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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.

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

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

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

  Euro share of world exports 2010 - 2015.jpg

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


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




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

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

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

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

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

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


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


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

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

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


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


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

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.



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:

  1. 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).
  2. 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).
  3. 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.
  4. 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.
  5. 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.