Fixing Greece: Part III

What happens next?

OF LATE, Greece’s current account has come close to registering, but has not yet equalled, surpluses achieved by her comparators at the time their crises abated. Against this, Greek public external debt remains much larger.

What next? Four things are worth noting:

First, Greece experienced the largest current account adjustment since 2008Q4—nearly 14 percent of GDP (see table). And this adjustment challenge was exacerbated by the lowest initial ratio of goods and service exports-to-GDP as well as the weakest export performance since (text chart). While export recovery was already lagging in Greece compared to other peripheral countries, the mid-2015 creditor showdown provided a further set-back such that nominal exports today are scarcely higher than in 2009. The largest burden of adjustment has, to date, fallen on domestic demand and import compression. Fortunately, there is scope for catch-up through export recovery as financial conditions ease.

GR_FINAL_text table

Second, while Greece’s current account today (-0.8 percent of GDP, 4QMA 2017Q1) remains below that registered by Portugal (+0.8 percent) and Ireland (+2.1 percent) at the time of their clean program exits, in cash terms Greece’s external position is a stronger than the headline figure implies. This is due to the fact Greece benefits from interest deferral of €1-1½ billion (½-1 percent of GDP, see Table 2 and Table 7) over the forecast horizon, meaning in cash flow terms her current account is near balance. Greece therefore generates roughly all the foreign exchange cash flow needed at the moment to service external debt. There is a decent case that, with export recovery, program exit is near.

GR_FINAL_text chart

Third, more important, Greece is currently experiencing her largest foreign direct investment (FDI) inflow—that is, net non-debt creating investment from abroad—since joining the euro (Figure 6, right chart). This is reflected in both resident FDI repatriation and large non-resident investment inflows totally 2½ percent of GDP. Together with the current account (ex. interest) surplus, Greece now creates 4¼ percent of GDP foreign exchange—without taking on any more external debt—with which to service external debt at 2 percent of GDP—of which about ½ percent is deferred (Figure 6, left chart). In this respect, for perhaps the first time since the Crisis, the Greek Transfer Problem has been solved.

GR_Final_FIGURE 6

Fourth, there remains the possibility of inclusion in the ECB’s Asset Purchase Program (APP). This would not necessarily generate foreign exchange inside Greece to recycle towards servicing external debt since many Greek bonds are held by non-residents. However, APP inclusion would cause bond yields to compress further—as elsewhere in the periphery—and catalyse other capital inflows to Greece. Further easing the external constraint, this would allow for domestic demand pick-up and the sustained recovery as witnessed elsewhere. That said, APP inclusion seems unlikely until mid-2018—by which time bond buying could be near an end.

Overall, the improvement in Greece’s external position—with or without APP inclusion—implies a period of recovery ahead. But this was also the case in 2014, when the Samaras government was expecting debt relief from the Europeans—having generated a primary fiscal surplus as agreed end-2012 (Figure 5, left chart). When this promise was reneged upon—eying elections ahead—Samaras turned populist, causing a stand-off with creditors. The rest is history. With the next Greek election due on or before October 2019, will this turmoil be repeated?

Near-term, problems will only re-emerge for Greece if: (i) fiscal slippage requires additional unpalatable fiscal measures causing renewed recession—as already legislated in the IMF’s program, against which the authorities hope to push; or (ii) regardless of the fiscal outcome, the Europeans try and prevent clean program exit—sparking further political turmoil in Greece. Such developments would re-awaken once more those calling for Grexit. But with some forbearance and political will, Europe can quite reasonably support Greece in some form of program exit—if not entirely clean, then with a precautionary ESM backstop. As such, absent negative political intervention, the Greece success story has some way to run.

If this proves to be the case, the main risks will only re-emerge once external debt service fully kicks in. And with scope for decent out-performance in Greek GDP, European institutions might feel emboldened into thoughtlessly implementing a “growth adjustment mechanism” based on their currently DSA framework. Consider how the EU Commission fails to distinguish external from domestic demand, does not project the current account or financial flows for Greece.

Why does this matter? This leads us once again back to the German experience in the 1920s. A caricature: facing reparation payments, following the Dawes Plan, Germany engaged in large-scale external borrowing to sustain demand and avoid the balance of payments constraint. This largesse was exacerbated by a mechanism whereby Germany’s private creditors had first claim on her foreign exchange surplus. As a result, rather than running a trade balance surplus as the logical counterpart to reparation payments, Germany’s current account deficit widened into the late-1920s. When official creditors eventually tried to call in reparations and reassert a claim on Germany’s foreign exchange earnings, this triggered private capital flight and a sharp current account compression (See, e.g., Albrecht or Tooze). Having experienced one extraordinarily painful sudden stop, it is incumbent on the international community that this should not happen again to Greece.

The EU institutions, in their design of the post-Crisis framework for Greece, ought therefore be able to fully account for future drivers of nominal GDP growth.

Suppose nominal GDP growth is driven by export growth and/or net FDI inflows, thus generating foreign exchange needed to service external debt without creating new external debt. This would be a favourable means of helping Greece recover.

GR_Final_FIGURE 7

However, as in 1920s Germany, if growth is instead driven by the accumulation of net private external debt—and government external debt simply replaced by opportunistic private external debt—then the prospect of a renewed widening of the current account deficit and danger of a sudden stop cannot be ruled out. And the period until 2022 where external interest payments and amortization remain contained is an opportunity for private capital inflows once more (Figure 7).

Clearly, this is a difficult line to walk. But any “growth adjustment mechanism” for Greece ought provide for sustainable recovery.

More generally, there is a case for the primary surplus to move counter-cyclically to net external debt creation—in Greece and elsewhere. That is, absent a central bank policy—through reserve creation—to offset booms and busts created by the ebb and flow of external capital flows, the primary fiscal balance provides the only tool for this purpose. For Greece, this would imply a fiscal rule that offsets net private debt creating inflows in the period ahead rather than the current mechanical fiscal requirements.

This could also create an automatic mechanism for expansion in surplus countries—creating a symmetry in adjustment that has been sadly lacking to date.  But this is a topic for another occasion.

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