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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.


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:


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.


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:


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.

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.

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.

Greece - State Transfers to Pension System.jpg

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.

So it seems that Europe and the IMF have found a way to guarantee the presence of the latter in the Greek economic program. The SMP and ANFA profits of the Greek bonds held by the Eurosystem (which are no longer returned by European governments to Greece) will be used as a guarantee for the IMF loan repayments.

These profits amount to more than €10bn in total up to 2020 while the total amount currently due to the IMF is 11.3bn in SDRs (about €14.3bn at current exchange rates).


Since the IMF insists that only a 1.5% of GDP primary surplus is reasonable in the long-run (for Greece), my assumption is that this amount (which currently stands at €2.7bn annually) will be added to the SMP/ANFA profits and provide a guarantee for the IMF (in effect the IMF will have a senior claim on these financial resources). The IMF needs to be able to guarantee its repayment (either through such measures or by maintaining the the Greek debt is sustainable with high probability) in order to stay in the Greek adjustment program.

That way the Europeans will be able to include the IMF in the Greek program without having to satisfy its recommendations for a long-run primary surplus of 1.5% GDP and a larger debt restructuring. This is made easier by the IMF itself who insists that only a 1.5% surplus target is realistic (politically) but if Europe wanted to avoid it then it would have to impose further consolidation measures on the Greek budget. These include more cuts on pension expenditures, a reduction of the exemption on income tax and lower public wages (a total of €4.5bn in additional cuts).

The end result will be that Europe will avoid having to perform any serious debt restructuring in the short-term, include the IMF in the Greek program and face the 2017 election cycle without serious concessions to the Greek side. It will insist on maintaining the 3.5% surplus target for the foreseeable future and place (again) all the adjustment burden on Greek shoulders regardless of the fact that such a target makes no economic sense.

The IMF view that Greek debt was unsustainable, the surplus targets unrealistic and serious debt restructuring necessary did briefly open a window for the return of economic logic in Europe. My feeling is that this window is quickly being closed by Europe which will insist on maintaining the current unrealistic course just because the alternative is difficult politically.

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.



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 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