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

Its main assumptions are:

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

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

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

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

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

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

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

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.

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

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

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

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


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

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

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

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

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

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

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

 ECB Opinion on Bank Resolution draft law

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

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

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

Greece ESM loan financing needs and sources

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

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

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

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

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

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Kostas Kalevras

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