Is The Official Sector Initiative Next For Greece?

The agreement struck earlier this year projects that Greece's debt to GDP ratio will near 120% in 2020. At the time, officials, including at the IMF, claimed this was meant the definition of sustainable. Investors were rightly skeptical. A Dow Jones report says the IMF is re-considering its position and now is interested in redefining sustainable to mean a 100% debt/GDP ratio.

Given that the private sector took a substantial haircut earlier this year, there is not much more savings that can be achieved imposing another "voluntary" haircut on them. Instead, the official sector, which holds about three quarters of Greek debt, needs to participate in some fashion IF Greece's debt profile is going to change substantially. And the IMF appears to be reaching the point that Greece's debt profile must change substantially IF it is to continue to participate in assistance programs.

The IMF recognizes the limited options that are available. None of them will sit well with government officials.

1. Reducing interest rates on official loans. This runs into resistance if the rate Greece pays is below the for countries like Spain and Italy to raise the funds in the first place. Moreover, no reasonable reduction in rates will be sufficient by itself to bring the debt/GDP ratios to sustainable levels.

2. ECB and national central banks accept a 30% haircut on Greek bonds. This had been discussed earlier in the year. Since, for example, the ECB bought Greek bonds at a discount, it could surrender profits and not violate the prohibition against transfer payments, It defended its refusal to participate in the PSI on grounds that its purchases were for the conduct of monetary policy.

It seems reasonable that it forgoes profits on the same grounds. However, other members of the euro system cannot make such a compelling argument. Nor can such an argument be made regarding the bilateral loans, for which the government's can take a haircut.

3. Another option that the IMF recognizes is for the 50 bln euro Greek bank recapitalization to be taken off the government books (and debt accounting) and "re-allocated" to the ESM. This of course assumes that the ESM is not blocked by the German Constitutional Court. However, this too would likely require unanimous agreement, which still gives the German parliament a veto.

In fact, it is this procedural point that may lie behind German willingness to support Draghi's proposal which were conditional on countries formally requesting EFSF/ESM assistance. German parliament can reject the proposals and/or influence the drafting of the memorandum of understanding.

This issue is not going to be resolved this month. It is yet another item that will likely be addressed next month. However, it shows an evolution of IMF thinking and rightly recognizes that in order for Greek debt/GDP ratio to be dramatically reduced, the official sector needs to participate more fully. Of course, "official sector" is simply a euphemism for tax payers.

A sufficient official sector haircut could require a central bank or even the ECB to need to be recapitalized. That is accomplished by a transfer of funds from the government(s) to the central bank. The resolution of the debt crisis in part involves the distribution of pain and loss. The creditors, now largely in the public sector, will likely have a turn too.