Lessons from Islamic Finance for a Greek debt swap deal
Greece and its creditors remain locked in a heated debate over how its debt should be financed. The newly elected Syriza government need to renegotiate their current bailout programme, in order to carry out their proposals to repeal austerity and re-invest in public services.
Greek finance minister Yanis Varoufakis’s strategy for doing this is to swap the outstanding Greek debt for bonds linked to growth. So far he has been rejected by Greece’s German creditors who are, naturally, keen to ensure they are paid back in full. But perhaps there is another way.
Varoufakis’s proposal recognises that Greece’s problem is one of insolvency, not liquidity. To distinguish these two concepts let us imagine a car with that is leaking oil. Naturally the driver would have to keep refilling to be able to cover even a small distance but no matter how much oil you put the leak will be there as a different approach is required. This is insolvency. To pretend it is a liquidity issue is like trying to argue that the leak would have been fixed had we put more oil in the engine. And so Varoufakis aims to direct and relate the external financing of Greece’s debt to some well-defined business outcome.
The Islamic finance model
A resemblance of products and practices of Islamic finance is apparent in Varoufakis’s debt swap suggestion. The “no money for money” principle followed by Islamic banks entitles the investor to a profit share only when sharing the business risk. In this way the economic burden of a fixed interest rate, which is not linked to the business outcome, is reduced.
Plus, the risk is not assumed by the bank; it is passed directly to the investors who have exchanged their contractually fixed interest rate for a profit share. In other words an Islamic bank can avoid profit distribution to its investors if the banks’ business ventures have not been profitable. Islamic banks operating along these principles have demonstrated greater resilience to the recent financial crisis, higher profitability and capitalisation compared to the debt-based conventional banks.
In the current situation, Greece may be thought of as the bank, the EU taxpayers would be the investors, while the business venture is Greece’s recovery. Shifting Greece’s debt to Islamic bonds linked to growth would alleviate the pressure of meeting with the next debt repayments as these become due.
This would enable the government to change the orientation of its policies from the short-term to the medium- or even long-term. In practice, this could mean less austerity for the already heavily burdened Greek employees, but more flexibility and determination to fight the bureaucracy, tax evasion, trade unions and corruption that are the reasons for Greece’s insolvency.
Why would the rest of Europe want such a deal? In the past few weeks we have observed a confrontational stance between Greek officials and various members of its international creditors.
What, however, may not have been accounted for in Varoufakis’s debt swap proposal is that these members would need to be present on a more permanent basis to ensure that the Greek program stays on track (and reduce any moral hazard issues). Greece would therefore be tying itself to a constant monitoring by the technocrats from the European Commission, European Central Bank and International Monetary Fund. They may, however, be able to work with the politicians towards a common goal.
The other benefit of swapping the current debt (even in part) with growth linked bonds would be a vote of confidence to the Greek efforts in staying part of an EU that is supportive of all its members and aspires in persisting as a union. Otherwise, speculation on a Spanish or Italian exit may follow suit.