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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.
The fall was driven to a large part by a fall in liabilities towards the Eurosystem, both for Target2 liabilities and extra banknotes:
Yet the total fall in Eurosystem liabilities was much lower than the decrease in bank lending, an adjustment of €28.4bn:
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 the IMF decided to publish its views on the size and path of Greek budget surpluses. In a nutshell, it still thinks that only a 1.5% primary surplus target is credible in the long-run and even that target must be accompanied by «growth-enhancing» budget reforms, including a lower tax-free income threshold and a reduction in pensions in order to lower state transfers to the public pension system.
Yet if Europeans and the Greek government «agree» on a higher surplus target (the 3.5% target agreed by the recent Eurogroup meeting) then the latter has to legislate measures upfront in order to make that commitment credible.
My first comment is to state the obvious fact that there really doesn’t exist any sort of «agreement» between the Greek government and its European partners. Rather, European countries would like to avoid any actual debt relief and thus will demand higher surplus targets than those that are reasonable from an economic standpoint. It is quite obvious that the Greek government is the weak side of this bargain and, as long as the IMF thinks that any target above 1.5% does not make economic sense, it should pressure the Europeans (who are the strong side in this debate) into accepting deeper debt relief, instead of standing ready to work with any surplus target they demand from the Greek side.
The IMF cannot claim to be a neutral technocratic institution and yet sign-off budget balance targets which it clearly believes to be unrealistic from a technical point of view only because they seem to be the only ones «politically acceptable».
Turning to the specific details of the IMF analysis, there are a couple of points to be made.
The IMF believes that the tax-free income threshold is quite high in the Greek case, which results in more than half of the wage earners to be exempt from income taxes (while the Eurozone average is close to 8%):
Its proposal is to lower that threshold significantly in order to be able to reduce the «high marginal tax rates». My objections are two-fold: First, the IMF does not insist on such a reduction in order to strengthen the revenues of the social safety net and lower the tax rates of middle-income wage earners. Rather, it would like to see the additional revenue being used in reducing the tax rates of high-income earners (which stand at more than 50% if the solidarity tax is taken into account). Thus it is actually proposing a post-tax income redistribution from the low-income earners to the top. In the IMF view such a redistribution will be «growth-enhancing» although I personally fail to understand how its effects will be anything else but contractionary, at least in the short-term, since it will by definition redistribute income from persons with a low saving rate to individuals with a higher saving rate.
Moreover, Greece displays one of the highest «risk of poverty» rates in the Eurozone which is close to 36% (and is actually even higher for people 16-54 years old) as well as a significantly high Gini index. As a result, a reduction of the income threshold, especially if it is not used to strengthen the social safety net significantly, will result in a rise of the post-tax poverty rate and income inequality with ambiguous medium/long-term growth effects.
The second point of the IMF is that Greece makes budgetary transfers to the pension system that are many times higher than the rest of Europe, at 11% of GDP compared to 2¼ for the Eurozone.
Although it is difficult to deny that the Greek pension system is expensive, unequal and in need of reform, it is still true that the above analysis does not take the state of the economy into account. According to the latest Eurostat figures, Greece still posts an output gap of -10.5% compared to only -1% for the whole of the Euro area. As a result, a large part of the budget transfers to the pension system are not structural but cyclical, due to the high unemployment level (close to 25%) and the significant incidence of part-time, low-paying jobs for the individuals who are actually employed.
Based on the latest statistics for wage earners (March 2016), the part-time employment share is 29% (532 thousand persons) with an average salary of 405€ while the full-time average is 1220€ (1300 thousand persons). At the same time, the average old age monthly pension is close to 800€. It is obvious that no pension system would be able to survive without significant state transfers given the level of unemployment and under-employment present in the Greek economy.
One way to compare Greece with the rest of Europe in a cyclically-adjusted manner is to calculate old age pension expenditure as a percentage of potential product. This is exactly what I have done in the following table (nominal potential product is equal to potential output multiplied with the actual GDP deflator):
We can see that pension expenditure actually compares quite favourably with other European countries such as France, Italy and Portugal.It is thus probable that a large part of the state transfers are the result of the large economic slack present in the Greek economy. That suggests that Greece primarily needs cyclical relief (through lower surplus targets for instance) rather than an upfront deep structural reform.
The recent narrative regarding Greek debt sustainability has moved from the debt-to-GDP ratio towards the annual debt financing costs (interest payments + maturing debt). According to this analysis, Greece already enjoys very generous terms until 2020 and beyond and will only require small debt reprofiling measures in terms of interest rate payments and debt maturities after 2022. What is needed according to its creditors is for Greece to continue on the reform path, achieve economic growth and commit to credible fiscal measures that will allow it to maintain high primary surpluses close to 3.5% of GDP. Unfortunately that can only be achieved through tough measures on the pension front. «As long as Greece continues on this path, creditors will do their part» as the story goes.
In my view the above story is problematic, mainly because it relies on Greece achieving and maintaining a 3.5% GDP surplus target, a target which I believe is not credible in the long-run. In order to examine the subject from a theoretical point of view, I will use some well known concepts in economics, debt overhang and dynamic inconsistency.
Debt overhang is a concept usually used in corporate finance. It is based on the idea that, as long as the corporate balance sheet carries too much debt (which always takes precedence in payment over stock), stockholders do not have an incentive to contribute new funds in order to fund new investment projects if the proceeds are mainly used to improve the recovery rate of creditors. Balance can only be achieved if creditors ‘share the costs’ through a restructuring of the liability structure of the company balance sheet.
The same applies in the case of Greece. Its own ‘stakeholders’ do not have an incentive to contribute funds (in the form of high taxes or lower pensions/wages) if the increased surpluses will mainly be used to improve and ‘guarantee’ the recovery rate of foreign creditors. Given that Greece has a negative external balance (especially the cyclically-adjusted figure) it is an accounting fact that a primary surplus will involve a deterioration of the Greek private sector net financial assets position. Maintaining a 3.5% surplus target in the indefinite future involves a very large transfer of financial wealth from the Greek private sector to foreign official creditors with only a small part of the (possible) growth dividend staying in Greece. Most corporations would not accept such a bargain unless under threat, something which is more than evident in the Greek case where the Grexit threat has been thrown around for more than 5 years now.
Dynamic inconsistency on the other hand involves the idea that sometimes the solution to a dynamic optimization problem depends on the specific time when the problem is evaluated, which has the effect that a specific action time path is not credible.
A classical example is capital taxes. A fiscal authority might want to commit to low capital taxes in order to achieve large investment and growth. Yet at time t=1 investment has already been made and the temptation is high to increase capital taxes in order to enlarge fiscal revenue.
In a way, the same applies in Greece. In order to achieve debt sustainability, the fiscal authority must commit to a path of large primary surpluses. Yet, given the fact that such surpluses deteriorate the private sector position and the possibility of a negative shock hitting the economy, it is highly likely that Greece will have to lower its surplus (or even run a deficit) at some point in time. When the time of a negative shock comes, the optimal solution for the sovereign is to try and smooth the effects of the shock on the economy, not maintain a target that will only make matters worse.
As a result, especially given the need to maintain the surpluses for a very long time (in order to achieve debt sustainability), such a path is not credible. The fiscal authority will deviate ‘at the first sign of trouble’.
Combining the debt overhang with the dynamic inconsistency argument leads to a clearly unstable equilibrium. Both the sovereign and the Greek private sector (Greek stakeholders) do not have the incentive to commit on a high surplus strategy. Under completely rational behavior they have every reason to not damage their financial position and maintain the best possible growth rate. Any commitment on the high surplus strategy will not be credible but only a ‘temporary deviation’ in order to avoid short-term negative outcomes since the Grexit threat is still considered credible.
In my view, only a path of low future surpluses (accompanied by a large upfront debt restructuring) is a long-term credible strategy. Otherwise, we ‘ll keep on observing the current ‘stop and go’ path, with the Greek government implementing the least possible measures and its creditors using Grexit as stick and the (insufficient) future debt reprofiling as carrot in a repeated game with a non-optimal outcome.
Bank of Greece recently released its balance sheet statement and profit & loss account for the year 2015. One important observation is the significant increase in its profits which totaled €1.16bn compared to €654mn during 2014. I have already commented on this profit flow in my post on the November balance sheet. Assuming a spread of 150bps over the MRO (which is paid to the Eurosystem by BoG) on ELA financing the cumulative profit flow during 2015 was €1073mn, a figure quite close to the total profit for that year.
In terms of bank lending, total bank loans and ELA outstanding are now back to March 2014 levels at €107.5bn and €68.9bn respectively. Nevertheless, this level of financing is supported by a much higher figure for collateral which stands at €189.15bn instead of €177.59bn in March, a fact which signifies the quick deterioration in quality of Greek bank assets (total collateral for December are only €16bn lower than their peak during 2015). This figure is close to 2/3 of their total primary assets (debt securities and credit claims) or more than 85% of credit claims (before provisions). Given the large non-performing exposure of Greek banks it is clear that most of their assets are already encumbered as collateral towards BoG.
One important development that seems to have gone unnoticed is the large increase in securities held for monetary purposes by BoG (as part of ECB’s QE) which have risen from €5.8bn in December 2014 to €20.7bn, although ‘Other Securities’ registered a drop of €6.2bn from €25.27bn to €19.05bn. As a result total ‘ Securities of euro area residents denominated in euro’ increased €8.7bn. Nevertheless, securities held by Greek MFIs did not move much during 2015 which means that any BoG purchases were performed abroad and (all else equal) should lead to a rise in Target2 liabilities. This is confirmed by the fact that ‘liabilities towards the Eurosystem – Bank Lending Operations’ reached a figure of €6.5bn in December while it was in negative territory until January 2015.
Given that securities purchases will continue during 2015 we can expect to observe a further change in BoG balance sheet mix with a larger part of Eurosystem liabilities being financed by securities rather than bank loans, something which will obviously change its net income flows significantly. Whether these purchases will lead to an increase of Target2 liabilities or not will depend on broader developments within the economy and private capital flows.
It is more than usual to read articles examining the Euro boom years which tend to suggest that capital inflows from the core funded the credit expansion in the periphery. Although that line of reasoning is not wrong when examining capital flows between countries, I do not think it is entirely correct in the case of a monetary union such as the Eurozone.
The main reason is the fact that the Eurosystem is structured in such as way that it is accommodating of capital flows between Eurozone members through overdrafts at the NCBs and unlimited Target2 credit. Banks as suppliers of credit and creators of deposits do not need a pre-existing stock of funds, nor to they need to pre-finance any outflows to other Euro members.
More specifically imagine the following example depicting the normal flow of credit and cross-border flows:
- A bank customer in Greece applies to a Greek bank for a loan to fund a new investment project (which will require German manufactured capital goods).
- The bank extends the loan and credits the corresponding customer’s bank account. No actual funds are needed by the bank apart from the 2% reserve requirements (which is elastically provided by the ECB).
- The customer pays for the capital good by transferring funds to a German bank. For the transaction to take place, the Greek bank debits its reserve account at the Bank of Greece with the corresponding amount and BoG increases its Target2 net liability position. In case the Greek bank is short of reserves (compared to average reserve requirements) it can source funds at the BoG marginal lending facility, at the weekly MRO or at the interbank (repo) market.
- Since the interbank repo rate is quite favorable compared to the marginal facility rate, the Greek bank will use high quality bonds from its bond portfolio (mainly Greek government bonds) to source funds from the European interbank repo market using the bonds as collateral. It is clear at this point that the new bank loan remains on the Greek bank books and is never transferred outside its balance sheet, nor does it play any significant role in the cross-border flows.
- Apart from the increase in bank liabilities to RoW (described in (4)), periphery countries also saw a large increase in the amount of government bonds held by the foreign sector. As a result, instead of (4), Greek banks could just use the flow of funds from abroad (which were used to acquire Greek government bonds) to repay their (extra) liabilities towards the BoG and maintain a stable amount of interbank funding. It should be noted at this point that any inflows of funds either from the interbank market or from foreigners for the purpose of buying government bonds will lower the net liability position of BoG to the rest of the Eurosystem (a position that actually remained quite small until the start of the 2008 crisis).
What is clear from the above is that cross border flows are accommodating (in the sense that central bank financing is always available to cover them) and that the reason of incoming flows has almost nothing to do with the original loans and transactions (in our case a bank loan to pay for an investment project ends up in a cross border liability of the government or the banking system).
Financing of cross border flows was always provided by the Eurosystem. Inflows of funds to buy government bonds and interbank loans were merely used by the banking system as a cheaper source of funds instead of large liability positions towards the corresponding NCB. Capital inflows did not ‘fund investment in the periphery’ but were the result of foreign portfolio preferences and mostly changed the composition of the net liability position in the periphery away from Target2 liabilities which were replaced by higher liabilities of the government and banking sector.
BoG published its November 2015 balance sheet data which makes it a good opportunity to look into recent developments.
Compared to the peak during June, liabilities towards the Eurosystem (Target2 + extra banknotes) have decreased substantially from €130.5bn (more than 70% of Greek GDP) to €117.8bn which is still a very high number. Almost all of the fall was driven by the €10.5bn reduction in Target2 liabilities.
This improvement of BoG’s net liability position was reflected on bank borrowing which fell from €126.2bn to €113.4bn. Most of the change is attributed to lower ELA which is down €9.3bn but still stands at May levels.
An interesting side effect of large ELA bank borrowing is the fact that BoG earns around €100mn monthly from the (assumed) 150bps spread over the MRO rate. As a result it has already accumulated profits probably close to €1bn from these operations. These profits will clearly prove quite helpful for the 2016 budget execution although they represent a ‘windfall flow of income’.
Lower loans from the BoG mean that banks can free up a part of the collateral they have been posting to the central bank with total collateral being almost €14bn lower than its peak during the summer. Given the fact that Greek banks already have €10bn less assets than during January while NPLs are still on an upward path this development is more than welcome. Especially since the total of debt securities and credit claims (before provisions) on their balance sheet is only a total of €288bn. Taking into account NPLs it is evident that Greek banks were already very thin in available collateral during the heated summer standoff between Greece and its creditors.
Lastly, one other positive news item is the fact that the government account at the BoG now holds more than €5bn. Since for the next months the remaining Greek debt obligations are quite contained it stands clear that the Greek government has some leeway to not try and conclude the first quarter negotiations (which contain some of the most difficult parts of the package such as pension reforms) without giving a fight. Specifically, it has to pay €1.2bn to the IMF in December and €1.4bn during the first quarter.
Based mostly on this article on Japan. What is important when looking at dependency ratios is not the ratio of old persons to the working age population but rather the ratio of non-working citizens to working ones. And this includes people (usually) younger than 24, especially in developed countries (where most people attend some type of college).
When examined under this perspective the relevant picture is quite different: Non-working dependency ratios were extremely high during capitalism’s ‘Golden Age’ (1950 – 1970). Greece will hit ratios last seen in 1975 at.. 2040 (with the dependency ratio being much higher in the ’50s) while Germany will only get into trouble after 2025-2030.
As long as pensions are not a ‘defined benefits’ but rather a ‘defined contributions’ scheme and remain flexible, population aging will not lead to the ‘dooms day’ scenarios that some people fear about. We managed to take care of baby boomers just fine during capitalism’s finest hour.
Something which I think goes overlooked from time to time is the fact that what is actually available as (taxable) income within a country is not GDP but GNP (which is GDP plus net income from RoW). As a result, calculations involving maximum tax income potential and debt sustainability should take into account any income lost from GDP as income of foreigners.
This is especially true for Greece where an examination of the available data actually shows that somewhere close to its Euro entry the country moved from a positive net income balance to an increasingly negative one, both nominally and as a percentage of GDP:
At its peak (2008), Greece lost more than 3% of its GDP as income returned to RoW with dynamics that were quickly becoming unsustainable. Ever since the 2009 crisis and especially after 2012 (and the PSI exercise) that lost income was significantly reduced (and even reversed at least during 2012). Nevertheless, it seems that funds lost to the RoW are slowly increasing again with the relative balance (as %GDP) moving from -0.6% in 2012 to 0.4% during 2014:
Although the figures are still almost an order of magnitude less than during the second half of the previous decade their long-run dynamics should be modeled in any debt sustainability exercise, especially since Greece will depend on FDI for a large part of its future economic growth (which will create large flows of income for the RoW).
The same dynamics (with a peak again during 2008) are actually present in the rest of Europe as well with the periphery increasing its lost income during the Euro’s first decade and EU center (Germany, France, Netherlands) moving from a roughly balanced figure to positive net income of close to 2% GDP (which obviously increases their taxable income):
BoG recently released the Greek balance of payments for July 2015 (which is actually the first release where the data are based on ELSTAT rather than bank transactions). The release is the first after the imposition of capital controls (following the announcement of the Greek referendum) and includes some quite interesting developments.
Compared to July of 2014 the balance of payments increased to €4.25bn (from €1.27bn), an increase of close to €3bn. The major movements in specific categories are as follows:
- The fuel balance dropped from -€726mn to -€227mn mostly due to a large fall in fuel imports of €731mn (although exports also fell €241mn). A large part of the drop is probably due to much lower oil prices compared to a year ago.
- Purchases of ships were nil compared to €114mn last year.
- Other goods imports fell strongly by €730mn to a little more than €2bn (while the average figure during the first 7 months of 2015 was around €2.6bn).
- Apart from travel receipts all categories of the services balance dropped significantly, especially payments abroad (-€690mn) and transport receipts (-€700mn).
- Secondary income receipts (basically government receipts from the EU) increased substantially by €1.75bn.
The effects of capital controls were very strong on most elements of the goods and services balances. It is helpful that exports of other goods did not seem to be affected and actually increased by €50mn. It will be interesting to observe August figures (when they do get released) to determine to what extent the drop in goods and services imports was permanent or just postdated.
The improvement of the goods and services balance was €1.24bn in a single month. As long as this improvement is permanent I think it is reason enough to not expect a large fall in Greek GDP during 2015Q3. Even a nominal drop of 6% during the third quarter (which is consistent with a fall of 5% in real GDP if the VAT increases are taken into consideration) is equal to roughly €2.9bn. In other words, the improvement of the July balance of goods and services is close to 40% of that drop. As long as the August external balance figures are also positive news it is very hard for Greek internal demand to negate the positive impact of the external sector. Third quarter GDP might actually prove to be quite resilient.
Despite the large economic losses in the Eurozone since 2008 one will hear the same constant argument: Most countries (especially those in the periphery) lived ‘beyond their means’ and the correction that followed was inevitable. Austerity might cause short-term pain but the subsequent economic recovery (however weak and thin) vindicates its use and merits.
In this short post I will take a rather simplistic approach. Since the ECB inflation target is 2% while the usual assumption about long-run growth in per capita real output is also 2% we can compare the path of NGDP per capita in European countries to a 4% trend:
What we see is quite significant. It is true that before 2008 Greece and Spain had a NGDP path that constantly diverged from the 4% long-run trend (this pattern is especially strong in the Greek case). France, Italy and Portugal roughly followed the long-run trend while Germany quickly suffered significant losses due to its stagnant domestic demand environment and low inflation.
What is especially interesting is the path of NGDP/capita since the Great Recession. All countries seem to have suffered significant and permanent losses with their expected expansion path moving to a new and lower level. This is even more visible in the case of Greece and Italy where their projected 2016 NGDP per capita level will only be 70% of the long-term trend. Interestingly, Spain seems to be the country that has suffered the least losses compared to the trend line while France, Germany and Portugal are quite far from the 4% growth path (France at 74% while Germany and Portugal are close to 78%) with France actually growing only by 1.5% since 2012.
Yes, the path of Greece and Spain up to 2008 seems to have been unsustainable (in the context of a monetary union). Yet their correction entailed significant and permanent losses while the whole of the Eurozone is now on a new growth path at least 20-25% lower than the long-term 4% trend. Austerity and tight monetary conditions result in large output losses that are lost forever. Adding a few years of income 20-25% lower than trend implies a permanent loss of more than a year’s worth of income which in the context of a person’s lifespan is more than important.