The latest ESM compliance report on the Greek adjustment program also contains an updated Debt Sustainability Analysis (DSA) which reaches some fairly important results.

Its main assumptions are:

  • Real GDP growth close to 1.5% after 2022 and 1.25% from 2030 onwards. Coupled with inflation equal to 2% after 2024 the Greek long-term growth outlook is equal to 3.25% in nominal terms (the IMF on the other hand expects a nominal GDP growth rate of 2.8%).
  • Total privatisation revenues of €17bn with no need for further bank recapitalisations (the IMF projects €10bn revenue and a need for an additional €10bn buffer for bank capital needs).
  • A 3.5% primary surplus until 2022 after which the primary surplus starts to decrease 0.5 p.p. per year levelling off at 2.2 % as of 2025 (the IMF does not consider these long-term surplus targets sustainable).

Event under these assumptions the baseline scenario expects the debt-to-GDP ratio to reach 165% in 2020 and 127% in 2030 while the Gross Financing Needs (GFN) are projected to increase from 2020 onwards reaching 23% in 2055.  As the report itself states:

Given the high debt-to-GDP and GFN-to-GDP levels, concerns remain regarding Greece’s debt sustainability under this scenario.

 Under more unfavourable scenarios the debt-to-GDP and GFN ratios are quite explosive and do not allow Greece to reach any measure of debt sustainability.

DSA - results* Scenarios B & C are the adverse scenarios.

Even the ESM is not able to paint a rosy picture of Greek debt dynamics despite making some very favourable assumptions regarding long-term growth and government primary surpluses. A small deviation from these (optimistic) assumptions puts the Greek debt to an unsustainable path.

Although the above make it clear that further rounds of debt restructuring will be needed, the fact that GFNs fall significantly during the 2018-20 period means that Europeans can narrowly focus on short-term targets regarding Greek primary surpluses while postponing debt reduction measures for the more distant future. As a result, Greece might be caught in a situation where short-term measures are demanded (such as bringing the income tax threshold reduction forward) while debt restructuring is only offered as a promise for .. the next decade and contingent on fiscal measures being passed immediately.

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In this post I am going to take a quick look at Greece vs Turkey population dynamics based on available statistics by the World Population Prospects of the UN. I will focus mainly on the working age population (25-64 years old) since this segment participates in production, defence and makes a society more or less dynamic. Moreover, projections up to 2050 have a small margin of error since (almost) the entire population has already been born.

Greece Population Dynamics 1995 - 2050

Greek total and working age population peaked in 2010 driven by the steady fall of people under 25 years old and the increase of the 65+ population. By 2020 working age population will be 6.1mn persons down from 6.4mn in 2010 while 65+ 2,35mn from 2.1mn. The 2025 numbers will be 5.9mn and 2.54mn. The negative dynamics will be present up until 2050 when total population will drop below 10mn, working age people will be only 4.4mn and 65+ 3.5mn.

It is clear that the Greek society will slowly lose all its dynamic and vibrant elements and transform into a nation of elderly people reliant on an ever decreasing working age population to care and contribute for their pensions. This is quite evident in the evolution of old-age dependency ratios, even if we enlarge the working age population to include the 65-69 segment:

Greece - Dependency Ratios

While the 65+ dependency ratio was a bit over 3:1 in 2010, it will drop to 2.6 during 2020 and reach 1.25:1 in 2050 while the 70+ ratio will also be less than 2 hovering at 1.85:1. The above suggests that either old-age pensions will be almost non-existent or that the working population contributions be very high in order to provide for the retired population. Instead of the classical class conflict we are likely to observe a strong age conflict.

Obviously Debt Sustainability scenarios regarding the large Greek government debt are prone to failure since the debt per person employed will quickly become too large (and compete with old-age pension contributions) unless Greek productivity miraculously increases at an astonishing rate.

Turkey on the other hand is a vibrant, young nation with the majority of its people being relatively young. In 2015 the country had a total population of 78.27mn with 42% younger than 25 years and a total of 73% being up to 44 years old. Its young age population will keep increasing until 2020 while its working age population will only stabilize around 2045 at close to 49mn (with a total population a bit less than 95mn). Still, its population over 65 years old will also show a substantial increase during this period growing from only 3mn in 1995 (5% of population) to almost 20mn in 2050 (20.5% of population) with an old-age dependency ratio of 2.5:1

Turlkey - Population Dyanmics 1995 - 2050

Nevertheless, during the 2020s, Turkey will still reap the rewards of a growing working-age population without the increase being overwhelmed by a stronger growth in the 65+ population (something which will happen after 2030).

Comparing the working age and 25-44 population groups of Greece and Turkey up until 2030 it is evident how different these societies will be as well as how their relative sizes will evolve:

Turkey vs Greece Population Ratios 1995 - 2030

At the end of 1995 (when the Imia crisis erupted) Greece had a working age population of 5.7mn while Turkey 24.5mn for a ratio of 4.3:1.

During the 2020 decade the working age population ratio will reach 10:1 while the same will happen for the more vibrant (and important as military reserve) 25-44 age group. Given that the Ameco database projects that Turkish GDP per person employed (in Euros) will be close to 2/3 of its Greek counterpart by 2019 one can assume based only on population dynamics that the Turkish economy will become 5 to 6 times larger than the Greek economy during the next decade (the IMF is already projecting that it will be 4.5 times larger by 2022).

Given such dynamics, coupled with the costs faced by Greece to service its government debt and old-age pension needs, it is highly unlikely that Greece will be able to maintain sufficient military forces in order to counter Turkish pressure. Having an economy 5-6 times larger as well as an industrial base capable of providing for most of its military equipment needs domestically will mean that Turkey will be in a position to procure a military force several times higher than its Greek counterpart with an investment still lower as a percentage of GDP.

Greek society will have to make a tough choice during the next decade. It will be next to impossible to simultaneously service its large government debt, provide for its elderly (in terms of old-age pensions and health services) and counter the Turkish military force with a sufficiently large investment in equipment.

Most people believe that the significant deterioration in the Greek balance of payments after the introduction of the Euro is a clear sign of the fall in Greek competitiveness and of unsustainable private debt expansion dynamics. It is assumed that the Greek economy was not able to provide the global market with goods and services of a sufficient quality and competitive price while the large expansion of domestic demand (due to significant private credit flows) expanded imports with a rate that led to a large increase in the goods deficit.

Although there is some truth in the above statement, a closer look at the detailed balance of payments data (from BoG) reveals some very interesting facts. The actual balance of payments figure deteriorated significantly from a deficit of €11bn in 2002 to €36.5bn in 2008 all while nominal GDP expanded by 50% in the corresponding time period.

Yet imports and exports of goods excluding oil & ships expanded with the same rate (although at a rate higher than nominal GDP which suggests that private credit flows did play a role). What made the corresponding deficit increase by around €10bn was the fact that exports are only 34-36% of imports although that ratio remained relatively steady throughout that period:

Greek Balance of Payments Imports Exports of other goods 2002 - 2008The actual increase in the balance of payments deficit can be attributed to 3 factors:

  1. An increase in the oil balance deficit which more than doubled by 2008.
  2. The ship balance moving from a surplus of €400mn to a deficit of more than €4.6bn in 2008 and
  3. A significant increase in the balance of investment income (mostly interest payments) from €2.3bn in 2002 to €10.6bn during 2008

Greek Balance of Payments - Oil Ship and Investment Income Balance 2002 - 2008

The first factor can mostly by attributed to a large increase in global oil prices during that period, especially denominated in Euros.  By 2008, global Euro oil price had increased 150% compared to 2002 while the Greek oil balance deficit had expanded by a comparable 170%.

The swing of the ship balance to a large deficit is most probably accounted by a corresponding increase in ship building/purchases investment by Greek ship companies. This was a period of large global trade growth with the Baltic Dry Index reaching new highs. The reasonable assumption was that these large investments would quickly translate into increased shipping payments that would be used to finance the initial outflows and (also) lower the current account deficit through a higher services surplus.

As for the investment income deficit this is mostly the outcome of stock-flow adjustment and monetary policy. Each year’s current account deficit added to an increase of Greek foreign net liabilities and to larger net interest payments in a semi-automatic way. Moreover, the increase in short-term interest rates by the ECB after 2005 made servicing the same amount of net liabilities even more expensive which is one of the reasons why the investment income deficit expanded more rapidly during 2006 – 2008.

If we assume that the sum of the Balance of Goods excluding oil & ships and the balance of services can be regarded as the most representative metric for the Greek external sector and competitiveness we observe that this deficit expanded by only €4.5bn during 2002 – 2008. The bulk of the balance of payments deficit expansion can be accounted by oil, ships and investment income. In other words, global factors (oil prices, expansion of trade and the shipping industry, ECB monetary policy) as well as the automatic effect of flows on stocks were the main drivers of the Greek external deficit.

Greek Balance of Payments changes since 2002 up to 2008

As I ‘ve highlighted many times in the past, the level of future long-run primary surpluses for Greece plays a major role in the debt sustainability scenarios. The major difference between the IMF and Euro institutions projections is identified in the primary surplus assumptions. The IMF projection for a 1.5% surplus makes debt restructuring necessary while the European institutions assume much higher primary balances which make debt sustainability more favourable.

IMF vs Euro Institutions Greek DSA

A recent ESM paper on Greek debt reveals the importance of these projections. If Greece achieves 3.5% primary surplus until 2032 and 3% until 2038 no debt restructuring is required as long as economic growth is 1.3%. On the other hand, the IMF scenario of 1% economic growth and a primary surplus of 1.5% after 2022 makes Greek debt explosive.

European institutions try to make the case that episodes of large and sustained primary surpluses are not uncommon in European modern history. The ECB especially highlights the cases of Finland and Denmark as well as other countries:

The European Central Bank says such long periods of high surplus are not unprecedented: Finland, for example, had a primary surplus of 5.7 percent over 11 years in 1998-2008 and Denmark 5.3 percent over 26 years in 1983-2008.

and

ECB - Selected Episodes of large and sustained primary surpluses in Europe

My comments are twofold. First, the average primary surplus figure is not always equal to the year-by-year primary balance. Denmark achieved a primary surplus equal or higher than 5.3% in only 5 years during the 1983 – 2008 period. Actually, the primary surplus was at least 3.5% during 9 of the total of 26 years.

Yet the most important element that is not highlighted in the above cases is the fact that large primary surpluses were achieved in the context of equal or (mostly) higher current account surpluses. This is highly important since it allows the domestic private sector to achieve a positive net asset position even when the public sector is in surplus. As a result, economic growth is not threatened by the public sector and the private sector maintains a healthy balance sheet.

To illustrate the above I ‘ve «corrected» the primary surplus by subtracting the current account surplus. I ‘ve also deliberately set the vertical axis maximum to 3.5% which is the surplus requested from Greece to illustrate the fact that it is almost never achieved.

corrected primary balance for current account - selected high surplus episodes.jpg

On the contrary, of the total of 60 years in the above episodes, 26 had a negative corrected primary surplus while it was lower than 1.5% in 40 years illustrating the fact that the IMF assumption of a 1.5% surplus is not unreasonable.

Since the Greek cyclically adjusted current account is highly negative it is clear that the assumption of high primary surpluses which will be maintained for decades is almost without precedence in the context of the private sector balance. Assuming a 3% nominal growth rate (based on the IMF assumption of 1% growth), a 10 year 3.5% primary surplus is equal to a 30% GDP transfer from the domestic private sector while a 20 year 3.5% surplus is equal to 52% GDP transfer which will not be counterweighted by a current account surplus.

In my view, the European institutions continue to make assumptions consistent with avoiding explicit costs for Greece’s creditors but inconsistent with economic reality and sectoral balances.

A recent paper tried to perform a very important exercise of evaluating the balance sheet effects of a Euro exit for various Euro countries. Its results were that the relevant sectoral net positions will be the main drivers of balance sheet effects. Periphery risks are concentrated on the net positions of the government and the central bank while the financial and non-financial sectors mostly hold a positive net position.

net position by sector and country

More specific risks do arise from the fact that certain sectors (within countries) have significant levels of short-term debts, although this fact does not change the overall picture substantially.

Debt by sector and country

I would like to use this opportunity in order to take a detailed view at the sectoral balance sheet risks from a Grexit scenario relying on BoG Greek NIIP data (data are for 2016Q3). I am focusing on specific categories and not taking categories such as direct investment or derivatives into account.

Greek Sectoral NIIP 2016Q3

On the asset side:

  • BoG now holds a large stock of foreign bonds as a result of its participation in the ECB QE program.
  • MFIs have a total of €19bn in deposits and €59bn in bonds a loans. Nevertheless, a large part of the latter are EFSF notes offered as part of the various rounds of Greek banks recapitalization exercises.
  • NFC and households have substantial claims in the form of deposits and banknotes, more than €52bn in total.
  • The general government holds no assets while its foreign exchange reserves are very low and mostly in the form of monetary gold. Although Greece does have a claim on the ECB reserves this would not change the picture in a serious way.

On the liability side:

  • The general government is the largest debtor with €28bn in bonds and €236bn in loan liabilities. Yet most of the bonds and almost all of the loans are long-term in nature.
  • BoG is the second largest debtor with almost €93bn in liabilities which consist of Target2 and extra banknotes.
  • MFIs have a large stock of liabilities in the form of deposits (which are usually a proxy for repo trades).
  • NFC and households have a very small stock of liabilities in the form of bonds and loans (a bit over €10bn).

Overall one observes that:

  • The largest part of the Greek NIIP is attributed to the Greek government with over €260bn in debt.
  • Taking into account the bonds held as part of QE, BoG net foreign liabilities drop to €47bn.Using the most recent available data (January BoG monthly statement) this figure further decreases to a bit over €38bn or close to 20% of GDP.
  • NFC and households hold a strong positive net claim from the RoW equal to almost €44bn. This most certainly masks firm-specific risks and mismatches but overall, the Greek non-bank private sector will improve its net position in the case of a currency depreciation (following a Grexit).
  • Using only deposits figures, Greek MFIs have a net liability close to €28bn. Since a large part of their liabilities will be under foreign (instead of domestic) law this creates a serious risk of missing debt payments or being unable to roll-over short-term repos and other obligations. Given that the Greek banking system will be the one intermediating in all of the private sector’s foreign transactions this net liability position can create rather difficult scenarios.

I will also use BoG MFI balance sheet data to take a closer look at Greek bank foreign risks:

Greek banks foreign risk Jan-2017

It is clear that things are a bit complicated, especially since Greek banks have a large stock of intra-group transactions with group members in other (Balkan?) countries. Nevertheless, after correcting for such transactions one observes that they owe €13.6bn in net liabilities to other MFIs (€18.5bn gross) and another €8.6bn in foreign deposits. The main source of risk will mostly be the first item which is usually secured by a standard contract (master agreements) and is under foreign law.Missing a payment on these liabilities will create serious problems for the corresponding bank and its ability to continue transacting in international markets. Obviously a risk assessment would be made easier if the maturity profile of these liabilities (and assets) was known.

Regarding the BoG liability position I believe that in the event of a Grexit, securities held for monetary purposes will be used to settle the largest part of Eurosystem claims while the remaining net position will be settled with some form of Greek government long-term securities (probably floating rate notes paying Euribor).

In summary, I generally agree with Kostas Lapavitsas who believes that a Grexit scenario will necessitate increasing Greek government foreign reserves to at least €12-15bn. The main immediate sources of risks are the short-term debt of the Greek government and Greek banks. The first consist mainly of liabilities towards the IMF (since SMP Greek bonds are under Greek law and would be converted to the new currency) while the second require a thorough risk analysis. A Grexit would be extremely difficult if Greece only held €7bn in foreign exchange reserves (with 2/3 being monetary gold) since a bank debt payment failure would create serious disruptions in the country’s international transactions.

ELSTAT released the second national accounts estimate for 2016Q4 today and the announcement did make a lot of noise. The main reason being the large growth revisions for the last quarter of 2016 with the volume decreasing by 1.1% compared to the last quarter of 2015, in stark contrast with the initial flash estimate of an increase equal to 0.3%. This development erased the initially estimated annual expansion of 0.3% with the current figure being slightly below zero.

Yet I think that looking into the detailed evolution of specific aspects of the Greek GDP paints a rather different and less alarming picture:

greek-volume-quarterly-national-accounts-2014-2016

Both private consumption and net exports posted positive growth compared to 2015Q4 while general government consumption fell by €200mn in volume terms. The negative outcome for 2016Q4 is entirely attributed to investment which dropped 1.76bn. The reason for this is twofold.

First, change in stocks was a negative 1.47bn which coupled with another -1.53bn in Q3 resulted in a second half figure of roughly 3bn. Nevertheless, private consumption was 0.9% higher in 2016H2 which does not justify such a fall in stocks (almost 10% of quarterly private consumption). Taking a look at a 4-quarter moving sum reveals that the sum is close to the trough of recent stock cycles.

greece-change-in-stocks-4-quarter-moving-sum

Given the fact that 2016Q1 change in stocks was a positive 1bn, even a zero change in stocks during 2017Q1 will lead the moving sum to a figure close to -2.7bn similar to what happened during 2012, at the depths of the Greek Depression. Obviously such dynamics are hard to reconcile with a stable/slowly increasing private consumption. A zero reading for τηε change in stocks during 2017Q1 will be equal to around 3.5% of quarterly GDP and thus have a large impact on quarter-by-quarter growth figures.

The second aspect of investment was gross fixed capital formation which came at roughly the same magnitude as previous quarters (5.45bn). Nevertheless, the corresponding 2015Q4 figure was exceptionally large (6.3bn) and resulted in a negative effect when compared to the last figure of 2016. Yet the 2015Q4 number seems to be a clear outlier, probably attributed to capital controls effects during 2015. This is quite clear if we compare the difference of fixed investment to its 4-quarter moving average since the start of 2011:

greece-fixed-investment-difference-from-4-quarter-moving-average

Overall, I think that 2016Q4 investment developments constitute a set of outliers and will not have a large impact of 2017 GDP movements. Although I do not share the government’s optimism about a large 2017 growth, I do not think that today’s revision for Q4 growth will change this year’s dynamics considerably.

One of the main targets of recent adjustment projects throughout the Euro periphery have always been the reorientation of production towards exports and an export-led recovery. Yet when analysing trade and external balance developments one must always pay attention on using the correct metric. A large contraction of domestic demand will almost surely lead to a fall of imports and an improvement of the current account balance. An increase of external demand even with a constant export income elasticity of demand will mechanically lead to an increase in exports. Yet none of the above suggest a rebalancing of production towards exports or a structural improvement of cost/quality competitiveness.

One metric that can avoid some of the above problems is the share of world exports. If that remains stable yet exports increase then this fact points to an increase of external demand, not of export penetration. On the other hand, an increase in export share will mean that a country is able to increase its exports more than the change in total world exports and gain competitiveness compared to other countries (whether this is a zero sum game is another story).

Looking into Euro exports through these lens makes it clear that no country (except Ireland and only for 2015) has been able to materially increase its (goods) export share compared to 2010:

  Euro share of world exports 2010 - 2015.jpg

As a result, the 20-30% rebound in real exports compared to 2010 is most probably a function of movements in external demand than of any structural changes in product quality, prices or mix:

euro-real-goods-exports-2010-2015-base-2010

Taking a more long-term view one can examine how the export share evolved since the introduction of the Euro. A small caveat is that export shares precision is two digits so they are not able to catch small movements in the case of countries such as Greece and Portugal with exports shares around 0.17 or .40.

euro-share-of-world-good-exports-base-2002

and

euro-share-of-world-services-exports-base-2002

Starting with goods exports share the data show that only Germany and Greece managed to maintain or increase their share until the Great Recession. Even Ireland saw a large decrease of its share during that period. During and after the Great Recession no country managed to increase its 2008 share (I am disregarding the Irish exceptional data point of 2015). This suggests a structural deterioration which was clearly not alleviated by the adjustment programs undertaken since 2011.

Regarding services exports share we observe a clear, stable upward trend for Ireland which managed to increase its share by 53% until 2015, a development which is surely closely correlated with its role as a tax avoidance hub. Germany, Greece and Portugal all managed to roughly maintain their 2002 share until 2008 while the rest witnessed a strong decline.

During and after the Great Recession we witness a substantial decrease in shares for most countries with the most pronounced decline being the one for Greece. The Greek services exports share managed to fall almost at half its 2008 level by 2015, a development that is most probably related to the large drop in shipping revenues during the corresponding period.

Overall, export share data do not suggest any actual structural adjustment in periphery countries in favor of exporting industries. On the contrary, services exports (with the exception of Ireland) have clearly deteriorated while goods exports only marginally maintained their shares. Any exports gains seem to have only been a function of autonomous external demand movements rather than structural in nature.

One of the classical narratives in the Greek (tragedy) story is how Greece is the outlier in an otherwise successful implementation of austerity and adjustment programs throughout Europe. Other European countries thoroughly introduced and implemented austerity policies, liberated their labor and product markets, adjusted their economies towards an export and investment-led growth model and are now enjoying the benefits of their efforts.

In this short essay I would like to point at two important problems for this story. The first one is that the periphery experienced large and persistent output gaps during the European crisis since 2011. Spain had a negative output gap of 8.5% in 2013 while Italy and Portugal registered gaps more than 4% of potential product. All number were significantly larger than the relevant numbers at the start of the crisis during 2011.

periphery-output-gap

An increase in the output gap is consistent with a rebound in economic growth in the immediate years during which the gap closes. Obviously this does not mark a policy of increasing output gaps and inflicting recessions as «successful», nor is a rebound not expected as soon as fiscal and monetary policy are relaxed. This is made clear from economic growth projections for 2017-18 period during which the closing of output gaps will lead to a significant decrease of output growth compared to 2015-16.

periphery-output-growth

The second point is the fact that a clear indicator of success for an adjustment policy is not economic growth during the period when output gap closes but rather if the adjustment has permanent positive effects on potential output. An adjustment program which is supposed to increase productivity, efficiency, growth prospects and lower macroeconomic imbalances would be assumed to lead to a corresponding increase of potential output.

Yet recent research suggests that austerity policies implemented during the Eurocrisis have had permanent negative effects on potential output which actually increase overtime:

The results show a coefficient close to one for 2014 and around 1.6-1.7 for 2019. This suggests that every 1% fiscal-policy-induced decline in GDP during the years 2010-11 translated into a 1% decline in potential output by 2014 and even more for 2019. The results are significant for both samples and the coefficient is similar for the Europe and Euro.

permanent-effects-on-potential-output-from-fiscal-consolidation-2sls-europe

If one takes a look at potential output for various European countries (base = 2011) the results are that crisis countries had a serious blow on their economic potential. Only Spain will achieve a level equal to 2011 by 2018, while Italy and Portugal will still be quite lower than their 2011 levels. At the Euro-12 level, potential product will be only 6% higher than 2011, a result driven to a large extent by the positive dynamics of the German economy (an increase close to 11%). If Germany is excluded from Euro-12, growth falls to 4% with half the increase occurring during 2017-18 (the 2016 level is only 2% higher than 2011).

periphery-potential-output

Obviously there are other structural factors playing a role in these developments (such as labor force growth dynamics), yet these results, especially compared to the German outcome, clearly suggest that adjustment programs did not provide a medium term boost to potential product. Claiming to return countries on a path of sustainable, strong growth yet keeping potential at 2011 levels for almost a decade can hardly be regarded as a sign of success.

BoG recently released its 2016 financial statement, posting a total of €1.09bn in profits with close to €1.5bn in net interest income, slightly lower than the relevant figures during 2015. In light of this I would like to take a quick look into the annual developments in the major components of its balance sheet.

During 2016, total lending to Greek banks (defined as the sum of MROs, LTROs and Other Claims) dropped from €107.5bn in December 2015 to €66.6bn at the end of 2016, a fall of roughly €41bn (a figure close to 25% of GDP or equal to annual goods imports for the Greek economy). Other Claims (ELA) played a significant role with an annual decrease of €25.2bn.

total-lending-and-other-claims-2016

The fall was driven to a large part by a fall in liabilities towards the Eurosystem, both for Target2 liabilities and extra banknotes:

target2-and-extra-banknotes-2016

Yet the total fall in Eurosystem liabilities was much lower than the decrease in bank lending, an adjustment of €28.4bn:

total-lending-and-eurosystem-liabilities-base-2016

The main reason was the significant increase in securities held for monetary purposes which increased from €20.7bn at the end of 2015 to a total of €42.5 in December 2016 (a change close to €22bn). Obviously this increase was the result of purchases by BoG in the context of the ECB QE program. As the ECB itself has acknowledged, a large part of QE securities purchases involve cross-border transactions which result in a corresponding increase of Target2 liabilities. As a result, Target2 balances cannot be used as a useful capital flight tracker anymore since they correspond to legitimate transactions in the context of QE.

Total collateral dropped from €189.2bn to €131.7bn in December, a figure still two times larger than the total debt securities held by Greek banks or roughly 2/3s of total credit claims held by the Greek banking system.

Overall, 2016 was a year of relative stabilization although the BoG balance sheet still reflects a substantial amount of stress present. The presence of capital controls acts as a first line of defence to any amount of capital flight while QE is destined to increase both BoG balance and its liabilities towards the Eurosystem. Moreover, while securities held for monetary purposes were only 22% of Target2 liabilities during December 2015, they have now climbed close to 60%. As a result, in the event of Grexit, a large part of the Target2 (negative) balance could be settled immediately with a transfer of securities and a corresponding fall of the BoG balance sheet. The amount not covered by securities is now close to €30bn and seems destined to fall in 2017 as well.

So it is more than clear that European creditors of Greece are continuing to demand long-term primary surpluses around 3.5% of GDP. One has to ask: What’s so special about this number? Why can’t it be lowered a bit and give Greece more breathing space?

The answer is quite simple:

2% interest rate x 180% debt to GDP = 3.5% of GDP/year

The 3.5% primary surplus target is the one consistent with maintaining the debt-to-GDP ratio stable when the nominal GDP growth rate is zero. This means that Greece can  withstand shocks to its nominal growth rate (negative real GDP growth or a deflationary shock) and still manage to keep its debt ratio stable. Obviously, as long as it manages to achieve positive nominal growth its debt ratio will decline each year while privatization receipts will lower debt even quicker.

From a slightly different point of view, the 3.5% target provides insurance to European creditors that any short-term failures of the Greek program will not lead to an increase of the debt ratio, only to a flatter decline path. The risk of the Greek program not achieving its ambitious targets is pushed on the back of Greece while its creditors can keep the upside of any positive shocks that will improve debt sustainability.

Yet again one observes that the Greek issue is mostly a political rather than an economic issue. It relates to the question of who provides insurance regarding the program targets. Since European creditors appear unwilling to provide such insurance my feeling is that agreeing on a lower target will prove substantially difficult, especially in the current political climate across Europe.

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Kostas Kalevras

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