Recently I have been going through the excellent blog of Dietz Vollrath (which is mainly focused on long-term economic growth and its drivers) and have found a number of points on long-term growth which are highly related to the Greek case. As the IMF debt sustainability analysis made clear, Greek long-term growth expectations of 2% annually were based on Greece achieving a steady TFP growth rate equal to the best Euro performer (Ireland). These expectations have already proven way too optimistic and economic growth projections have been lowered to 1.5% yearly. Yet, as the DSA states, if Greece were to achieve a labor force participation rate close to the highest of the Euro area, unemployment fell to German levels and TFP growth reached the average in the euro area since 1980, real GDP growth would average 0.8 percent of GDP. As a result, any long-term growth projection higher than 1% per year seems highly optimistic and conditional on extremely favorable TFP growth rates. In this blog post I would like to explore a few of the headwinds that are likely to put a serious break on Greek long-term growth and how the structural reforms blue pill will not be able to help.

Structural Reforms long-term impacts

Before looking into specific issues let me remind people that the IMF’s own research indicates that most of the proposed reforms in the Greek case (labor and product markets) have low impact on long-term TFP growth rates. The reforms that do impact technical change and productivity in a positive and permanent manner are those that involve actually investing large sums of funds on R&D, ICT capital and infrastructure. Labor market reforms on the other hand have negative effects in the short-term and no impact on long-terms horizons yet they remain high on the reform agenda, even after Greece has already implemented a whole set of measures that have reduced labor bargaining power, minimum wages and allowed for much more flexible working conditions (something which is evident in the very large share of non-permanent work contracts in new hires):

Short and medium term impact of structural reforms on total factor productivity

Sectoral Composition and Growth

Dietz Vollrath also makes a very valid point when analyzing the services sector. He highlights the fact that when someone buys a service what he is ultimately purchasing is time, not a thing. When you buy a massage you are buying 60 minutes of a professional’s time. Increasing productivity in services is not even very difficult, it is also not desirable. We could increase productivity in schools by enlarging the number of children in each class but no parent would be overly fond of such an idea. Ultimately, what the services sector can achieve is either to increase its mark-ups by offering higher quality services (ie in restaurants and tourism) or provide massive, high productivity services (think large retail stores like Zara or large super-markets) which require closing down most SMEs and lowering labor inputs (since much less labor will be required to provide these services). In any case, both avenues require real investment and restructuring of the economy and not just having the state ‘reform and get out of the way’. Obviously taking the second route can increase productivity but at the expense of employment, markups, competition and most probably quality.

In any case, what the above highlights is that one cannot expect that economies with very different sectoral composition between services and industry can achieve comparable TFP/productivity gains without a long and painful process of economic restructuring. This is especially true in the case of Greece when compared to Ireland and Germany:

Sectoral Value Added Shares Germany Ireland Greece

* Source: OECD STAN archives

Economic Restructuring and the financial sector

Closely related to the argument above is the fact that economic restructuring (which means moving resources from low-productivity firms and sectors to high-productivity ones) requires a working financial sector. As long as banks carry a large pool of NPLs on their balance sheets they will mainly attempt to ‘postpone the day of reckoning’ and not help in moving capital towards high-growth/efficient sectors. This phenomenon is highlighted in recent research by BoE on the impaired capital reallocation mechanism in the UK. The high increase in the standard deviation of firm rates of return since the crisis is a significant indicator of such ‘distortions’:

figure 4 - SD of firm rates of return relative to change in capital stock

Obviously Japan is also another example of how NPLs can become a long-term bottleneck for economic restructuring and a drag on new bank lending and economic growth. As long as Greek banks are not properly recapitalized and cleared of their NPLs (which will probably reach €100bn) they will remain a barrier for restructuring the Greek economy and increasing long-term growth.

This is even more important for Greece because of the relative dominance of SMEs in the economy since SMEs are much more reliant on bank financing for their continued operation and growth:

Source of SME financing

Poverty and risk-aversion

Another point emphasized by Dietz Vollrath is the fact that there is a close (and probably non-linear) relationship between poverty and risk-aversion. High growth is usually closely related to high risk and opening an enterprise in a high growth/export oriented sector requires, apart from capital, risk taking individuals. As long as people face the risk of poverty and social exclusion (over 37% of Greek nationals aged 18-64 faced that risk during 2014) and are in trouble of securing their most basic needs such as food and shelter they are bound to be extremely risk averse and not willing to take business risks. You cannot have almost 40% of the population risk poverty and still expect strong productivity growth based on implementing risky and cutting-edge entrepreneurial ideas.

Sectoral Balances

Furthermore, whatever our projections about economic growth, the economy should be able to achieve it without creating (or worse, increasing) economic imbalances. One of the most basic tools to guarantee consistency on this front is to use the sectoral balances which involves the basic macroeconomic accounting identity that the sum of savings in an economy should balance to zero. In the Greek case this revolves around the fact that ‘debt sustainability’ requires a long-term fiscal primary balance of 3.5% from 2018 onwards. This large fiscal surplus requires a corresponding balance for the private domestic and external sector. Either the current account surplus will have to reach and remain at close to 3.5% of GDP or the private domestic sector will face a constant deficit of its net accumulation of financial assets.

Given the fact that Greece has achieved a current account surplus of less than 1.5% GDP and an output gap that is probably close to 10% its cyclically adjusted external position is still close to deficit. A quick way to determine that is to assume an import-to-GDP ratio of 25% and a low correlation between the output gap and exports (since the latter depend on external demand). As a result, closing the output gap and bringing the Greek economy back to potential will mean a deterioration of the current account balance by 2-2.5% of GDP which will bring it back to deficit. Consequently, achieving the 3.5% long-term fiscal primary surplus target implies a domestic private sector deficit of close to 4% GDP. Basing long-term growth on the accumulation of large imbalances is obviously not the way to make credible projections.

Fiscal financing of growth

One last thing that is related with the long-run target of a 3.5% primary surplus has to do with the simple fact that achieving high growth cannot be decoupled from the availability of public financing. An economy cannot grow without a strong and high quality public capital stock, nor without heavy investment in public education and R&D (especially since Greek growth will depend mainly on moving resources between non-tradable/tradable and low/high growth sectors). Nor can a country achieve high employment in the context of an aging population without finding ways to increase participation rates of women and people close to retirement which require financing of things such as (re-)educational initiatives and childcare (see the IMF on the related German case).


Overall, the point of this post is not to make any long-term projections for TFP/economic growth (a task which is clearly very hard) but rather to highlight the fact that achieving the IMF ambitious targets does not (mainly) rely on structural reforms but rather on actual investment (which requires large fund injections), financial sector restructuring, NPL clearance and reduction of poverty all while respecting sectoral balances which most probably requires an upfront debt restructuring and much more realistic fiscal surplus targets.

Το στατιστικό δελτίο του Ιουλίου του πληροφοριακού συστήματος Εργάνη έλαβε αρκετά μεγάλη δημοσιότητα καθώς επρόκειτο για τα πρώτα στατιστικά στοιχεία για την απασχόληση μετά την επιβολή των capital controls. Καθώς σήμερα δημοσιεύτηκε το ίδιο το δελτίο θα ήθελα να εξετάσω λίγο αναλυτικότερα τα στοιχεία τα οποία περιέχονται σε αυτό, ιδιαίτερα σε αντιπαραβολή με το δελτίο του Ιουλίου 2014.

Ισοζύγιο Προσλήψεων - Αποχωρήσεων Ιούλιος 2015

Το στατιστικό στοιχείο το οποίο κέρδισε το μεγαλύτερο μέρος της προσοχής ήταν βεβαίως το γενικό ισοζύγιο προσλήψεων – αποχωρήσεων. Όπως είναι σαφές, στο φετινό Ιούλιο παρατηρήθηκε σημαντική αύξηση των αποχωρήσεων κατά 16.650 άτομα και παράλληλη μείωση των προσλήψεων κατά 13.280 άτομα με συνέπεια η συνολική διαφορά σε σχέση με τον Ιούλιο του 2014 να φτάσει τις 30.000 θέσεις εργασίας. Κατά συνέπεια το ισοζύγιο από θετικό κατά 13.000 θέσεις ένα χρόνο πριν έγινε αρνητικό 16.650 θέσεις φέτος.

Το στατιστικό στοιχείο το οποίο φαίνεται να έχει ιδιαίτερη σημασία είναι η διάρθρωση των νέων προσλήψεων ανά είδος σύμβασης εργασίας:

Προσλήψεις αν΄είδος θέσεων Εργασίας Ιούλιος 2015

ιδιαίτερα σε σχέση με ένα χρόνο πριν:

Προσλήψεις αν΄είδος θέσεων Εργασίας Ιούλιος 2014

Είναι σαφές ότι η μεγάλη διαφοροποίηση παρατηρείται στην κατανομή των προσλήψεων ανάμεσα σε πλήρη και εκ περιτροπής απασχόληση με την αναλογία να είναι ουσιαστικά αντιδιαμετρικά αντίθετη από 3:1 υπέρ της πλήρους απασχόλησης το 2014 σε 1:3 το 2015. Επιπλέον, το άθροισμα των αναγγελιών αυτών μειώθηκε από περίπου 100.000 θέσεις το 2014 σε 90.000 φέτος. Βλέπουμε λοιπόν ότι η επιβολή των capital controls είχε σημαντική επίδραση πάνω στη ‘βραχυπρόθεσμη αβεβαιότητα’ των επιχειρήσεων οι οποίες φαίνεται ότι επέλεξαν (προσωρινά;) πιο ευέλικτες μορφές απασχόλησης προκειμένου, κατά μία έννοια, να περάσουν το ρίσκο τους στους εργαζόμενους.

Η αυξημένη αβεβαιότητα είναι εμφανής και στις αυξημένες μετατροπές συμβάσεων εργασίας από πλήρη απασχόληση σε άλλες μορφές εργασίας οι οποίες έφτασαν τις 8.300 περιπτώσεις σε σχέση με 3.300 ένα έτος νωρίτερα:

Μετατροπές Πλήρους απασχόλησης σε άλλες μορφές

Το έλλειμμα των περίπου 10.000 προσλήψεων φαίνεται ότι πιθανότατα εξηγείται από την μείωση των προσλήψεων στο λιανικό εμπόριο (οι οποίες δεν εμφανίζονται καν στο δελτίο του 2015).

Δραστηριότητες Ιούλιος 2015

σε σχέση με το 2014:

Δραστηριότητες Ιούλιος 2014

Παρότι οι αποχωρήσεις είναι αρκετά αυξημένες σε σχέση με το 2014 (κυρίως όμως λόγω οικειοθελών αποχωρήσεων και λήξεων συμβάσεων ορισμένου χρόνου) οι αναγγελίες προσλήψεων στις βασικές κατηγορίες δραστηριοτήτων (εστίαση, καταλύματα, βιομηχανία τροφίμων) δεν παρουσιάζουν ουσιώδη μεταβολή ενώ και το ισοζύγιο της εκπαίδευσης είναι παρόμοιο με ένα χρόνο πριν. Φαίνεται ότι το λιανικό εμπόριο (το οποίο δεν εμφανίζεται φέτος στον πίνακα ΙΧ) αλλά και οι δραστηριότητες πολιτικού μηχανικού (με το προσωρινό πάγωμα των μεγάλων έργων) ήταν οι δραστηριότητες οι οποίες πιθανότατα συνέβαλαν στην μείωση των προσλήψεων.

Το γενικό συμπέρασμα λοιπόν είναι ότι οι τομείς της οικονομίας οι οποίοι βασίζονται στον εξωτερικό τομέα (εστίαση, καταλύματα) ή έχουν ανελαστική σχετικά ζήτηση (βιομηχανία τροφίμων) διατήρησαν τη δυναμική των προσλήψεων που πραγματοποίησαν το 2014 αλλά με πολύ μεγάλη έμφαση σε ευέλικτες μορφές εργασίας προκειμένου να μειώσουν το ρίσκο των capital controls και τυχόν διακοπών στη δραστηριότητα τους. Οι τομείς που βασίζονται στην εσωτερική ζήτηση ή σε σταθερές χρηματοροές από το Ελληνικό δημόσιο (λιανικό εμπόριο και έργα πολιτικού μηχανικού) πιθανότατα ήταν αυτοί που μείωσαν σχετικά άμεσα τη ζήτηση τους για εργαζόμενους.

Τα στοιχεία του Ιουλίου λοιπόν αναδεικνύουν μία περισσότερο ευέλικτη αλλά στάσιμη οικονομική δραστηριότητα με τις επιχειρήσεις να ‘ασφαλίζονται’ έναντι των εξελίξεων μέσω μεταβολής των μορφών εργασίας στις νέες προσλήψεις. Τομείς που βασίζονται στην εσωτερική ζήτηση δείχνουν να υπέστησαν ισχυρή πίεση από την τραπεζική αργία η οποία πίεση μένει να φανεί κατά πόσο μειώθηκε μετά την μαζική έκδοση χρεωστικών καρτών και τη χαλάρωση των περιορισμών στις συναλλαγές ή έχει πάρει περισσότερο μόνιμα χαρακτηριστικά μείωσης της οικονομικής δραστηριότητας.

Just a small post on the newly released June monthly statement by BoG:

BoG monthly statement June 2015

The large increase in central bank lending to Greek banks is quite evident: BoG loans were used to finance increased banknotes hoarding (+€5bn in a month) and deposit outflows (+€7.5bn). This increase stretched posted collateral which reached close to €200bn. Given that debt securities and credit claims held by Greek banks amount at a bit less than €300bn (with around €18bn being securities in currencies other than the Euro) with a significant part encumbered in various covered bonds and other securities it is obvious that banks were running out of available collateral and capital controls were really around the corner as long as ELA financing needs did not decrease. Obviously the increase in haircuts at the 6th Jule meeting only made matters worse. Based on the above numbers it is clear that it will be extremely difficult to relax capital controls without cash/deposits returning to the Greek banking system.

Another interesting observation is the extremely low figure for the government account which amounted at only €600mn. This reflects the large effort by the Greek government to keep paying official creditors during 2015 and the slow deterioration of state finances due to the ongoing recession. Since ELA was capped before the end of June the above figure suggests that the Greek government was in no position to pay the IMF on 30 June even if it wished to do so (since it could only use funds available at the BoG). Its financial position was extremely stretched and it would have to quickly decide whether to resist creditor demands by issuing IOUs or accepting the terms of a new bailout.

Even if government entities still had funds in bank accounts that could be tapped by the central government, the ELA cap made transferring them to the government account held at BoG close to impossible. These funds might be able to help in domestic payments to government employees and pensioners but would not allow paying (principal and interest on holdings of) foreign debtholders making Grexit very likely in order to avoid a general default on government debt.

One last issue that I don’t see people touching often is the fact that the very large ELA amount will result in significant windfall profits for BoG during 2015 which will be remitted back to the government. Assuming an ELA spread of 150bps over the MRO rate (BoG has to pay the MRO rate on its liabilities towards the Eurosystem), BoG should have already earned an amount close to €450mn in profits (although a part will probably be set aside as provisions). These profits might prove significant for the 2016 state budget execution.

I ‘ve been going through the detailed FAQ and legal documentation of ESM financial assistance procedures, available at the ESM website (see here and here) in order to determine how Greek banks will be recapitalized. What I have been able to determine so far is that the legal framework provides significant flexibility in managing the recapitalization exercise and can be used to justify both a (uninsured) depositor bail-in as well as capital injection through a loan to the Greek HFSF.

What is quite clear is that should the ESM be involved through the direct recapitalization instrument (DRI) a depositor bail-in is more or less certain since a contribution of 8% of total funds will be required. Bruegel does a very nice job in analyzing the various scenarios and probable scenarios. One should bear in mind though that these numbers are a moving target since the insured/uninsured deposits mix is not known, while any increase in central bank financing (through ELA) will lead to higher haircuts on deposits (since central bank exposure is fully collateralized and does not participate in bail-ins). As a result, every small cash redrawal (even from small insured deposit accounts) makes the required deposit haircut a bit higher.

What is not clear is whether Greece will be able to use the ESM loan to recapitalize its banks through the HFSF (as it did in 2012/2013) and avoid a depositor bail-in. In principle, the ESM legal guidelines allow an ESM loan for such purpose while the €25bn of the Greek privatization fund earmarked for use in the recapitalization exercise make such a loan easier (since it will be ‘collateralized’ by Greek assets). Yet in a strange twist of events, the fact that Greek debt is considered (by almost all parties involved) unsustainable makes granting a large loan instead of direct recapitalization a bit problematic. According to articles 2 and 3 of the relevant ESM guideline:

The aim of the financial assistance to institutions is to preserve the financial stability of the euro area as a whole and of its Member States by catering for those specific cases in which an ESM Member experiences acute difficulties with its financial sector that cannot be remedied without significantly endangering its fiscal sustainability due to a severe risk of contagion from the financial sector to the sovereign. The use of this instrument could also be considered if other alternatives would have the effect of endangering the continuous market access of an ESM Member. As far as the use of the instrument of an ESM loan for the recapitalisation of financial institutions is not possible, such financial assistance shall thus seek to help remove the risk of contagion from the financial sector to the sovereign by allowing the recapitalisation of institutions directly, thereby reducing the effect of a vicious circle between a fragile financial sector and a deteriorating creditworthiness of the sovereign.


The following criteria related to the requesting ESM Member shall be met in order for a request for financial assistance for the purpose of directly recapitalising institutions to be considered eligible:

  1. The requesting ESM Member is unable to provide financial assistance to the institutions in full without very adverse effects on its own fiscal sustainability, including via the instrument of an ESM loan for the recapitalisation of financial institutions. The use of the instrument can also be considered if it is established that other alternatives would have the effect of endangering the continuous market access of the requesting ESM Member and consequently require the financing of its sovereign needs via the ESM.

So it is clear that debt sustainability can be used as an excuse by creditors in order to push for the use of the direct recapitalization tool and increase the Greek ‘own contribution’ to the third financing package. The fact that the ESM envisions its contribution to be limited to €50bn – which are only enough the cover amortization of existing debt obligations and interest payments – makes the above scenario somewhat more probable given the IMF’s reluctance to continue its involvement in the Greek program.

On the other hand, since most retail uninsured deposits have already left the Greek banking system (and foreign deposits of significant amounts are almost non-existent), a depositor bail-in will mostly hit NFC working capital and create serious short-term problems on the economy (while also push a large percentage of these firms into insolvency). This is another reason to favor an ESM loan over the DRI although it requires that Greek and creditors motives to be .. aligned.

Overall I think that the ESM guidelines provide a great deal of flexibility for Greece and its creditors to use either instrument. Which one will eventually be used will be another indicator of whether creditors are determined to accept a larger part of ‘Greek risk’ or not. A possible large haircut in NFC deposits obviously makes a large part of the theoretical Grexit cost moot.

Update: Yiannis Koutsomitis mentioned on twitter that the ESM confirmed the availability of €10b in a segregated account to be used for future bank recapitalization (should the third package proceed as expected). That is definitely good news and hopefully makes things a bit clearer. I would like to take this opportunity to stress that, in this particular case, I am not trying to predict what course of action will be taken concerning Greek bank capital needs but rather to collect and analyze the available information and consider the political/economic implications of each option.

 Update2: The ECB published its opinion on the bank resolution draft law to be voted into effect on Wednesday 22/7. It seems that the bail-in tool will only be available after 1/1/2016. Here are the relevant interesting parts:

 ECB Opinion on Bank Resolution draft law

Frances Coppola also does a great job in analyzing the recap exercise.

Yesterday, I received an interesting comment on my Grexit post by Frances Coppola, a comment that is actually not that far from my point of view as would seem on first impression. I ‘d like to use this post to elaborate a bit on this interesting subject.

In my view, Grexit involves (among other things) a trade-off between a balance of payments constraint and large limitations on internal economic policy (and the winners and losers in social groups that policy implementation can create). It is true that the Target2 monetary construction, along with a loose central bank collateral framework can accommodate very large capital flows in the Euro area (BoG Target2 liabilities currently stand at more than €100bn, roughly 55% of GDP). Although most of these capital flows are not directly trade related, the sheer magnitude of Target2 accommodation (and the relative strength of the Euro as a reserve currency) do provide a way around balance of payments constraints for Euro countries, at least for a significant time span. Nevertheless, this relative freedom comes with the cost of well known Euro problems (a fit-for-all monetary policy, low labour mobility, small net fiscal transfers) and the prospect of a loss of a large part of sovereignty if a country is forced to borrow from the ESM and sign an MoU.

A return to a national currency (especially for small deficit countries such as Greece) reintroduces a balance of payments constraint on economic growth. The country has to apply an economic policy consistent with a positive (or at least balanced) long-run balance of payments which allow it to improve/stabilize its NIIP and slowly accumulate FX reserves, which is consistent with relative exchange rate stability. Since most deficit countries are currently experiencing large output gaps, one has to look at cyclically-adjusted current account balances, most probably based on the IMF framework. The EC has performed such an exercise which estimates that Southern European countries still have a structural current account deficit:

EC Cyclically Adjusted Current Account Euro Countries

One can even do a back-of-the-envelope calculation based on the long-run import/domestic demand ratio. For the Greek case, this is around 27-30% which implies, given a 10% output gap, that imports would most probably be 2.5-3% of GDP higher if the Greek economy was running at potential. Since external demand is not closely related to the output gap (at least for a small economy) this implies that the external balance would deteriorate by roughly the same amount if Greece were to slowly try to close its output gap.

An initial devaluation of the newly introduced currency would most likely change the above figure, although I am not a fan of external adjustments through relative price changes (it is my belief that most of the external realignment happens through changes in relative income growth). Nevertheless, a devaluation could result in a (slow) favorable sectoral realignment since (as long as the devaluation did not translate into higher nominal wages) it would increase the profit margins of exporting firms and sectors. That would change the sectoral mix towards export oriented enterprises and help improve the structural external balance up to point.

Still, it is true that Greece (or any similar Euro country) would trade more internal ‘policy flexibility’ for a binding external constraint. This constraint would be made stronger by the fact that debt hierarchy (senior official debt higher than 120% of GDP in the Greek case) would not allow tapping external markets, at least in large quantities.It might be relaxed through a mechanism such as ERM II (which I touched on my previous post on the subject). Ultimately, this becomes a political choice, dependent on the constraints imposed by each choice (Euro membership or a return to national currency). What the July Eurosummit made clear is to what extent austerity is a binding policy constraint inside the Eurozone, at least for highly indebted countries.

A few details of the new Greek loan package have been published during the last few days. Based on these I ‘d like to take a look at the financing sources of the package.

The European Commission paper on the loan request tries to analyze Greek financing needs and sources. It also includes a helpful table:

Greece ESM loan financing needs and sources

Based on the above gross financing needs (excluding cumulative primary surpluses and privatization proceeds) are around €90bn. It is true that the bank recapitalization package might be less than expected so one can assume actual needs at €80-90bn.

Looking into financing sources we see an expected cumulative primary surplus contribution of €6bn. This is based on a projection of 0-1% primary deficit in 2015, 0.5-1% primary surplus in 2016, 2% in 2017 and 3.5% 2018 (and onwards). Privatization proceeds are expected at €2.5bn although IMF itself estimates them at €1.5bn.

SMP/ANFA profits contribute a bit over €7.5bn. This creates a financing gap of €64-74bn which must be covered through other sources. The head of the ESM stated today that the ESM contribution will be around €50bn. This leaves €14-24bn uncovered which must be contributed by the IMF (which could theoretically contribute €16bn under the outstanding program) and private investors (?).

Given the outstanding arrears to the IMF and the latter’s thesis that Greek debt is most probably unsustainable, I am not sure that the IMF will be able to contribute the expected amount of funds. It is actually probable that board pressure by emerging economies (and the program’s negative track record) will not allow it to continue participating in the program and make it seek an early exit. Primary surplus and privatization proceeds contributions also carry high risk of being missed (especially given the fact that the IMF is already projecting €1bn lower privatization proceeds) which could create a shortfall of a few more billions.

Overall, given the stated limit of €50bn for the ESM contribution I believe that at least €16-26bn (which actually correspond to the bank recap package) are not secured even in the baseline scenario. As a result, I am not so sure that a deposit bail-in has been avoided (at least not yet and based on the available information), since it might end up being the Greek ‘contribution’ part in order to secure financing and ‘debt sustainability’.

A few days ago, this article would have started with the statement that Grexit is closer than ever. Today it seems that Grexit has been postponed for a few months. Yet I fail to understand the underlying strategy of the Greek government since the proposed austerity measures (along with capital controls and low confidence) are destined to push the economy in a deep recession. This recession will make achieving the primary surplus targets even harder and government debt clearly unsustainable (even based on the IMF’s quite optimistic projections). The current program will fail in 2016 and Grexit will come back on the table with a Greek government that enjoys a much more fragile domestic political support and an even weaker economy with a higher output gap.

Probably the biggest problem of returning to the drachma is the fact that there are certain (probable) scenarios where the economy almost collapses and others where we observe the usual path of a large devaluation following an unsustainable currency peg: A short-lived large fall in output followed by a long path of economic growth. Usually people will just choose the scenario that fits their story and ideology and not consider (or even imagine) any other possible paths. The ‘ugly scenario’ basically includes official creditors accelerating Greek debt in the form of EFSF loans and the Greek Loan Facility. That will push Greece in a permanent default state and most probably not make it able to accumulate any foreign reserves (since they would be claimed by creditors). EU structural funds will most likely be lost and Europe will not support the newly created currency exchange rate in any way. Greece will have to function in a ‘semi-pariah’ state with strict and permanent capital controls and an economy that will slowly lose most of its human capital and internationally oriented sectors (such as shipping).

In this blog post I will not analyze the above scenario any further but rather take a closer look at a controlled exit from the Eurozone which will include the help of the other Euro member countries (if not for anything else but to enhance the recovery of their official loans).

First of all let me remind people that currency movements happen mostly because of large gross capital flows and not due to the underlying real trade flows (this paper from BIS Claudio Borio is quite informative). Capital flows, at least in the short-term, will happen for only a few reasons:

  • RoW liquidating domestic claims in order to transform them in foreign currency (think of other Euro banks not rolling over repos with Greek banks or equity investors exiting the Greek stock exchange).
  • Domestic firms and households trying to exchange their liquid assets (mostly deposits) for foreign currency.
  • Institutional players taking large currency positions. This requires being able to borrow large amounts of the currency that will be shorted at favorable terms.

In the Greek case we know that a Grexit will happen under strict capital controls (which are already present), while the terms and price (interest rate) under which the RoW will access the drachma will be determined exclusively by Bank of Greece. Since drachma does not exist in any way, a Eurodollar market is not present and cannot help anyone to circumvent capital controls. Private players outside Greece have already liquidated most of their claims (either equity or interbank loans) while the bulk of Greek liabilities are long-term official loans by other Eurozone member countries. The same is true to a large extent for Greeks themselves who have moved large amounts of liquidity outside Greece. This is the main reason why BoG has more than €120bn in liabilities towards the Eurosystem (Target2 and extra banknotes combined).

As a result, coupled with the presence of capital controls and the fact that Greece already has a strong current account surplus (on a yearly basis) there is actually small scope for strong pressure on the exchange rate of a newly introduced drachma. It is probably one of the few times that capital controls can truly be used as a policy tool and not to trap large funds looking for a way out (as was the case in Iceland). As long as outstanding Greek debt to the ECB (in the form of SMP bonds) and the IMF is rescheduled in the form of a long-term loan by the ESM, the GLF spread over Euribor is lowered to  5bps and interest payments postponed until 2020 (as has already happened with the EFSF loan) Greece will have truly minimal refinancing needs (in terms of foreign currency obligations) for the rest of the decade and be able to slowly accumulate FX reserves through its current account surpluses.

The main subject where a host of different opinions exist is what will happen with ELA financing by BoG and the corresponding liabilities towards the Eurosystem. The story usually goes that BoG will have to default on these liabilities and the Eurosystem having to perform a large capital injection. In my view any such claim is most probably false, at least in the favorable scenario. EU already has an exchange rate mechanism for EU members that do not participate in the Euro area but wish to maintain a controlled exchange rate relationship, called ERM II. This mechanism defines a ‘central exchange rate’ with the Euro, with a fluctuation band of +/- 15%. Intervention at the margins is automatic and unlimited while a short-term financing facility exists with a maturity of 3 months (which can be renewed at least once):

for the currency of each participating non-euro area Member State (hereinafter ‘participating non-euro area currency’) a central rate against the euro is defined;

there is one standard fluctuation band of ± 15 % around the central rates;

intervention at the margins is in principle automatic and unlimited, with very short-term financing available.

For the purpose of intervention in euro and in the participating non-euro area currencies, the ECB and each participating non-euro area NCB shall open for each other very short-term credit facilities. The initial maturity for a very short-term financing operation shall be three months.

The financing operations under these facilities shall take the form of spot sales and purchases of participating currencies giving rise to corresponding claims and liabilities, denominated in the creditor’s currency, between the ECB and the participating non-euro area NCBs. The value date of the financing operations shall be identical to the value date of the intervention in the market. The ECB shall keep a record of all transactions conducted in the context of these facilities.

The very short-term financing facility is in principle automatically available and unlimited in amount for the purpose of financing intervention in participating currencies at the margins.

For the purpose of intramarginal intervention, the very short-term financing facility may, with the agreement of the central bank issuing the intervention currency, be made available subject to the following conditions: (a) the cumulative amount of such financing made available to the debtor central bank shall not exceed the latter’s ceiling as laid down in Annex II; (b) the debtor central bank shall make appropriate use of its foreign reserve holdings prior to drawing on the facility.

Outstanding very short-term financing balances shall be remunerated at the representative domestic three-month money market rate of the creditor’s currency prevailing on the trade date of the initial financing operation or, in the event of a renewal pursuant to Articles 10 and 11 of this Agreement, the three-month money market rate of the creditor’s currency prevailing two business days before the date on which the initial financing operation to be renewed falls due.

My view is that in the case of a Grexit current BoG liabilities towards the Eurosystem will be transformed into a long-term financing facility, capped somewhere close to their current level. BoG will have to pay interest to the Eurosystem, either the 3-month rate applicable to ERM II financing facility or the MRO (as it happens today for Target2 liabilities) with the clear agreement that BoG will use its FX reserves in order to slowly pay back the facility (through annual current account surpluses). This will obviously mean that BoG financing towards Greek banks will remain significant, absent a domestic QE program. Short-term financing by the Eurosystem will be provided in order to facilitate temporary FX needs (the Greek current account is actually in deficit during the first months of a year) and to allow the smooth payment of government liabilities denominated in Euros. Obviously this financing facility will be capped for intramarginal interventions.

As long as the central rate is reasonable and both sides are determined to defend it through monetary policy (interest rates), capital controls and automatic interventions, confidence on the drachma will quickly be strengthened and domestic players will have little reason to try to convert their assets into foreign currency.

Obviously one important problem is the fact that creating the actual physical currency will take time. Electronic payments as well as the over €50bn in Euro banknotes circulating in Greece right now (for a GDP of less than €179bn) will help minimize the short-term impact.

Although I hope the above will remain only a scenario exercise, it is my view that, given the political climate inside Europe and the short-term economic reality, Grexit will emerge again during 2016, especially if the current package is not accompanied by serious debt restructuring.

Yesterday the IMF released its debt sustainability analysis for Greece based on developments during 2015 (but not including the bank holiday and capital controls imposed after the referendum announcement). I consider it a very important document mainly because it shows (probably for the first time) how the basic assumptions of the adjustment programs were terribly optimistic and significantly disconnected from reality. It is also the first time that I know of that the IMF includes a (highly probable) scenario which requires Europe to write off part of Greek official debt (basically the Greek Loan Facility of €53bn) in order for the latter to become sustainable. It seems that the IMF has decided to catch up with reality. Having its largest ever program in arrears probably also played a role.

The first part of the analysis describes how some of the developments since June 2014 improved debt sustainability. These include:

  1. Lower interest rates future path due to easing of monetary conditions in the Euro area which contribute a total reduction of €23.5bn in Greece’s debt up until 2022.
  2. The return of the HFSF bank recapitalization buffer of €10.9bn. Obviously the IMF is not being honest in this point since the buffer will be needed in one form or another for further capital injections in Greek banks and/or for the creation of a bad bank to clear NPLs.
  3. Intra-governmental borrowing of about €11bn to cover debt repayments which the IMF assumes that 2/3 will be sustained for the indefinite future by rolling over this short-term borrowing. This action will lead to an improvement of the debt-to-GDP ratio of 5% GDP.

On the other hand weaker GDP performance and downward revision of historical GDP contributed to an increase by 4% GDP of the 2022 debt-to-GDP ratio. Overall, taking all the above developments into account would improve the 2020 debt ratio to 116.5% (from a projection of 127.7% in the June 2014 review).

Yet at the same time the IMF has to acknowledge reality which includes much lower primary surplus targets, lower privatization proceeds, lower GDP growth, clearing arrears and rebuilding buffers as well as paying down a part of the short-term intergovernmental borrowing. This reality results in a total of financing needs of €52bn from October 2015 up to 2018 with the 12-month forward financing requirements from October 2015 amounting to €29bn.

Let’s take a closer look at a few aspects of ‘reality’.

First of all, primary surplus targets have been reduced from 3% for 2015 and 4.5% for 2016 onwards to 1% during 2015, 2% for 2016, 3% for 2017 and 3.5% for 2018 and beyond. Although in my opinion Greece should only be looking at the structural (cyclically adjusted) primary balance with official lenders taking the risk of short-term economic developments, these short-term targets are obviously much closer to the actual reality on the ground.

What is quite impressive is how the IMF has revised down its privatization proceeds targets. Projected privatizations were €23bn over the 2014-22 horizon yet only €3bn materialized during the last 5 years (the ‘fire sales’ argument of the current Greek government). As a result, the IMF now has much lower (and reasonable) targets of annual proceeds of around €500mn over the next few years. The magnitude of the targets revisions in each review is interesting:

Projected Annual Privatization Proceeds

What is the most important part of the document in my opinion is the analysis of long-term economic growth. The IMF acknowledges that its long-term growth target of 2% was unattainable and conditional on unreasonable assumptions and has now been updated to a still very ambitious target of 1.5%. It is clear from the document that even this target will most likely be missed. Only short-term targets based on closing the output gap and subject to a return of confidence are attainable in my opinion. In the words of the IMF itself:

Medium- to long-term growth projections in the program have been premised on full and decisive implementation of structural reforms that raises potential growth to 2 percent. Such growth rates stand in marked contrast to the historical record: real GDP growth since Greece joined the EU in 1981 has averaged 0.9 percent per year through multiple and full boom-bust cycles and TFP growth has averaged a mere 0.1 percent per year. To achieve TFP growth that is similar to what has been achieved in other euro area countries, implementation of structural reforms is therefore critical.

What would real GDP growth look like if TFP growth were to remain at the historical average rates since Greece joined the EU? Given the shrinking working-age population (as projected by Eurostat) and maintaining investment at its projected ratio of 19 percent of GDP from 2019 onwards (up from 11 percent currently), real GDP growth would be expected to average –0.6 percent per year in steady state. If labor force participation increased to the highest in the euro area, unemployment fell to German levels, and TFP growth reached the average in the euro area since 1980, real GDP growth would average 0.8 percent of GDP. Only if TFP growth were to reach Irish levels, that is, the best performer in the euro area, would real GDP growth average about 2 percent in steady state. With a weakening of the reform effort, it is implausible to argue for maintaining steady state growth of 2 percent. A slightly more modest, yet still ambitious, TFP growth assumption, with strong assumptions of employment growth, would argue for steady state growth of 1½ percent per year.

Greece Real GDP and TFP Growth

What the IMF also acknowledges is that any serious ‘return to markets’ from Greece will quickly make the current debt figures unsustainable because higher market rates will not be consistent with debt sustainability. As a result, in order for official creditors to avoid haircuts, more financing will be needed with concessional financing and a doubling of the grace and maturity period of loans.

It is unlikely that Greece will be able to close its financing gaps from the markets on terms consistent with debt sustainability. The central issue is that public debt cannot migrate back onto the balance sheet of the private sector at rates consistent with debt sustainability, until debt-to-GDP is much lower with correspondingly lower risk premia (see Figure 4i). Therefore, it is imperative for debt sustainability that the euro area member states provide additional resources of at least €36 billion on highly concessional terms (AAA interest rates, long maturities, and grace period) to fully cover the financing needs through end–2018, in the context of a third EU program (see also paragraph 10).
Even with concessional financing through 2018, debt would remain very high for decades and highly vulnerable to shocks. Assuming official (concessional) financing through end– 2018, the debt-to-GDP ratio is projected at about 150 percent in 2020, and close to 140 percent in 2022 (see Figure 4ii). Using the thresholds agreed in November 2012, a haircut that yields a reduction in debt of over 30 percent of GDP would be required to meet the November 2012 debt targets. With debt remaining very high, any further deterioration in growth rates or in the medium-term primary surplus relative to the revised baseline scenario discussed here would result in significant increases in debt and gross financing needs (see robustness tests in the next section below). This points to the high vulnerability of the debt dynamics.

In particular, if primary surpluses or growth were lowered as per the new policy package—primary surpluses of 3.5 percent of GDP, real GDP growth of 1½ percent in steady state, and more realistic privatization proceeds of about €½ billion annually—debt servicing would rise and debt/GDP would plateau at very high levels (see Figure 4i). For still lower primary surpluses or growth, debt servicing and debt/GDP rises unsustainably. The debt dynamics are unsustainable because as mentioned above, over time, costly market financing is replacing highly subsidized official sector financing, and the primary surpluses are insufficient to offset the difference. In other words, it is simply not reasonable to expect the large official sector held debt to migrate back onto the balance sheets of the private sector at rates consistent with debt sustainability.

Given the fragile debt dynamics, further concessions are necessary to restore debt sustainability. As an illustration, one option for recovering sustainability would be to extend the grace period to 20 years and the amortization period to 40 years on existing EU loans and to provide new official sector loans to cover financing needs falling due on similar terms at least through 2018. The scenario below considers this doubling of the grace and maturity periods of EU loans (except those for bank recap funds, which already have very long grace periods). In this scenario (see charts below), while the November 2012 debt/GDP targets would not be achievable, the gross financing needs would average 10 percent of GDP during 2015-2045, the level targeted at the time of the last review.

If grace periods and maturities on existing European loans are doubled and if new financing is provided for the next few years on similar concessional terms, debt can be deemed to be sustainable with high probability. Underpinning this assessment is the following: (i) more plausible assumptions—given persistent underperformance—than in the past reviews for the primary surplus targets, growth rates, privatization proceeds, and interest rates, all of which reduce the downside risk embedded in previous analyses. This still leads to gross financing needs under the baseline not only below 15 percent of GDP but at the same levels as at the last review; and (ii) delivery of debt relief that to date have been promised but are assumed to materialize in this analysis.

What is also important is that a reasonable scenario which includes of long-term growth close to 1% and a medium-term primary surplus target of 2.5% of GDP would require a haircut by official lenders:

However, lowering the primary surplus target even further in this lower growth environment would imply unsustainable debt dynamics. If the medium-term primary surplus target were to be reduced to 2½ percent of GDP, say because this is all that the Greek authorities could credibly commit to, then the debt-to-GDP trajectory would be unsustainable even with the 10-year concessional financing assumed in the previous scenario. Gross financing needs and debt-to-GDP would surge owing to the need to pay for the fiscal relaxation of 1 percent of GDP per year with new borrowing at market terms. Thus, any substantial deviation from the package of reforms under consideration—in the form of lower primary surpluses and weaker reforms—would require substantially more financing and debt relief (Figure 7).

In such a case, a haircut would be needed, along with extended concessional financing with fixed interest rates locked at current levels. A lower medium-term primary surplus of 2½ percent of GDP and lower real GDP growth of 1 percent per year would require not only concessional financing with fixed interest rates through 2020 to cover gaps as well as doubling of grace and maturities on existing debt but also a significant haircut of debt, for instance, full write-off of the stock outstanding in the GLF facility (€53.1 billion) or any other similar operation. The debt-to-GDP ratio would decline immediately, but “flattens” afterwards amid low economic growth and reduced primary surpluses. The stock and flow treatment, nevertheless, are able to bring the GFN-to-GDP trajectory back to safe ranges for the next three decades (Figure 8).

If one includes the fallout of the bank holiday it seems that we have clearly reached the end game. A recession during 2015 along with a low primary surplus will make the current DSA a bit outdated. Deciding to base the DSA on actually achievable targets (which in my opinion only include the ‘adverse scenario’ of 2.5% primary surplus target and 1% long-term GDP growth) will mean that Europe will (finally) have to consider a debt write-off. That is the economic reality on the ground. The way that the official sector reacts to it and the targets it (tries to) sets for the new Greek medium-term program will say a lot about who will bear the costs of further adjustment. In my view the policy of ‘externalizing’ the costs on the Greek economy and ‘extend and pretend’ is almost over, at least in democratic terms. Unfortunately, now will be the time of the politicians, name calling and trying to place the blame on the other party.

PS: It is also quite strange how the IMF puts such high value on ‘structural reforms’, when its own research shows that, at least ‘reforms’ that do not include more funding of investment in high-skilled labor, R&D, ICT capital and infrastructure but target the usual suspects of product and labor market have negative short-term and neutral long-term effects (labor market) or only marginally positive results (product markets). Only financing of serious investment in R&D, ICT capital and (to a lesser part) infrastructure can result in substantial effects on long-term TFP growth.

Short and medium term impact of structural reforms on total factor productivity

The negotiations between Greece and its European creditors (and the IMF) seem to have disintegrated into populist name calling. A number of high ranking European officials are trying to suggest that European loans are used to finance pensions and wages and European taxpayers money will not be used to keep the purchasing power of Greek pensioners unchanged.

First of all it should be stated that Greek people have already lost a great deal of ‘purchasing power’ and income, a loss that usually only happens in cases of wars. Real GDP per capita (2014 values) is down 20% since 2009, real compensation per employee 17% and real gross disposable income 25.5%. Suggesting that Europe is not liable in any way to try and maintain at least this low level of income shows how far the EU is from any form of an Optimum Currency Area (which almost by definition requires large fiscal transfers).

Another rather obvious point is that loans to Greece, either in the form of the bilateral Greek Loan Facility (GLF) or EFSF loans do not involve the transfer of taxpayers money but only the increase of contingent liabilities of European countries that provide guarantees for the bilateral loans or for securities issued by the EFSF in order to finance its loans to Greece. As long as Greece does not default, European governments are earning a positive net income from their financing towards the Greek government.

The most important part, which seems to almost always be cast aside, is the fact that Europe can claim to finance Greek pensions only if Greece has a primary budget deficit and this is financed by European loans. Otherwise, Europe is financing Greek government debt, regardless of how favorable the loan terms may be.

Looking into Greek budget execution results for the past years and IMF disbursements we see that the IMF loans were quite enough to finance Greek budget deficits up until 2012 (in 2013 Greece achieved a primary surplus). One should also take into account the fact that the Greek government had around €7bn in cash reserves just before May 2010 and T-Bill issuance increased another €7bn during 2011 (while the remaining budget deficit on a cash base for 2010 was around €7bn). It becomes evident that the total of budget deficits for 2010 – 2012 was around €15.7bn while IMF loans totaled €21.7bn which coupled with cash reserves and T-Bills created a buffer of €35.7bn, more than double the cash needs during that time. Thus the GLF and EFSF loans were used only to repay maturing securities (until the 2012 PSI) and for the PSI/debt repurchase exercises and their aftermath (bank recapitalization).

Greek governmebt deficits and imf loans 2010 - 2012

The hard facts suggest that the Europeans have so far only engaged in a transfer of private into official debt and piggybacks of Greek debt between the ECB SMP and official loans while the IMF did the heavy lifting of financing actual government budget deficits. European politicians did not ‘finance Greek pensions’ but rather increased potential losses for their own citizens by transforming Greek bonds into official claims by the other European countries.

Imagine that you are a country that has achieved a primary budget surplus, even though just a few years ago it run a double digit primary deficit (and that deficit was not due to bank support for the 2008 crisis). This surplus becomes even more impressive if one looks at the structural primary balance which runs close to 4% of GDP (and is not achieved because of an output gap close to 10%).

This country has also managed a substantial current account surplus which is positive even if EU transfers are taken into account. Nevertheless, the country still has a sizable negative NIIP, close to €218bn for 2014 (or 122% of GDP). But taking a closer look at external assets and liabilities the reality is that the country’s private sector has a strongly positive net position while it is the government and the central bank that accounts for most of the liabilities. In particular the government registers €36bn in government bonds held by the foreign sector, €3bn in money market instruments and €227bn in (official) loans, a total of €266bn (almost 150% of GDP and – excluding T-Bills – more than 85% of total government debt). Moreover, its central bank has foreign liabilities of almost €50bn.

This country has gone through immense austerity and internal devaluation in order to achieve the above surpluses with a loss of more than 25% of its GDP. Its output gap is still close to double digits and more than 26% of the work force is unemployed with GDP growth rates hovering around zero.

As you have probably imagined by now this country is Greece and most of the losses described so far can be directly accounted by austerity. What is being demanded from Greece right now is to ultimately continue the transfer of resources from Greek people (a budget surplus is always a net reduction of financial assets of the private sector) to official lenders under the threat of default and Grexit. Yet is such a transfer the rational thing to do?

It is obvious to most people by now (including the IMF) that the Greek bailout was mostly a bailout of private bondholders and the transformation of Greek government debt from Greek law bonds to English law billateral and EFSF official loans. This mistake was officially recognized in 2012 with the Greek PSI, the subsequent debt buyback and the November 2012 Eurogroup statement although the actual reduction was too little, too late. With official lenders insisting on their state of denial the Greek government is asked to achieve large primary surpluses in order to maintain the illusion that its debt will follow a downward path towards sustainability until 2020 and the official sector will not lose its assets. The above is achieved through a ‘stick but no carrot’ approach of dictating both the primary surpluses figures and most of the austerity measures details, always in conjunction with ‘growth enhancing structural reforms’ (which nevertheless don’t seem to be that growth enhancing according to IMF itself) under the threat of the ECB closing down Greek banks (through capital controls or restrictions on ELA) and withholding funds to pay.. the official creditors.

Corporate Finance 101 states that under debt overhang it is not rational for the equity holders of a company to finance new projects since any improvement on the recovery value will mostly accrue to debtholders (who are senior) and leave little free cash flows for other stakeholders. This is exactly the case of Greece where its main stakeholders (government and people) are asked to increase ‘equity’ by transferring resources that will be used mainly to pay official creditors (mainly the IMF at this point in time). Greece is mostly given promises of future reductions in debt service costs (which should have been implemented a year ago) and growth through the structural reforms impact.

Yet under a scenario of a (partial) default by Greece, the reduction would almost exclusively hit foreign creditors. and immediately improve the country’s NIIP and debt service costs. Given its twin surpluses and the reduction in the face value of its debt, Greece would almost immediately gain access to financing (defaults do not usually result in long-term market exclusion) and be in a position to dictate its fiscal policy and (slowly) return its economy on a growth path.

The real battle therefore is not one of what reforms are appropriate but ultimately a battle of resources. The actual stakeholders of Greece are asked (in a fairly undemocratic manner) to ‘lower their stakes on Greece’ (as Paul Mason put it) and transfer resources to official creditors that will improve their recovery rates on loans granted only to repay past debts. Creditors demand debt seniority with management rights available only to equity holders (who usually settle for being junior in the balance sheet structure and earn only a ‘call option’ on future free cash flows for the right to manage). At some point, ‘taxation will have to coincide with representation’.


Ενημερωθείτε για κάθε νέα δημοσίευση στο email σας.

Μαζί με 176 ακόμα followers