Greece will not default this summer, yet debt sustainability is questionable

In its meeting Monday 22 May, the Eurogroup did not reach an agreement necessary to conclude the second review in Greece’s third bailout package. So Greece cannot yet count on fresh funds from its creditors. Athens badly needs money to repay 2 billion euro to private investors by 17 July and almost 4 billion euro to the ECB by 20 July; excluding short-term government debt (Treasury bills). In other words, without new funds Athens would need to put up some magic trick to prevent a default.

In a press statement, Eurogroup chair Jeroen Dijsselbloem has welcomed the staff level agreement (SLA) reached early May between Greece, the European institutions and the IMF. This agreement entails additional austerity measures to make sure Greece runs a primary surplus of 3.5% until 2021/2022. It also requires Greece to address NPLs, further improve the business environment and ensure a modernisation of the state. In the last part of this special we take a closer look at some of the details in this SLA and whether we think it is feasible.

Mr. Dijsselbloem has also praised Athens for passing most of the prior actions mentioned in the SLA on 18 May. The main reason why Greece and its creditors failed to reach an agreement Monday 22 May is because of disagreement over debt relief. Dijsselbloem has expressed willingness on the part of the creditors to agree on further (conditional, i.e. if necessary) debt relief measures as of 2018. But the details still need to be discussed. And according to recently leaked minutes of the Eurogroup meeting, creditors appeared to be far from reaching an agreement. The crucial issue here is that the IMF and the Eurogroup are still in debate whether and, if so, how much debt relief Europe needs to offer Greece.

A very tricky trinity

According to Europe, Greek debt is sustainable, but according to the IMF it is not. The IMF is only willing to participate financially in the bailout package if Greece passes the fund’s debt sustainability analysis (DSA). The Eurogroup is limited in how much debt relief it can and wants to offer. Amongst other things because German elections are coming up in September. At the very least, measures would need to fit within the framework agreed in May 2016 to make it acceptable for national parliaments. That means nominal haircuts are not an option, while it is uncertain whether measures such as interest waiver periods are sufficient to get the IMF on board. And yet the latter is essential, since especially Germany and the Netherlands require that the IMF steps in before they agree to release the next tranche of funding. Hence there is a very tricky trinity here.

Why Europe thinks debt is sustainable, and the IMF disagrees

The main differences between the most recent analysis of Europe and the IMF stem from different growth, interest rate and primary surplus projections (see table 1). For example, in its most recent DSA (IMF, 2017) the IMF expects a yearly primary surplus of 1.5 percent between 2018 and 2030, compared to 3.5 percent expected by Europe. Estimates for privatisation proceeds also differ. While the European Commission expects proceeds of 18 billion euro until 2018, the IMF only foresees additional income of 3 billion euro. To put things into perspective, from 2011-2016 privatisation proceeds amounted to only 3.2 billion euro, while the initial target was 50 billion euro. All these differences result in a major gap in expected debt-to-GDP and gross financing needs to GDP ratio’s (figures 1 and 2). The one figure on which they do agree is that gross financing needs should ideally remain below 15 percent of GDP and are allowed to rise to 20 percent of GDP at the most. How to get there is the issue to be resolved.

Given Europe’s track record of engineering eleventh hour deals when it comes to Greece, we expect that some deal, including conditional debt relief measures (see below), will come in time. In other words, we believe that Greece will receive the funds necessary to repay its various debt holders this July. Accordingly, a credit event should be prevented for now. We expect a final decision either at the next Eurogroup meeting on 15 June or at the one after that, on 10 July. While the latter may be too close to the ECB repayment date to follow all procedures and release the tranche in time, some form of bridge financing might be the solution in such a scenario. Whether the IMF will step in with fresh money after the second review is concluded is a close call, but at least we do not see the IMF formally opt out of financial participation before the next tranche has been transferred to Athens. Some ad interim solution is more likely, postponing a more durable agreement between Greece, Eurogroup and IMF to after the German elections.

With a deal, liquidity risk should fade for a while and short-term debt affordability should be ensured thanks to rate reductions and temporary interest waivers. This holds even more so in the case that Greek debt is included in the ECB’s QE programme. The latter has no impact on current interest payments, yet it would make it easier, i.e. less expensive, for Greece to raise money in the markets. Still, Greece’s debt sustainability remains highly questionable in our view. In this respect, April 2019, when Greece has to roll over 4 billion euro of government debt, might well prove a fresh test case.

Ongoing strict austerity efforts have so far failed to meaningfully reduce Greece’s dependency on foreign financial support. For one, because policy effectiveness has proven to be low. One longstanding issue, for example, is that of tax evasion. Tax evasion is estimated to amount to about 8 percent of Greek GDP, i.e. around 14.5 billion euro. This seriously lowers government income. Second, the economic consequences of the harsh austerity measures have been significantly larger than previously expected. The economy is still some 30 percent smaller than prior to the crisis, (official) unemployment stands above 23 percent and youth unemployment is around 50 percent. The large drop in employment has also significantly reduced government direct tax income. The government has been forced to offset this by an increase in direct taxes, mainly affecting lower incomes. The fact that 88 percent of government revenue arises from taxes, underscores the fiscal problems of the Greek government amidst the weak economic environment. We expect growth of at most 0.5 percent this year and around 1.5 percent next year. In its latest forecast in May, the European Commission’s foresaw growth of 2.1 percent and 2.5 percent respectively. In other words, we believe the EC is too optimistic.

If history were any guide

Moreover, even though the currently agreed austerity measures could be sufficient to reach a primary surplus of 3.5 percent of GDP in 2018 as intended, history gives us barely any examples of countries maintaining such a large surplus for many years.

In countries where multiple years of primary surpluses above 3.5 percent of GDP were achieved, such as in Finland and Belgium, they were accompanied by high real economic growth rates. Of all countries that have been able to run substantial surpluses for a long time, Italy is probably the country that is the most similar to Greece with respect to institutional strength and policy effectiveness. With Italy being the better brother without a doubt. Italy’s public primary balance has been in surplus every year since 1992, except in 2009. From 1996 until 2000, the surplus was above 3.5 percent of GDP. On average, the surplus amounted to 2 percent of GDP. Yet it was no free lunch. High taxes and large tax evasion, limited space for growth enhancing public spending and investment, combined with large institutional inefficiencies have put a lid on Italian economic and disposable income growth. And consequently, on the improvement of government finances. Between 1992 and 2016, annual GDP volume growth was 0.6 percent on average (0.9 percent when excluding 2009). In the same period, government debt-to-GDP rose from 100 to 133, despite the primary surpluses.

Based on the past few years, there is little reason to assume that in a scenario of a prolonged strict austerity regime, Greece would fare much better than Italy has done in the past two decades. In the end, we believe it is unlikely that a society will accept to cope with low growth- and welfare gains for decades to come as a consequence of strict austerity. As such we deem it unlikely that Greece can maintain to run primary surpluses as envisaged in Europe’s most recent Greek DSA. On top of that, the DSA of both Europe and the IMF show how very small changes in the projections of economic growth and interest rates have a very large effect on the outcome of the analysis.

The upshot is that we expect that economic and government revenue growth will remain weak and continue to weigh on Greece’s capacity to repay its debts. In turn, the fact that the country will be busy paying off loans provided by the European institutions and the IMF for the next 43 years (figure 4), is likely to weigh on growth. We believe significant debt relief is therefore necessary to limit the risk of a sovereign default and Grexit.

When digging deeper into the deal between Greece and its creditors, our longstanding doubts about Greek public debt sustainability do not change. Below we briefly discuss the main points of the fresh measures and how we assess this agreement.

The preliminary deal, which has been outlined in the supplemental memorandum of understanding (MoU), focusses on four main areas:

Restoring fiscal sustainability

The main goal of fiscal sustainability is to ensure a primary surplus of 3.5 percent of GDP for 2018, which has to be maintained until 2021/2022. On top of the measures agreed in the first review, Greece needs to implement the following measure, in order to reach this surplus: pension reforms that should deliver savings worth 1 percent of GDP (2019-2021) and personal income tax reforms (PIT) that have an equal savings impact of 1 percent of GDP. In case Greece (expectedly) fails to run a primary surplus of 3.5 percent, the PIT reforms should be frontloaded and implemented in 2019.

At the same time, Greece is allowed to legislate an expansionary tax package of 2 percent of GDP that can only be implemented if institutions project a primary surplus of more than 3.5 percent of GDP. This means that if Greece would reach a primary surplus of 3.8 percent, it can spend 0.3 percent on a pre legislated expansionary package. This package consists of two sub-packages:

1. A growth enhancing tax package matching the yield from the personal income tax reforms. The package encompasses a reduction of personal income tax, corporate income tax rates and property taxes.
2. A targeted spending package composed of an increase in spending on targeted welfare benefits, public infrastructure, and active labour market policies.

Furthermore the plans for restoring fiscal sustainability include different reforms regarding tax policy, public revenue, public financial management, public procurement, and health expenditures.

Safeguarding financial stability

The main reforms related to safeguarding financial stability consist of measures that are aimed at preserving liquidity and capital in the banking system. Greece still has capital controls in place that limit the possibility to withdraw cash and bank transfers. The Bank of Greece (BoG) needs to present a roadmap with broad sequencing of steps towards full liberalisation.

Another important pillar is the resolution of non-performing loans (NPL) that still cripple many banks and limit the availability of loans for viable investment opportunities. NPLs still amount to about 50 percent of total loans, the largest percentage among Eurozone Member States. The BoG will have to address impediments to the secondary market for NPLs and also show that it can adequately monitor non-performing exposures and ensure that banks comply with the targets set by the BoG/ ECB. Finally, insolvency legislation should be simplified and adapted to stimulate out of court debt workout.

Growth, competitiveness and investment

Main pillars in this respect are reforms to increase flexibility of the labour market. For example, Greece is required to adopt new regulation regarding collective bargaining and collective dismissals. And the 2011 collective bargaining reforms cannot be rolled back until the end of the ESM programme. Furthermore, the minimum notification period in case of collective dismissals should be set at a maximum of three months. Also, labour legislation has to be simplified. Additionally, undeclared work has to be tackled via an action plan. This plan will aim at providing sufficient incentives for compliance and discouraging fraudulent behaviour. Another important request is that Greece curtails rent-seeking and monopolistic behaviour to create more efficient and competitive markets and improve social fairness.

A modern State and public administration

De-politicising the Greek administration is key together with modernising the Greek administration. Other key components of the required reforms focus on fighting corruption which include amending the legal framework for the financing of political parties. Legislation also has to ensure insulating financial crime and corruption investigations from political intervention. Setting up independent agencies and regulatory bodies - for instance an independent statistical authority - should further enhance the modernization of the state.

Besides reform and austerity measures from the Greek side, the deal will likely include more details on debt relief measures to be implemented after the programme ends in 2018. Only if necessary for debt sustainability, though. Measures could include (i) interest waiver periods, with the obligation for Greece to pay interest over interest once the waiver period ends, (ii) the return of profits the ECB has earned by holding Greek government bonds, (iii) a ‘swap’ of IMF for ESM loans. The latter would lower interest rates on a part of Greek government debt, as the ESM would take over the loan from the IMF. The interest rate on ESM loans is lower than on IMF loans.

Alternatively, the Eurogroup could announce that at this moment it cannot agree on the details of the measures necessary, and that it promises to take a decision after the German federal elections in September, like they did a year ago. In the first scenario, IMF participation is substantially larger than in the latter, yet still not guaranteed as it remains to be seen if Europe can offer enough.

We deem it unlikely, however, that the IMF will officially opt out of financial participation before the second review is closed. No chance of future IMF funds would bring about the risk that the third financial support package needs to be renegotiated by Eurozone Member States. In that case, the new package would likely also need to be approved by national parliaments. That may even hold if the IMF opting out does not lead to additional funding from Member States being necessary, as some calculations show. Because, crucially, it would still imply that one of the conditions of the current package, i.e. IMF participation, would no longer be met. Negotiations over a ‘new’ package without the IMF would very likely take too much time to be able to solve Greece’s daunting liquidity issues in July. Nevertheless, the probability of this scenario is larger than zero and the risk of the IMF opting out at some point is likely to rise over time. The more money that has been disbursed to Greece, the less sense it makes to insist on IMF participation. Especially, once German federal elections have passed. Furthermore, the more time Europe and IMF need to align their projections, the more difficult it apparently is, and the less likely they will be able to.

So what should we make of the staff level agreement? Well, in short, we do think that the measures proposed can improve Greece’s competitiveness, financial stability and fiscal sustainability. Yet based on Greece’s track record of policy effectiveness over the past few years, we have our doubts about the ultimate impact on economic growth and government finances. We do not believe that Greece will able to maintain a primary surplus of 3.5 percent of GDP until 2030. Simply, because the current degree of fiscal austerity will weigh on future growth. The longer the economy remains in the doldrums the less likely it is that the Greeks are willing to pursue the current degree of fiscal austerity. Fortunately for Greece, Europe acknowledges that further debt relief might be required. Unfortunately for Greece, it has trouble deciding on the size and measures, and it has ruled out nominal haircuts. As long as Greece’s public debt problem is not adequately dealt with, the risk of a sovereign default and Grexit remains present. The first big test after the conclusion of the second review will likely only come in 2019, given that the redemption profile is rather limited in 2018.