a perspective on greece’s sovereign debt crisis tassos belessiotis eu fellow 2010-11 5 october...

A perspective onGreece’s sovereign debt crisis

Tassos BelessiotisEU Fellow 2010-11

5 October 2010

• Fiscal developments in the EU in recent years• Determinants of debt accumulation• Greece’s path to debt crisis• How should/could Greece exit the crisis?• A new SGP regime• Concluding comments

A perspective onGreece’s sovereign debt crisis

1. Fiscal developments in the EU in recent years

2. Determinants of debt accumulation

The basic equation:d(D/Y)/dt = (pb/Y) + (i-y)(D/Y) = (pb/Y) + (r-g)(D/Y)

D = nominal government debtY = nominal GDPpb = nominal primary balance (surplus(-)/deficit(+)) excluding interest payments servicing the public debti (r) = average nominal (real) rate of interest on public debty = nominal GDP growth

The debt ratio increases in the primary deficit; it increases in the nominal (real) rate of interest; decreases in nominal (real) GDP growth; and it is directly proportional to the debt ratio t-1 with the interest-growth differential as factor of proportionality.

3. Greece’s path to sovereign debt crisis


Graph 12: 10-year bond spread to German bund


A brief chronology-1

- Soon after was voted into office, the PASOK government shocked financial markets by announcing that the 2009 general government deficit would be 12.7% of GDP, more than double the estimate prepared by the previous government; the government pledges to save Greece from bankruptcy and targets a 2010 deficit of 8.7% of GDP;

- Fitch Ratings cuts Greece’s rating to BBB+, a rating below investment grade for the first time in 10 years; going into Christmas, S&P and Moody’s follow with similar downgrades;

- Mid-January 2010 Greece’s Stability Program forecasts a reduction in the deficit to 2.8% of GDP in 2012 but in March a new package of further budget cuts are announced; the initial Stability Program was not realistic;

- In the meantime, the bond market prices Greece’s debt as junk and the spread against German bunds widens to unprecedented level, approaching and sometimes exceeding 1000 basis points

- In this environment, with the country crippled by debt service costs, refinancing obligations and downgrades by rating agencies, and with European leaders unable to take a position as to whether they should assist Greece or not, the question was raised whether Greece should unilaterally go to the IMF;

- Discord among EU leaders raises the prospect that if Greece is left to default Europe’s monetary integration would also be at risk;



- On April 11, 2010 euro area finance ministers approve a EUR 30 billion mechanism augmented by a further EUR 10 billion from the IMF, which Athens refuses to activate;

- But, ten days later, on April 22 Eurostat reports that the 2009 budget deficit will be 13.6% of GDP;

- Prime minister Papandreou the next day asks for the activation of the EU/IMF package and a week later S&P downgrades Greece’s debt to junk;

- As financial markets fail to be convinced by the April agreement to support Greece, pressure on the country became relentless, especially in light of massive debt refinancing falling due in May;

- In the beginning of May, an EU/IMF rescue package of EUR 110 billion is announced with Greece pledging a further EUR 30 billion budget cuts over 3 years; a wave of strikes coincide with the May 6 parliamentary approval of the latest austerity bill;

- On May 9, Chancellor Merkel’s coalition loses the state election in North-Rhine Westphalia and its majority in the Bundesrat upper house after agreeing to support Greece;

- EFSF: On May 10, an emergency financial safety net of EUR 750 billion is announced composed by EUR 440 billion of euro area guarantees, EUR 60 from the EU budget and EUR 250 billion from the IMF;



- In some member states Greece’s rescue package needs to be approved by national parliaments, but disbursement of a first installment takes place before EUR 8.5 billion of maturing 10-year bonds fall due on May 19;

- Following the announcement of the package, bond markets eased pressure for a brief period; other member states in the EU periphery – Italy Portugal, Spain, Ireland – put in place austerity measures to prevent Greece’s crisis contaminating them too;

- Slovenia’s parliament backs the rescue plan but refuses to contribute, its share taken up by other euro area states; Slovenia again refuses to contribute in the latest installment and, due to not having a government, Belgium is out too;

- Mid-May, under pressure from financial markets but also by several member states, the Commission puts forward proposals to strengthen fiscal discipline which are endorsed by ECOFIN; the proposals aim at strengthening budgetary surveillance, especially the preventive arm of the SGP, and raises the prospect (corrective arm) of imposing sanctions on member states which persistently violate the rules;

- Stabilization and ambitious structural reform measures are put in place by Athens and while the need for adjustment and reform is widely recognized, resistance also remains strong; the program is implemented under close monitoring and early reviews (IMF, EU) show that it is generally on track.

4. How should/could Greece exit the crisis

There are various ways by which Greece could exit the crisis:

-- Through an orderly adjustment based on the present stabilization and adjustment program and on supportive developments in growth and in interest rates;

-- Through an orderly/disorderly adjustment of the type seen in Latin America, for example;

-- There is also the possibility that the situation moves beyond the control of the authorities and a truly disorderly adjustment takes place, but we’ll just put this aside;

-- Or, through some political compromise Greece and the EU muddle through for some time;

-- Recall the debt accumulation equation;

- first, if there is no stabilization and adjustment program the debt ratio will explode through the contribution of a large primary deficit, collapsing economic growth and very high rates of interest; this is a truly disaster scenario with incalculable consequences for the country and for Europe;- second, the government controls only the primary balance, and the cut-off combination of pb/Y and of (r-g) would be that which makes d(D/Y)/dt = 0; this would ensure that the debt ratio is stabilized but obviously at a very high level; this is clearly no good;- third, for the debt ratio to begin to go on a declining path, in addition to a sizeable primary surplus Greece would need to see low interest rates on government debt and strong economic growth, requirements which may not be reasonably expected to see in the near to medium term;


- It is clear that the only instrument that the government controls is primary expenditure; - finally, there is the possibility of debt restructuring, something that many including the EU and the IMF are against; there are good arguments to postpone this until, of course, it becomes unavoidable;

- What restructuring really means is that the debt ratio would fall by the amount of the “haircut” but the other variables will also be affected since they are endogenous; the rate of interest, in

particular, will undoubtedly increase;- The “haircut” would have to be sizeable, in order to at least signal that is the “final”

restructuring and no other one is likely to follow;- The primary balance must move to surplus to reassure investors that the government is

serious;

- The implications of debt restructuring are difficult to predict although it’s certain that Greece would be cut off from financial markets for perhaps a long period of time;

- If it seems reasonably certain that restructuring is unavoidable, the case for it may be made; but in the present environment of low economic growth and with Greece implementing successfully so far its stabilization program it would be unreasonable to switch policies and not to give it a chance that it might succeed;

- Finally, the required current account adjustment to generate earnings to finance the external debt and support economic growth is also very demanding.


Modalities of the adjustment program

- The Greek authorities request in early May a 3-year Stand-By Agreement (SBA) with the IMF for an amount of EUR 30 billion with the euro area contributing another EUR 80 billon; a first disbursement of EUR 5.5 billion made available upon Board approval with the remaining available in twelve installments subject to quarterly reviews;

- The euro area will provide bilateral support of EUR 80 billion in accordance to the member states’ share in ECB capital; euro area lending will have the same maturities as the IMF’s covering the full three years of the program;

- The euro area loans will have a floating rate of interest, based on the 3-month Euribor, plus a spread of 3 percentage points initially, rising to 4 percentage points for amounts outstanding after three years; each drawing will be subject to an one-off service charge of 0.5 percent;

- Monitoring will be on a quarterly basis, and on the basis of quantitative targets, the first review already completed in the course of 2010:Q3, the last will be during 2013:Q2; funds disbursement will be conditional on these reviews.


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5. A new SGP regime

-- The Commission and President van Rompuy’s task force have centered their work on strengthening both the preventive and the corrective arms of the SGP and on making fines semi-automatic; this is an intensely political debate and disagreements have been plenty among the member states;-- To appreciate what is going on, unlike the US where rules provide for explicit redistribution across states through Washington, in the EU there is no such mechanism; US states are subject to a balanced budget constraint but in exchange they benefit from redistributional fiscal federalism; the SGP in the EU is a budget constraint, limiting in principle the scope for fiscal policy; in the event of a shock the fiscal room is restricted but there is no corresponding transfer from the centre to offset the impact of the shock;-- In these circumstances, governments have found it easier to violate the SGP, despite commitments to respect the rules, especially if there is no realistic threat of sanctions; -- In November 2003, after breaching for the third year in a row the 3% deficit mark, the Commission recommended that Germany and France bring their deficit below 3% within a year; the Council rejected the recommendation and allowed breaking the GSP for an extra year; the political fallout was that the small member states saw a differential application of the SGP; -- Sitting on the fence, the ECJ saw merit both for the Commission and the Council;-- ECB President Trichet’s priorities: address fiscal misalignments; current account imbalances; make sanctions effective; quality checks on statistics; and anchoring the new rules in national law.

5. A new SGP regime

The Commission’s legislative proposals for the new SGP released on Wednesday, 29 September; definitive text will be adopted by mid-2011 and implemented by 2012.

1.In the preventive arm, a new concept of “prudent fiscal policy”; this will ensure that in good economic times progress is made towards achieving the MTO (government budget in balance or in surplus) by setting annual expenditure growth not exceeding prudent growth of GDP – unless compensated by measures yielding higher revenue growth; Council recommendations can follow in case of non-compliance;2.In the corrective arm, debt developments will be given greater prominence; progress only when the distance from 60% has been reduced over the previous 3 years by 1/20 each year;3.On enforcement, for euro members, significant deviations from “prudent fiscal policy” will lead to an interest bearing deposit equal to 0.2% of GDP (due on the issuance of the Council recommendation unless the Council decides otherwise within 10 days), which will become non-interest bearing when the country is in excessive deficit, and a fine when non-compliance with the recommendation to correct the excessive deficit; in addition, for sanctions a reverse voting mechanism (a Commission proposal adopted unless explicitly rejected by the Council by QMV);4.The requirement that the budgetary framework of the member states is consistent with and reflects the objectives of the SGP; a Directive will set out the minimum requirements;5.A new Regulation setting out an Excessive Imbalance Procedure (EIP), to identify, prevent and correct macroeconomic imbalances through surveillance; Council could open EIP for a member state leading to EIP recommendations to correct imbalances; the process is based on peer pressure, but6.for the euro area members which fail to act on the Council EIP recommendations an annual fine of 0.1% of GDP can be adopted by reverse QMV.

5. A new SGP regime

6. Concluding comments


European Financial Stability Facility (EFSF): On May 10 an emergency financial safety net of EUR 750 billion is announced composed of EUR 440 billion of euro area guarantees, EUR 60 from the EU budget and EUR 250 billion from the IMF; the SIV was set up in Luxembourg for three years;

The program requires significant structural reforms necessary to strengthen potential economic growth and to improve competitiveness;

It is no surprise that the program of structural reforms is controversial and public opposition is often very vocal through strikes and other acts of protest; the upcoming November local elections will likely be seen as a referendum on the program;

According to the IMF, implementation for the moment is generally going well; recent data indicate that there is shortfalls in revenues offset by underexecution of discretionary expenditure; government intends to continue underspending in order to create some margin to cover unforeseen events;

Germany announced recently that she does not agree with the idea of extending the EFSF beyond the 3-year horizon, for reasons of moral hazard and weakening commitment; things can, of course, get very messy as the endgame for Greece approaches;

The new SGP and governance framework could potentially help address the problems encountered in SGP version II;


• Will growth in Europe resume? History tells us that in the aftermath of financial crises, growth remains weak for many years; this has been one of the biggest financial crises, and if growth remains weak changes may be necessary also as adjustment fatigue sets in; a deflation/competitive disinflation policy to restore competitiveness may prove unsustainable for the medium-term viability of the rules governing EMU;

The new governance framework, among other things, may be tested as the endgame for the 3-year EFSF or Greece’s 3-year program, approaches;

Greece and Portugal are around 5% of euro area GDP, no major threat, muddling through is feasible with some severe conditionality; things are more complex if Italy and Spain get into problems; the political commitment to EMU is so great that everything possible will be done to address the problems despite current statements and the likely difficulties.

Thank you

a perspective on greece’s sovereign debt crisis tassos belessiotis eu fellow 2010-11 5 october...

Documents

nominal government debty

nominal real gdp growth

budget deficit

debt ratio t

nominal gdppb

debt service costs

primary deficit

general government deficit