Fixing Greece: Part I

WITNESS, IF YOU WILL, the resurrection of the Greeks. Disbursement of €7.7 billion on 7th July by the European Stability Mechanism (ESM), with another €0.8 billion soon to follow, and an “Agreement in Principle” International Monetary Fund (IMF) precautionary arrangement, has brought Greece to life once more—and deservedly so.

The Greek government bond (GGB) 10-year yield at roughly 5½ percent sits close to post-crisis lows. The Tsipras government has returned to markets with a five-year bond with 4.635 percent coupon, below that attained by the previous administration in 2014. SYRIZA can be forgiven for eyeing program exit.

But the Greek situation raises a substantial analytical challenge still—especially with public debt to GDP hovering above 170 percent. The IMF claims Greek debt to be unsustainable—pressuring EU creditors to offer more substantive debt relief—and insist on both more fiscal adjustment near-term yet lower primary surplus targets beyond 2022. The Europeans (EU) and Greeks take a more sanguine view. International investors seem unperturbed.

How can Greece be fixed? And what prospects from here?

Debt sustainability wars

           THE LATEST Greek program documents (EU Commission and IMF) make no effort to conceal divergent views between Brussels and Athens—the “Europeans”—and Washington, DC. Differences mainly relate to fiscal policy and public debt sustainability.

Three points of contention stand out: near-term austerity; the medium-term primary surplus; and long-term growth.

First, near-term austerity. A quick recap. Following the aborted effort of the SYRIZA government to reverse austerity mid-2015, the Greek government committed to a primary surplus of 3½ percent of GDP by 2018—on threat of extinction. This required 4½ percent of GDP additional—quickly legislated—consolidation despite ongoing depression. Meanwhile, 2016’s primary surplus success (+4.2 percent of GDP), though largely due to “temporary factors,” offers hope that the worst is at last behind the Greeks.

In assessing progress towards these 2015 commitments, European institutions recently saw a small fiscal shortfall (0.3 percent GDP) promptly addressed by the Greeks.

But the IMF were not convinced. Relative to the European assessment, the Fund remains circumspect as to tax revenue yields and likely future
pension spending; in addition, they remain cautious regarding future growth and capacity for fiscal restraint.

Overall, the IMF see a shortfall relative to the Europeans’ 3½ percent primary surplus objective. And so, to secure continued IMF involvement additional fiscal measures have been legislated: average pensions will be cut 12 percent and the personal income tax credit reduced 40 percent in 2019 to yield an additional 2 percent of GDP fiscal adjustment—on top of the 4½ percent of GDP plus 0.3 percent additional action, as assessed by the Europeans and agreed since 2015, itself on top of the roughly 10 percent primary balance adjustment since 2009.

The primary surplus will therefore, in the IMF’s baseline, increase from 1¾ surplus this year to 2.2 percent in 2018 and 3½ percent in 2019.

Given their disagreement with the IMF on the impact of 2015 measures, the Europeans have additionally agreed—and the Greeks legislated—an offsetting 2 percent of GDP in expansionary measures for the Greek economy “contingent” on fiscal performance. If the 3½ percent primary surplus is assessed as durably achieved in 2018—as the Europeans currently expect—then an expansionary tax and spend package of 2 percent of GDP will be triggered to offset that legislated for 2019 to keep the IMF involved in the program.

If this seems messy, that’s because it is.


Second, medium-term primary surpluses. Based on historical experience, the IMF argue that primary surpluses of 3½ percent of GDP into the (almost) indefinite future beyond 2022 are unlikely to obtain.

The IMF therefore envisage expansionary measures noted above will be enacted after 2022, and the primary surplus settle down at 1½ percent from 2023 onwards. The Europeans, on the other hand—while softening their previous position aiming for a 3½ percent primary surplus into the foreseeable future—expect the primary surplus to fall to 2.2 percent in 2025, holding thereafter. This 2.2 percent target conveniently means, despite rising interest costs, the total (primary and interest) fiscal deficit approaches, but never exceeds, the Europeans’ 3 percent deficit limit—whereas in the IMF’s baseline this redline is crossed.

Third, long-term growth. To assess sustainability, a view is needed on long-term growth and inflation. Greece is a rapidly ageing society, with working-age population expected to contract roughly 1 percent a year from 2020—hence rising pension costs.

Demographics imply a negative long-run real growth rate given past productivity trends. And so, assuming total factor productivity (TFP) growth at triple the historical rate thanks to “structural reforms” allows the IMF to, reluctantly, justify 1 percent real growth from 2025 for forecasting purposes. The Europeans also acknowledge the impact of ageing, but see real GDP growth at 1¼ percent beyond 2030.

As for the GDP deflator, despite saggy global inflation and a huge output gap in Greece, with unemployment expected to remain in double digits until 2040 (IMF ¶11), both institutions see inflation returning to close to, but below, 2 percent from the mid-2020s—with the EU long-run assumption roughly 0.1 percentage points above the IMF.

Together the EU’s growth and inflation assumptions compound to deliver Greek 2060 nominal GDP (€740 billion, 2016’s being €176 billion) roughly 20 percent above the IMF’s projection (€625 billion)—2060 being the current horizon for the EU’s debt sustainability analysis; the IMF now carry theirs to 2080!

This background allows us to recreate and contrast the debt sustainability analyses of EU Commission and the IMF. Some additional differences should be noted, however. The Europeans expect larger privatization proceeds through time (€17 billion versus the IMF’s €2 billion). In addition, IMF are more concerned about bank solvency given high non-performing loans. And so, while the Europeans now expect €27½ billion less ESM funding than envisaged in 2015, when the total envelope was agreed at €86 billion, the IMF set aside an additional €10 billion buffer for bank recapitalization needs and larger draw on ESM funds.


In addition, each have their own interest rate assumptions—for official borrowing and the interest rate at which private borrowing can be sourced. Roughly, the EU Commission sees the official interest rate increasing to close to 2 percent by mid-2020s, and 3.3 percent in the long run; the private interest rate at about 5½ percent to being with, falling through time. The IMF is on average slight more pessimistic.

Together, these fiscal, growth and interest assumptions compound to large differences in the prospects for Greek debt “sustainability”—and necessary debt relief.

Figure 1 recreates the EU Commission baseline forecast for Greece public debt-to-GDP (left) and Gross Financing Needs (right). It shows debt-to-GDP dipping below 100 percent in 2060. Onto this baseline we fold the impact of various IMF assumptions. With IMF growth, the EU baseline would increase to 120 percent debt-to-GDP in 2060; together the IMF’s primary balance and growth takes this to 160 percent and so on.

Figure 2 decomposes the cumulative drivers of the EU Commission’s baseline. Debt-to-GDP falls about 80 percentage points by 2060, mainly driven by nominal GDP growth—the denominator effect—which reduces debt-to-GDP by about 170 percentage points. The primary surplus meanwhile subtracts about 100 percentage points, with the cumulative impact of interest payments adding about 190 percentage points through 2060. Together, the primary surplus and growth assumptions are enough to drag down the debt-to-GDP below 100 percent despite the heavy interest bill.

Fully, Greece will pay about €800 billion in interest through 2060 which, with a 4 percent discount rate, is slightly more than €300 billion in net present value terms—or about 170 percent of GDP!

The EU Commission’s baseline illustrates the importance of global interest rates and the premium Greece must pay. Yet any interest rate forecast over the next 45 years is no more than guesswork. Indeed, scenarios where the interest rate remains low for a protracted period—think Japan on a global scale—seem reasonable. Against this, the growth assumptions appear optimistic.

The right chart in Figure 2 therefore recreates the EU Commission and IMF baselines assuming fixed 2 percent official and 4 percent private interest throughout. In this case, Greek debt dynamics look much more favourable—in the Commission baseline falling below 60 percent by 2060. With nominal growth at ¾ the EU Commission baseline, however, debt-to-GDP returns close to 100 percent in 2060.

In any case, this all serves to highlight how, as the Greece fiasco approaches its final stages, the institutions are now engaged in a game of Debt Sustainability Wars:

The Eurogroup has agreed to implement a “second set of [debt relief] measures” for Greece whereby some re-profiling of debt could occur “according to an operational growth-adjustment mechanism” on the basis of an “updated DSA in cooperation with the European institutions.”

For the IMF, their Approval in Principle arrangement means IMF resources will only be released “conditional upon Greece’s European creditors providing commitments for debt relief sufficient to secure debt sustainability.” But the IMF’s judgment as to debt sustainability will “be guided solely by the IMF’s own debt sustainability analysis.”

Meanwhile, not to be outdone, Governor Draghi has insisted, in the context of possible inclusion in the Asset Purchase Program, the ECB will conduct its own assessment of debt sustainability. Even the fledgling ESM is in on the act.

DSAs are all the rage!

Curiously, whereas the IMF’s “expertise” was insisted upon in 2010, the EU now sees outside support as a hindrance and not a help.

And lament we might! The Troika’s marriage is loveless. Seven years have passed and in different beds they sleep. Worse, given past failings it seems unlikely “European institutions,” with or without IMF oversight, will concoct a sensible “growth adjustment mechanism” for Greece—not least they are yet to recognise why the original Greek program went awry.

To this we now turn, in Part II, with a view to prospects thereafter.

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