outcome). The only way you are sure to win this game is to pull out the steering wheel and throw it out of the car. Your opponent, realising that you have no control of your vehicle, will swerve to avoid the collision for which he would be 100 per cent responsible. If he doesn’t, he commits suicide.

At this stage, neither the Greek government nor its lenders are willing to blink and swerve to avoid the collision. Neither side, of course, wishes to go down in what seems like an inevitable crash, as both sides have a lot to lose. But it is too early in the game. Each hopes that the other party is about to blink and swerve first. To increase the likelihood of this, each party has adopted an intransigent stand to convince the other that its own position is non-negotiable (because of promises given to the people or because of eurozone rules and agreements).

At the same time, each is offering the other party a fig leave as an incentive to swerve. The European lenders are offering debt restructuring and help with combating tax evasion. The Greek government is offering to abandon the demand for a new haircut of Greek debt and to go instead for swabbing their debt with growth-indexed  and perpetual bonds – this implies an indirect haircut if it’s going to be any relief of the tax burden – and the breathing space for Greece to restart economic growth.

What are these new financing instruments, called debt swaps that the Greek government is proposing? Are they going to offer real relief from the burden of crashing debt and austerity? What do they mean for the creditors? What are the chances of the lenders accepting to swap their fixed-interest loans with a maturity date for bonds with an uncertain interest and no maturity? Are they enough of an incentive for the European lenders to relent and relend, without an austerity programme in place? And, if so why were not used before in bail-outs?

Growth-indexed bonds

The growth-indexed bonds are bonds with the size of debt payments linked to the country’s rate of economic growth. The lower the economy’s rate of growth the lower the debt payments; with zero or negative growth the debt payments would still be positive but minimal. When the economy picks up, the debt payments rise accordingly. For example, a country with an economy which is expected to grow at 4 per cent may issue bonds with a 6 per cent interest with a proviso that this rate will fall or rise with the movements of the country’s economy. If the growth rate falls from 4 per cent to 3 per cent the interest rate will fall from 6 to 5 per cent; if the growth rate rises to 5 per cent the interest on the debt rises to 7 per cent.

Therefore, the growth-index bonds contribute to the stabilisation of public spending, reducing the need for the government to cut drastically public spending in times of recession. In times of rapid growth, growth-indexed-debt helps control new public spending. This is exactly the opposite of what the eurozone austerity policies are requiring Greece, and other countries in a support programme to do: cut public spending to pay off debt and to maintain credibility in capital markets.

The counter-cyclical properties of growth-indexed bonds help reduce the depth of the recession, improve the investment climate of the country and reduce the business risk, attracting investments and encouraging the creation of new business rather than the closing of existing ones by the strangulation of demand by the austerity measures. Moreover, the reduced need for cutting of public spending to generate a larger primary surplus to meet the debt payments helps limit the impact of the recession on the poor.

Basically, the growth-indexed bonds are an insurance against the risk that growth might turn out to be lower than expected by shifting part of the risk on the lenders, who accept it counting on the upside risk being higher, or at least not lower, than the downside risk. With this proposal Greece is calling on its lenders to take equity shares in the Greek economy and therefore to have the interest and the incentive to help the Greek economy to grow. The faster it grows the faster they are repaid and the larger their return.

Despite their many advantages, the growth-indexed bonds, although they have been studied by the IMF, the US government, and the G-7,have not been used extensively because of concerns over the reliability of the growth statistics and the bonds’ potentially limited liquidity. These should not be the main concerns in the case of Greece, but that without deep reforms, the downside risk of low growth would exceed the upside risk of high growth. In such a case the conversion of debt to growth-indexed bonds would amount to a new haircut of the debt which the lenders vehemently resist. This is why the Greek minister of finance keeps emphasising that the Greek government is committed to making all the necessary reforms for Greece to regain its competitiveness and attract foreign direct investment.

Perpetual bonds

The perpetual bonds are bonds without a maturity date. The basic difference from conventional bonds is that there is no guarantee that the principal of the debt will ever be repaid. The borrower pays just interest every year to the creditors. Therefore they are more like a sort of equity than debt. The price of the bond is the present value of the annual interest payments (the latter divided by the discount rate). The bond issuer can recall the bond any time but, to make it more appealing to the investor, a condition could be included that prohibits the recall within the first five years from bond’s issue.

Perpetual bonds were first issued in 1752 by Great Britain to reduce the cost of servicing its public debt and financing the Napoleonic wars. In recent years, perpetual bonds were issued by banks in Great Britain, Brazil and Japan and public utilities in Mexico and Brazil. In the US, they have been proposed as a means to reduce the refinancing cost of conventional bonds at maturity.

With the Greek proposal to swap its debt to the European Central Bank with perpetual bonds, the Greek debt remains high but the capital markets are not concerned because Greece would not be obligated to repay it, just to pay the annual interest. However, the consequence of the lack of a maturity date and associated risk is a requirement for a higher interest rate which might increase the cost of borrowing.

Under the circumstances of a non-viable Greek public debt, which cannot be repaid without rapid growth, it is in the interest of Greece’s European lenders to relent and give Greece the fiscal breathing space to do the necessary reforms, without the debilitating burden of high debt payments in the midst of recession. In this way they may even increase their own return and/or the chances of eventual repayment.

Therefore, the swap of the debt to the ECB for perpetual bonds, despite the possibly higher cost for the debtor, and the swap of the debt to the European partners for growth-indexed bonds (despite the hidden short-term debt haircut) are creative solutions for a compromise that ultimately would benefit both debtors and creditors.

The end game

How the game of chicken will end is anybody’s guess. The two parties will perilously approach the bridge during the ad hoc Eurogroup meeting on February 11, during which it is expected to stick to their guns in the hope that the other party swerves under pressure. The next day, at the leaders’ summit, strenuous efforts will be made by the moderates (possibly Italy and France) for a compromise to avert a devastating collision during the official Eurogroup meeting on the 16th. Without a compromise, there will be only losers, unless of course, one of the two backs down. This appears unlikely.


Dr Theodore Panayotou, 2007 Nobel Peace Prize Contributor, is professor of Economics and Ethics and director of the Cyprus International Institute of Management (CIIM), visiting professor at Tel Aviv University and member of the Cyprus President’s Council of the National Economy. He taught Economics for 25 years at Harvard University. He has published over 100 books, monographs and peer-review articles on economics and business and served as consultant to companies, governments, the UN and the World Bank. Contact: [email protected]

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