BlogSpot - Greece: Is it the right time to get rid of austerity?

After being first bailed out in 2010, Greece has undertaken broad economic reforms to mend its public finances and return to growth following six years of deep recession. Those cutbacks have come at a cost: some 25% of Greeks remain jobless, while a quarter of households live close to the poverty line, and public debt remains high and difficult to sustain.

The newly elected Siriza party has re-opened the debate with the new finance minister Yanis Varoufakis, proposing to European officials that Athens raise EUR10bn by issuing short-term Treasury bills as “bridge financing” while a new bailout is agreed with its eurozone partners. This may not be a straightforward undertaking—the FT believes the ECB is unwilling to approve the debt sale. Nomura stresses three key points for the financing of the Greek sovereign and banks: (1) State financing needs T-bill stock increase, (2) waiver of eligibility for the standard operations at the ECB, linked to program compliance, (iii) ELA financing, with unclear terms and greater needs due to deposit outflows and state financing.

The irony of the current turmoil, according to Angel Ubide, is that, until it became clear that there could be early elections in Greece—and with it a Syriza-led government—markets seemed to be ignoring the debt sustainability issue. Greece’s 10-year yields had declined to 5.5 percent last September, and a consensus was building that in 2015 Greece would be able to exit the fiscal adjustment and reform program imposed by the Troika. Is it the right time to get rid of austerity?

A debt overhang problem?

Kenneth Rogoff argues that debt overhang creates considerable policy uncertainty for investors, preventing a full recovery. He adds that even after two bailout packages, it is unrealistic to expect Greek taxpayers to start making large repayments anytime soon – not with unemployment at 25% (and above 50% for young people). This is why Paul Krugman calls on policymakers to recognize this and reduce debt service to avoid “endless suffering.”

The negative relationship between economic headwinds and growth in the presence of high debt overhangs was highlighted by Rogoff and Lo. J.Fisher argues that simultaneous debt reduction and structural reforms is impossible. In fact, reducing the debt overhang (by cutting expenditures and increasing taxes) tends to create a growth deficit that put at risk the implementation of structural reforms.

Thorsten Beck adds that the solution envisioned by many Eurozone finance ministers to reduce interest rate payments further and lengthen the maturity of loans simply delays the day of reckoning, therefore further debt restructuring for Greece is needed.

Focus on pragmatic solution. According to Wolfgang Munchau (Eurointelligence), any pragmatic solution would have to focus on the flows first (vs. the stocks of debt). Taking that into account, Paul Krugman suggests suspending all interest payments on Greek debt immediately until the Greek economy has recovered.

Greek finance minister Yanis Varoufakis has proposed (see the FT) a “menu of debt swaps”: growth-linked bonds and European Central Bank-owned Greek bonds with “perpetual bonds”. He promises in an interview in Die Zeit that Greece will never submit a budget deficit again and will continue structural reforms. He also calls for a ‘Merkel plan’ along the lines of the Marshall Plan for Greece. For Joseph Stiglitz, this debt-to-equity swap represents a fair and efficient solution. Paolo Mauro suggests that the bonds could be indexed to the economic growth differential between Greece and the Eurozone, which would be consistent with the risk-sharing notion. However, he stresses that it might reduce incentives of the Greek government to foster growth (a variant of the “moral hazard” concept). He also suggests that Greek government might be tempted to tamper with the GDP data.

For Marco Valli (Unicredit) stresses that the key issue for the negotiation lies in the amount of burden sharing, between the Greeks (sustaining a primary surplus) and the external creditors, mostly European taxpayers. On the former, they expect difficult negotiations, to reduce the target below the current 4% primary surplus. On the latter, to deal with the 2015 liquidity needs, Valli sees a lower interest rate on EU bilateral loans and a further maturity extension of bilateral and especially EFSF loans as relatively uncontroversial.

Daniel Gros, in a CEPS note, looks at the various elements of the negotiations and is relatively less pessimistic than most analysts. He discards the need for a haircut (given that the first substantial payments are due in 15-20 years) and the abolition of the Troika. He stresses that debt service, despite the high debt level, is rather low (compared to Italy or Ireland for example). He sees a new program, with a grand name, as likely, and more ECB financing coming once it is agreed.

A Moral Hazard: for debtors or creditors? Debtors’ moral hazard is often pointed out to justify the argument that Greek debt restructuring would have negative spillover effects on other peripheral countries (risk of contagion), and also lessen the incentive for reforms. Joseph Stiglitz and Kenneth Rogoff underline that creditors bear similar responsibility as borrowers, exposed to losses after risky lending practices.

Reuters cites an internal German discussion that outlines the German position as rejecting any rollback of existing reforms, and cuts in spending. FAZ writes that there was a single concession Berlin was willing to make - to change the name troika into another name - without changing its functions and, more importantly, its composition. The article also said that Berlin specifically opposes an increase in the Greek minimum wage.

The structural reform agenda

Malcom Barr at JP Morgan writes that there has been significant progress on a number of objective measures, but product market regulation and the costs of doing business remain high relative to the rest of the Euro area. And business perceptions of the efficiency of goods and labor markets are particularly low.

The new administration focuses on reducing clientelism and tax evasion, which should find ample support among European partners. But proposals to raise minimum wages and pensions, reinstitute collective bargaining, increase public sector employment, and halt privatizations are widely seen by Euro policymakers as a step backward that will slow growth in the long run.

Risks associated for Greek and EU economies

Thorsten Beck argues that if Greece leaves the current Troika program with no additional agreement, the ECB might not be able to continue supporting the Greek banking system due to legal constraints. The FT identifies two key parameters:

An immediate €10bn financing need due to the end of the Troika program, for which the government would need to issue additional T-bill, requiring ECB’s support. If the idea of a bridge loan does not go forward, for David Mackie (JP Morgan), the only ways that the Greek government can avoid default to the end of May is to either conclude the existing EFSF program and agree on a new one or negotiate a reprofiling of the IMF SBA liabilities due in the coming months—easing the cash flow pressure on the government by €3 bn.
With the removal of the waiver allowing Greek banks to participate in standard ECB monetary operations with sub-investment grade collateral (see the official statement, Reuters, Die Welt and FAZ), the ECB stepped up the pressure on the Greek government. Spiegel writes that the ECB was increasing the pressure on Greece to agree on a program. For JP Morgan, this is a lesser risk, given that it merely shifts financing from the MRO/LTRO operations to the more expensive ELA.

Banking system ready to collapse? When banks borrow from the ECB, they must provide eligible collateral. The Economist notes that, after the removal of the waiver, Greek banks will no longer be able to present bonds that have been issued or guaranteed by the Greek government. Greek banks are therefore suffering a double blow. The uncertainty caused by elections and a change in government prompted big deposit outflows, of €4.4 billion in December and more than twice that in January. According to the Wall Street Journal, €70bn outflowed from Greek banks over the past five years—forcing banks to borrow heavily from the ECB and leaving them today with much less eligible collateral. The growing reliance on “emergency liquidity assistance” (ELA) makes the banks, and thus the Greek government vulnerable.

Walsh and Wolff highlight that in the last week especially, after the election, the market value of the four biggest Greek banks has literally collapsed and it is now 15.2 billion or only 43 percent of the book value of 2014Q3.

Financial markets reaction—Simon Wren-Lewis from Mainly Macro fears peripheral countries wanting to revise the terms of their Troika programs will ‘frighten the markets’. José Carlos Díez believes peripheral Euro bond markets remained calm (Spanish ten-year bonds, for example, are still trading at interest rates below US Treasuries) only because of the positive impact of the QE announcement. He likens the consequences of a Grexit to Argentina's corralito for Greece and Lehman Brothers for the financial system.

Contagion & moral hazard—Eurointelligence asserts that Varoufakis reject the Troika’s technocratic supervision, but two issues arise:

Simon Nixon writes in the WSJ that the eurozone is in a bind—for example, Spain cannot afford to exempt Greece from reforms, as this would trigger an outcry within Spain and strengthen Podemos. He argues that the eurozone might sacrifice Greece to save Spain.
Thorsten Beck points out that a generous debt restructuring – one that would allow a blank slate for the Greek budget – would create moral hazard risk for eurozone nations with high debt-to-GDP ratios.