Greece: why the crisis is not over (Note)

Abstract :

· An agreement has been reached between the IMF, the eurozone, and the Greek government. It provides for new loans and public debt relief.

· These loans are being granted in exchange for structural reforms and fiscal austerity measures. These austerity measures have slowed Greece’s growth and competitiveness, preventing recovery and a return to a sustainable debt path.

Significant debt restructuring and long-term assistance from the IMF are needed to give Greece the time and resources to return to a path of growth, primary surpluses, and sustainable debt. « Strangled » by the repayment of aid packages and the rapid and painful reforms that need to be implemented, Greece now seems doomed to seek a new debt agreement every six months.

At an extraordinary meeting of the Eurogroup on Wednesday, May 25, a « comprehensive » agreement on Greek debt was finally reached between the International Monetary Fund (IMF), the eurozone finance ministers, and the Tsipras government in Athens: release of new loan tranches (€10.3 billion) and debt relief (until 2018).

These measures should enable Greece to make its debt sustainable and, in the long term, return to growth. This agreement follows numerous austerity measures, particularly fiscal measures, voted by the Greek Parliament and demanded by international creditors: an increase in VAT, liberalization of the banking system/bank lending, creation of a privatization fund, creation of a correction mechanism to automatically reduce government spending if Greece deviates from its budgetary trajectory, etc. But is this « loan for reforms » contract welcome and useful for Greece’s recovery and its exit from the slump? Will the Eurogroup agreement be enough to make Greece’s debt sustainable?

1. A brief chronological overview: how did Greece get to this point and what is the current situation?

From the mid-1990s until 2009, Greece deliberately underestimated its public deficit. In the fall of 2009, the newly elected Greek government discovered that the deficit for that year was actually 13.6% of GDP[1] and that the figures for 2006 and 2007 had also been significantly underestimated. Greece’s creditors and international financial markets then began to doubt Greece’s ability to repay its debt. Interest rates on Greek government bonds soared, and the country was forced to find a way to reduce its debt service while limiting its borrowing, as it now had only very limited (or even non-existent for long maturities) access to the bond markets.

By spring 2010, the country’s public debt was no longer sustainable, and speculation about Greece’s default was rife (it should be remembered that Greece had already defaulted four times since 1800). The majority of the public debt was held by foreign banks, particularly French and German ones.Several forms of aid were then provided by the Troika (IMF, ECB, European Commission): a haircut of nearly 50% of the nominal value of the debt (partial default) and loans from the IMF and European governments, which were used to repay the remaining bonds and meet short-term public financing needs. These loans were seen as a bailout plan for Greece, a way of buying time with creditors to avoid total default. This bailout plan was granted on condition that the country recovered: Greece had to return to growth in order to service its debt and substantially reduce its public deficit. The ECB also provided assistance to Greece by agreeing to refinance Greek banks using Greek sovereign bonds as collateral.

Table 1 – The Greek economy since the start of the sovereign debt crisis

From 2011 onwards, Greece’s debt quickly became unsustainable. The country was sinking into recession (see Table 1) and the 2010 plan was no longer adequate. A second bailout plan was therefore put in place in March 2012. The IMF loan was subject to requirements very similar to those of the first. Greece had to improve its ability to raise taxes, reduce public spending, and implement reforms to encourage employment and economic development. However, the ECB stepped in to stabilize the financial markets: in July 2012, Mario Draghi made his famous speech: « Within its mandate, the ECB is ready to do whatever it takes to save the euro. And believe me, it will be enough. » The announcement of the OMT, a new debt buyback program for countries under the program, caused bond interest rates in Europe to fall sharply, temporarily easing the pressure on Greece. The two aid packages combined are worth around €240 billion.

In the summer of 2015, the loans granted in 2010 under the first bailout plan were coming to maturity (€1.55 billion from the IMF, €6.5 billion from the ECB) and Greece, still in recession, did not have the means to repay them. By deciding to default, it could be forced to leave the eurozone (« Grexit »). In addition, the ECB decided at the same time to stop its government-guaranteed loans to Greek banks, as the central bank did not want to end up with less collateral than the loans it had already granted to Greek banks. A third bailout package was then released (€86 billion in tranches of €20 billion, the first of which—the only one released so far—in the fall of 2015), once again in exchange for a series of austerity measures to be implemented in the country.

What does this new agreement of May 25, 2016 bring? Two important things:

· The release of new loan tranches: €7.5 billion in June and €2.8 billion in the fall, provided that Athens makes progress in privatizing assets (electricity, water, gas, ports, service companies, buildings, land, etc.), reforming its energy sector, and improving bank governance. These new loans will enable the third plan to resume, but above all they will enable Greece to avoid defaulting, as it has to repay more than €3 billion to the ECB in July.

· Temporary debt relief planned until 2018. This relief of Greece’s enormous debt (180% of its GDP) will take the form of purchases of Greek government bonds by the European Stability Mechanism (ESM) in order to smooth the interest rates faced by the Greek government. At the end of the third plan (2018), the Europeans will have to consider new debt restructuring measures—extending repayment periods and maturities, with no interest or principal payments—provided that the « loans for reforms » contract is fulfilled.

For its part, the IMF, which made its aid conditional on Greek debt relief, realistic targets, and a sufficiently long grace period, has committed to finding a financial arrangement by the end of 2016, pending proof that the debt is sustainable. It is said to be advocating a 20-year extension of debt maturities (amortization), i.e., until 2080 instead of the current maximum of 2060, as well as an extension of grace periods until 2040.

2. Why is Greece not emerging from the crisis despite these aid plans?

At the onset of the crisis in 2010, Greece faced two major problems: colossal public deficits and a decline in price competitiveness. The deficits had to be reduced through structural reforms in public finance management. With regard to price competitiveness, under a flexible exchange rate regime, adjustment can be achieved through nominal currency depreciation. The loss of demand following a decline in public spending can then theoretically be offset by a recovery in exports, which are more competitive. However, this cannot happen in a monetary union.

The key macroeconomic question is the speed at which this adjustment should take place: should competitiveness be restored quickly or gradually? With regard to Greece, the eurozone has probably made three mistakes:

1) Too much austerity too quickly, which is even counterproductive in reducing deficits, as it plunges the economy into a severe recession (see Table 1) and makes any adjustment extremely difficult. [3]

2) A partial and belated default on Greek debt, which should have been more significant from the outset so as not to have to renegotiate it every year.

3) An adjustment carried out in the midst of an economic recession and then deflation in the eurozone. In a monetary union, when the exchange rate is no longer an effective tool for restoring price competitiveness, comparative inflation is key: restoring competitiveness is complicated if partner countries are close to zero inflation.

Thus, following 2), the Troika asked Greece for large primary surpluses in the coming years in order to repay the remaining debt and adjustment loans; This means that correcting the mistake made in 1) is much more difficult, as it requires greater austerity. If Greece eliminated its negative output gap, it would achieve primary surpluses of close to 7% according to the OECD, which would be enough to pull it out of this debt crisis.

Between 2007 and 2015, Greek public debt rose from 103% to 179% of GDP, despite the implementation of three macroeconomic adjustment programs aimed precisely at restoring Greece’s public finances (see Figure 1).

Chart 1 – Deficits, growth, and debt in Greece since 2008

Sources: OECD and BSI Economics

In a recent study[5], Sébastien Villemot breaks down the contributions to the increase in Greek debt in accounting terms and concludes that the two main contributions to the rise in debt are (negative) growth and interest charges: the increase in Greek debt is therefore mainly due to the snowball effect (i.e., the mechanical increase in debt due to the differential between real interest rates and growth).

Despite its austerity efforts, Greece is struggling to return to growth and competitiveness, which would enable it to generate sufficient surpluses to make its debt sustainable. Greece’s trade deficit fell by nearly 10% between 2007 and 2012, resolving one of the biggest imbalances of the pre-crisis years; however, exports collapsed and exacerbated the economic crisis. According to a study by Costas Arkolakis and Manolis Galenianos, which compares the current level of Greek exports with the theoretical response of trade to a reduction in net capital, Greek exports should have increased by 25% (rather than falling by 5%), and this underperformance of exports is responsible for one-third of the decline in Greek GDP.

So is the continuation of the « loans for reforms » agreement signed last Wednesday good news for the Greek people? The Tsipras government has adopted new austerity measures demanded by the former Troika: higher indirect taxes (including 24% VAT and additional taxes on gasoline, tobacco, and Internet use), the creation of a « residence tax » for the hotel industry, creation of a new privatization fund to accelerate the sale of public assets and boost their exploitation (at Germany’s request), liberalization of bank lending, creation of a correction mechanism that would automatically reduce government spending if Greece deviates from the budgetary path chosen by its creditors, etc.

These measures, which have led to numerous protests in the country, follow the announcement of two painful reforms two weeks earlier, on pensions and income tax. According to John Cochrane, the very high tax rates (^third highest among 21 European countries) applied to Greece, which is undergoing rapid systemic reforms and deep and painful structural adjustment policies, are extremely counterproductive and crush any hope of recovery. « We can hope that Greece will repay its debt, but this can only be achieved by helping its economy to grow, not by imposing ever-higher taxes on citizens and entrepreneurs. »

Conclusion

Many believe that Greece should have defaulted in 2010, when its debt was unsustainable, but nothing has really changed in this regard since then. Its future therefore remains uncertain: while debt relief and the release of additional loan tranches give the Greek government some breathing space by providing it with liquidity to repay some of its creditors, negotiations will have to resume in earnest at the end of 2016 when the first and second bailout plans come to maturity. However, in 2015, the budget was once again in deficit and growth was virtually zero: current IMF forecasts do not predict positive annual growth until 2017. Greece has therefore not emerged from its crisis.