July 25, 2011
by Victoria Marklew, Northern Trust
With the second bailout agreement for Greece announced on Friday (July 22), the EU has stumbled toward a new level of institutional development. However, Greece still does not have a sustainable funding package in place; and the easing of contagion pressures on other Euro-zone members may be short-lived.
Let’s start with Greek Bailout #2, valued at €109 billion. The full details will be hammered out between now and mid-September, but it appears that about two-thirds of the total will come from the European Financial Stability Fund (EFSF) and the remainder from the IMF. The whole amount will be in addition to last year’s €110 billion package. The deal includes cash for budget needs and for recapitalization of the Greek banks, an as-yet-undefined sovereign debt buyback scheme, and “collateral enhancements” from other Euro-zone governments. The latter reportedly will total €35 billion and will try to encourage investors to swap into new 30-year Greek bonds by backing them with AAA-rated securities. The EFSF loans to Greece will be extended to 15 years from the current 7.5 and the interest rate will be lowered to around 3.5% from the current 4.5-5.8%. Finally, there is an expectation that Athens will raise something like €50 billion from privatization during the time of the two funding programs.
The other side of the Greek bailout deal is the involvement of the private sector creditors, who will be offered four options – three separate bond exchange offers plus the aforementioned rollover into 30-year debt – as well as the bond buyback scheme. The Institute of International Finance, which helped negotiate the creditor details, says it anticipates 90% participation in the plan, which will result in private creditors taking a loss of about 21% in the net present value of their Greek sovereign debt holdings.
French President Sarkozy declared on Friday that the plan in its entirety will reduce Greece’s sovereign debt burden from 150% of GDP to about 126%. The deal certainly goes much farther than most of us external observers had expected, but is highly unlikely to be the final answer in putting Greek public finances back on a sustainable path. Reducing the debt to 126% of GDP will require that everything go exactly according to plan, from the level of private-sector participation in the restructuring to the amount that the government can raise from privatization to the willingness of the Greek electorate to keep swallowing ever-nastier austerity measures.
The Greek economy has dropped into recession, with real GDP contracting 7.4% on the year in Q4 2010 and another 4.8% in Q1 2011. With leading indicators pointing to a renewed slowdown in the rest of the Euro-zone, and severe spending cuts underway, there is a risk that the Greek economy will not return to growth by 2012. The weaker the economy, the harder it will be to get the headline deficit and debt ratios under control.
And even if Bailout #2 does go according to plan, a public debt burden of 126% of GDP will not be sustainable for Greece. Although the economy enjoyed real GDP growth that averaged an annual rate of over 4.0% between 2001 and 2007, the expansion was fuelled by hefty increases in public and private borrowing. The underlying economy remains chronically uncompetitive – as evidenced by the current account deficit, which averaged over 8% of GDP in the same period, and jumped to near 15% in 2008. Add in the negative near-term impact of hefty spending cuts and a massive restructuring program, and it becomes apparent that Greece needs to see a reduction in its public debt burden to somewhere below 100% of GDP in order to get back on its feet.
All of this suggests that we will be re-visiting the issue of Greek debt sustainability and the need for another “debt deal” within the year – possibly sooner, as the markets digest the details and do the math. Which takes us to the contagion issue. Recall that the whole point of Bailout #1 was to allow Greece to return to the markets in 2013; and that the subsequent lending programs put in place for Ireland and Portugal make similar assumptions. Recall, also, that market fears that these aims were unrealistic sent bond yields soaring in early July, including in much larger Euro-zone countries. Italian ten-year yields jumping past 6.0% concentrated the collective Euro-zone mind wonderfully and led to last week’s summit agreement. The various zone players had to come up with a way to ensure that such contagion would not hit again. ECB Governor Trichet, by insisting that the ECB would not accept defaulted Greek government debt as collateral in funding operations for the beleaguered Greek banks, had drawn a line in the sand – the central bank wanted to get out of the business of helping fiscally insolvent members and back to the business of being a central bank.
