GREFERENDUM AND A NEW DEAL: KEY DIMENSIONS

Referendum and Grexit

On July 5, the Greek rejected massively (61% of opposition) the conditions of a rescue package from creditors. Market analysts were quick to revise their scenarios, with Grexit becoming the baseline at relatively high percentages (Barclay’s, Standard and Poor’s).

Contagion risks were viewed as considerably more limited than in the past—total exposure of other member states and the Eurosystem to Greek debt amounts to around 3.5% of the Eurozone GDP (Barclays), with very small exposure of European banks to Greece. Potential spillovers to fragile Eurozone countries would result from a new “union reversibility” (Barclays), and immediately translate into higher financing costs (RBS).

Yet costs for Greece would be high. In particular, it would transform the banks’ liquidity crisis into a solvency crisis (Barclays). With confidence falling further, capital controls and the banking sector close to bankruptcy, the pace of decline in economic activity and unemployment are likely to worsen. Currency depreciation could translate into high inflation and lack of basic imports (RBS). For Standard and Poor’s, real Greek GDP would immediately fall by 25%, and would still be 20% below the baseline, 4 years later..

Could Greece be forced to exit the Eurozone? There is a legal void for exit in EU treaties. With Greek banks running out of liquidity and of ECB’s assistance, Greece might be obliged to issue a parallel currency, i.e., IOUs, to pay salaries and pensions, that could then turn into a permanent parallel currency (Reuters). This could violate Article 7 of the Treaty on European Union, leading to the suspension of the country from the Eurozone rather than its complete expulsion (Peter Spiegel). A worsening of the situation, with difficult access to hard currency, could induce a Greek request for exit (Reuters).

The agreement and the way forward for Greece

A new agreement between Greece and its international creditors was reached. Beyond the considerable political noise, analysts are mixed about its implication:

• A window of opportunity? Angel Ubide (Peterson Institute) outlines the main elements of the deal: loans of €86 billion, a short-term economic stimulus plan for Greece, and the promise of at least some debt forgiveness in the future in return for tough measures—OSI (official sector involvement, mostly a rescheduling of the official European debt with longer grace periods and maturities) and eligibility of Greek bonds to the ECB’s bond purchases, a step that would also ease financial conditions in Greece. Jacob Funk Kirkegaard (Peterson Institute) argues that much in the deal is good for Greece, with a focus on reforms of labor markets, product markets, the pension system, the judicial system, the value-added tax, and energy markets, as well as the depoliticization of public administration and banking sector appointments, and scaled up privatization.

• A step forward but no long-term solution? Thorsten Beck (VoxEU) doubts that the recent agreement provides a long-term solution to Greece’s economic crisis but calls for using the momentum to eliminate the option of Grexit once and for all and breaking the bank-sovereign ties to turn Greek banks from a source of crises into a growth-supporting sector. He highlights the lack of ownership, social instability, risks of lasting capital controls, and the negative impact of permanent primary fiscal surpluses.

• Kicking the can one more time? For Barry Eichengreen (Project Syndicate), the new program provides no basis for recovery or growth, and structural reforms alone will not reverse the downward spiral—and will eventually trigger Grexit. Paul Krugman (NYT) looks at the British recovery after WWII, with a large debt burden, to support the argument that Grexit, with sharp currency depreciation, is overwhelming. Adair Turner (Project Syndicate) argues that eurozone governments will end up writing off a large proportion of their loans to Greece, with large losses the more they wait: appropriate future reforms cannot change the fact that Greece’s debts are unsustainable.

FT Alphaville and Eurointelligence report the approval by the Greek Parliament backed austerity measures demanded by the country’s creditors as part of the prior actions, clearing the way for talks to begin on a EUR86bn bailout package. The main rift came from Alexis Tsipras’s own party (KT Greece).

Looking back, some observers are critical of the policies advocated by creditors (notably the IMF), which should bring their own lessons. For Paul Krugman, the unsustainability of debt is not new and driven in part by policies. Ashoka Mody (Bruegel) criticizes the IMF for following political constraints during crunch times. Guntram Wolff (Bruegel) sees two major IMF mistakes in Greece that the IMF needs to acknowledge: earlier debt restructuring and substantial and early reforms to restore the competitiveness of Greece. Going forward, Wolff sees as central for the IMF: insisting on lower primary surpluses; insisting on structural reforms that matter for growth; and reviewing its governance in the Troika.

Debt Restructuring – The heart of the debate

Joseph Cotterill (FT Alphaville) and EuroIntelligence report on the IMF’s latest update of its debt sustainability analysis—which calls for an upfront debt relief agreement. The DSA has worsened, with considerable downside risks, with the introduction of capital controls and their impact on the economy. The IMF’s DSA also notes how difficult it will be to fix the debt overhang without restructuring: (i) Greece is expected to maintain primary surpluses for the next several decades of 3.5 percent of GDP, which few countries have managed to do; (ii) Greece is still assumed to go from the lowest to among the highest productivity growth and labor force participation rates in the euro area… (iii) the proposed additional injection of large-scale support for the banking system would be the third such publicly funded rescue in the last 5 years. Hence the need for debt restructuring, with several options: (i) maturity extension, but a very dramatic extension with grace periods of, say, 30 years on the entire stock of European debt, including new assistance, (ii) explicit annual transfers to the Greek budget or (iii) deep upfront haircuts.

Other solutions have been brought forward. For Joseph Stiglitz, the most reasonable solution is a write-off of Greece’s debt, or at least a deal that would not require any payments for the next 10 to 15 years, argues. This debt restructuring should include several Eurozone countries, not only Greece, according to Thomas Piketty, who reminds us that Germany’s external debt was wiped-off after the WWII. Long-term debt extensions and the use of growth-linked debt, which would act as a shock absorber (RBS) have been proposed, including by the Former Greek Finance minister himself (proposition).

The Commission's assessment of the Greek request for an ESM bailout also calls for debt restructuring, of course only after strong prior actions from the Greek government, though some observers (e.g., Peter Doyle) believe the underlying assumptions are too optimistic.

Peter Doyle (FT Alphaville) criticizes the IMF’s most recent Greek DSA which he says proves the inconsistency of past policy advice. Julian Schumacher and Beatrice Weder di Mauro (VoxEU) criticize the IMF’s standard DSA models for not being appropriate for Greece – a middle-income country with highly concessionary financing, and call for the ESM to develop a new, appropriate analytic tool to reflect Greece’s special situation. Using different assumptions, the authors find a NPV debt/GDP ratio at only 93%, and call for a common DSA model based on the relevant numbers.

Debt relief is important because future IMF support depends on the solvency of the country, and IMF support is needed: the FT assesses that of the envisaged €82-86bn financing needs, the share of the ESM is €40-50bn, a further €16.4bn is earmarked from the existing IMF program, while most of the rest was supposed to come from a follow-on IMF program. As noted Jacob Funk Kirkegaard (Peterson Institute), Greece is expected to “request continued IMF support (monitoring and financing) from March 2016“—after the expiration of the current IMF Extended Fund Facility. The continuing involvement of the IMF ensures that the commitment to debt relief is real.

The Greek banking system and the ECB

The situation of the Greek banking sector is critical. Free Exchange remind us that the outflow of money from Greek banks has been financed by ever-growing amounts of central-bank funding called “emergency liquidity assistance” (ELA), provided by the Bank of Greece (at its own risk) but with limits imposed by a majority of two-thirds on the ECB’s governing council. The ECB’s decision to raise this limit allows the banks to reopen on July 20 and creates breathing room. David Keohane (FT Alphaville) reports on the decision of the ECB to increase ELA to Greece by 900 mln euros—with total Eurosystem exposure to Greece at 130 bn euro for a 120 bn euro deposit base—while the bailout package effectively puts euro zone authorities at the ECB in charge of bank resolution in Greece according to Tyler Durden (Zero Hedge). Keohane stresses that extending more liquidity to Greek banks means the ECB exposes itself to further losses in case of Grexit, and hence encourages a decision from governments towards debt restructuring.

Daniel Gros (CEPS) stresses that Greek banks are close to collapse, even with a new bail-out program—hence, a program needs to include recapitalization, possibly with bail-in and restructuring, and possibly depositors taking a large part of the burden (with only a small part of the assets unencumbered and no government resources). He remarks that foreign official funds will be needed, e.g., a direct equity investment by the EIB or the EBRD or special ESM bonds. Silvia Merler (Bruegel) looks at four possible scenarios to recapitalize Greek banks and shows that ESM direct recapitalization would require a very significant bail-in of 8% of total liabilities, implying a significant haircut on uninsured deposits. The best solution would be to limit bail-in to what is currently mandatory under the amended state aid requirement and suspend Greece’s contribution.

In the meantime, Paul de Grauwe and Yuemei Ji (VoxEU) make the case for the ECB not asking for repayment of its Greek bonds: repayment is like ‘reverse QE’—to maintain QE targets, more bonds from other EZ members must be bought, shifting the free borrowing from Greece to other EZ members. Instead, the ECB could extend the maturity of the Greek bonds.