WIIW The Vienna Institute for International Economic Studies - Wiener Institut für Internationale Wirtschaftsvergleiche

“(A)t this point… financial crisis has already happened, so… the biggest costs of euro exit have been paid. Why, then, not go for the benefits?” Krugman, “Ending Greece’s Bleeding”, NY Times, July 6, 2015

Default I.

In 1982, Yugoslavia could not continue to service its external obligations. Those were mostly foreign debts of the banks, taken on behalf of the corporations. Before a program with the IMF was negotiated, additional capital and financial controls were introduced, e.g. a cap on how much foreign currency could be taken out of the country, there were shortages of imported goods, and building up of arears on government’s current expenditures. With the IMF programme in place, the restrictions were lifted and most of the arrears cleared, though illiquidity in the corporate sector persisted. That standby agreement, and the subsequent ones, led to the restructuring of the foreign debt without an explicit write-off.

In Greece, by comparison, the IMF, or rather Troika, bail-out made early capital and financial controls as well as import restrictions unnecessary, but those are or will be coming now that the renewal of the programme is in doubt. Greece’s foreign debts are mostly public, now. The private ones were partly written off, while the public ones were restructured (much more favourably than the Yugoslav ones or most others that come to mind). Still, as in the case of Yugoslavia, the debt needs to be restructured again.

Devaluation and (hyper)inflation

In between 1982 and 1988, Yugoslavia attempted to adjust to the trade balance and current account constraints, but did not succeed entirely, at least not throughout the whole period, as mostly imports went down. For its part, the economy stagnated, so that foreign debt to GDP ratio did not improve and sustainability was not achieved. This was despite initial devaluation, followed by persistent depreciations, which however fuelled continuous speed up of inflation that came to close to 100 percent per year in the end, i.e. in 1988. These exchange rate and price adjustments proved devastating for the banks and then for the corporate sector too because savings were in foreign currency (primarily in Deutsch marks) while loans were in dinars. The new programme with the IMF restructured the foreign debts once again in 1988, and obliged the central and the governments of the federal states to take joint and several liability of public debts, but macroeconomic stability was not achieved.

In Greece, similar process of prolonged recession with trade balance adjustment is playing out, while devaluation and inflation are yet to be resorted to if drahma or some quasi-money is introduced. Savings will continue to be in euro, inside or outside the banking system depending on its health, and on whether the authorities allow banks to offer foreign currency deposits, while loans will be re-nominated in the new currency. The attempt to improve competitiveness with devaluations and help the debtors through inflation can fail if the banks and the corporate sector face insolvency in the process as happened in Yugoslavia in the 1980s.

In 1989, inflation turned to hyperinflation in part as a policy choice because of the intention to eventually switch to a fixed exchange rate regime at a parity established in the market. Hard peg to German mark was introduced at the end of that year and that regime change was spectacularly successful in stopping inflation for almost the whole next year. The real exchange rate, however, appreciated due to inertial wage hikes. More importantly, the budgets on all levels were starved of money as they could not resort to inflationary taxation. In addition, the corporate sector faced higher real interest rates and high illiquidity and insolvency. So, in the autumn of 1990, there was a run on the foreign currency reserves by the governments and the central banks of the federal states (Yugoslavia was highly decentralised). Initially, rather than giving up on the fixed exchange rate, capital controls were reintroduced and in the end the governments and the central bank defaulted on the foreign currency savings, i.e. those were frozen. Basically, the banks went bankrupt.

An exchange rate regime for Greece

In Greece, a partial run on the banks has already happened in the anticipation of the change in the currency regimes, i.e. of the reintroduction of the drahma. The government and the central bank will have to choose the exchange rate regime for the drahma, if it is reintroduced. Chances are that the new old currency will eventually be fixed to the euro, after it floats for a while. Capital controls and possibly trade barriers will be needed in the interim and for some time afterwards. In addition, the decision will have to be made whether the remaining euro deposits will be re-nominated in the new currency or will be restructured with a haircut. If the country ends up with a hard peg to the euro, the main difference with the membership in the monetary union will be the significantly higher real interest rates, which means a more restrictive monetary policy.

Default II.

In 1991-1992, Yugoslavia, now consisting only of Serbia and Montenegro, as the other federal states had seceded, stopped servicing its foreign debts and was in a state of moratorium, i.e. default. Sanctions were introduced by the Security Council and the country lost its membership in the UN and the Bretton Woods institutions. That lasted until 2001 when large chunk of the public foreign debt was written off (the part to the private creditors was written off only in 2004). In the period of the moratorium, foreign debt grew with the interest rate so that the overall debt burden, given that the economy had shrunk by about 40 percent by that time, was higher by an order of magnitude than at the time of the initial default.

Similarly, foreign debt of Greece will be kept on the books of the official creditors and interest will be added to it. In fact, European Stability Mechanism (ESM) will continue to refinance the debt in the capital markets. Effectively, through the European Financial Stability Fund (EFSF), which has been superseded by the ESM, that owns about half of the Greek foreign debt, joint and several liability for much of the public part of the Greek foreign debt has been accepted by the euro group (similarly as Yugoslavia in 1988). If the debt has an unsustainable path, in terms of the growth of Greek economy, irrespective of whether it is serviced or not, the debt burden will keep mounting. Greece’s GDP has already shrunk by about 25 percent and can easily decline some more in the short run. If, however, Greece defaults, this is as if the run on the ESM (or EFSF) by sovereign debtors has begun and all the other countries in the euro group may decide to default too, as in the case of Yugoslavia in 1990, though that will happen only if the euro is given up on.

Secession of Montenegro

In 2006, Montenegro seceded from Yugoslavia and became an independent country, but continued to use euro as an official currency (Montenegro first, while still within Yugoslavia, a union with Serbia at that time, unilaterally adopted the German mark as its legal tender and then switched to euro). This has worked so far because of large inflows of foreign investments targeting mainly real estate with potential in tourism. Greece can also remain on euro, though the ECB will not be its central bank effectively as long as the country is in default on its foreign obligations. A type of a fire sale of public and private assets can temporarily allow for the access to additional foreign currency, which will be the way to increase the supply of money if borrowing remains limited and expensive. However, on the experience of Montenegro, a very small country, and also Croatia, another country specialising in tourism, the boost to the tradable sector that the sale of real estate to put up hotels and other touristic services can provide is rather limited and may have already been largely exhausted by Greece anyway.

Conclusions

When Yugoslavia defaulted initially and its flirtation with debt restructuring and monetary policy manipulations started in early 1980s, foreign debt to GDP ratio was relatively small, about one third or even less. In dollar terms it was about 20 billion and did not nominally, i.e. in dollars, change almost at all throughout the 1980s, but it proved unsustainable given GDP and export performance. The foreign debt that Yugoslavia (now consisting only of Serbia and Montenegro) inherited after 1992 was similarly small (as were the debts of other successor states), but it ballooned during the moratorium due to negative growth rate and the compounding interest. So, neither repeated debt restructuring nor default worked.

In case of Greece, debt its partners in the euro group have issued on its behalf is not unsustainable in terms of the interest paid on the EFSF bonds and given euro group’s growth prospects, though it is in terms of the interest Greece pays on them and given its growth prospects (at least according to the IMF). The stumbling block, therefore, is the persistent threat of Greek default, which comes with growing debt obligations for the other euro member states, through a succession of bail out agreements, which they may not have the will to take over in the end. In case of Greece defaulting unilaterally and leaving euro, Greece’s debt will grow with the interest rate while the burden on the rest of the euro member states will stop increasing (it should decline in terms of debt to GDP ratio). Eventually, Greek debt will have to be written off, but it may very well be that the burden of the ex post write off proves to be lower than that of an ex ante write off for the other euro member states, but not for Greece, at least on the Yugoslav experience.

Part of the path to default Greece has already travelled, while the rest is ahead, if it fails to learn from history and thus chooses to repeat it.