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Friday, April 23, 2010

Greece: Third time lucky?

EU Finance Ministers held yet another meeting on Greece, and have finally agreed on the details of the potential rescue package, which have been outlined in a press conference by Eurogroup head Juncker and EC Monetary and Economic Affairs Commissioner Rehn. The financing package looks substantial, it comes at rates that while concessional are still high enough to send a tough message and give Greece a strong incentive to put its house in order. My overall impression is that this should be enough to give Greek bonds some support in the near term, but this is just the beginning of an arduous adjustment process for Greece – the challenge of combining robust economic growth with draconian fiscal adjustment, both essential to reach debt sustainability, remains a formidable one. The agreement also leaves unchanged the underlying vulnerability of the eurozone, and the debate on institutional reforms will have to continue. It is also not clear yet to what extent the mechanism would constrain the ECB’s exit strategy, as the rates charged on EU loans are benchmarked on EURIBOR rates. Also, other large-deficit EU countries would be wise to take additional fiscal measures soon, to avoid becoming the next weak spot.

When will the rescue take place? Rehn and Juncker insisted on the “if and when needed” formula, but during the Q&A Rehn slipped and gave a more realistic “if, or rather when needed”. To be activated, the rescue mechanism will require a formal request by Greece, an assessment and opinion by the European Commission and the ECB, and a unanimous decision by EU leaders. It sounds laborious, but the groundwork has been laid in such a way as to make the following steps faster. Just yesterday, Greece formally requested the initiation of discussions with the IMF. While this does not constitute a formal request for either IMF or EU money, it is clearly the first necessary step in that direction. The key obstacle ahead now is agreeing on the IMF and EU conditions. Rehn indicated that on fiscal policy for 2010 the existing Greek program will be sufficient. However, detailed fiscal conditions will need to be agreed for 2011 and beyond, and the IMF will doubtlessly insist on tough structural conditions to create the conditions for growth and debt sustainability; pension reform and labor market liberalization are some of the likely candidates. Greece faces a few tough years ahead.

How much? The EU will offer up to EUR 30bn for the first year, which I assume would mean 12 months from the activation of the program, bringing us roughly to mid-2011. Over the same period, the IMF could probably provide up to an additional EUR 15bn, which would already be in excess of 2000% of quota – it seems extremely unlikely it could provide more. This would give a neat 2/3 to 1/3 split between EU and IMF financing, with the EU playing the greater role.

Note that the EU today could obviously not speak for the IMF, so we will have to wait for official confirmation from the IMF of when Greece applies for a program and how much financing would be provided.

This is a substantial amount of money. Greece faces about EUR 17bn in debt redemptions over the next six weeks, and another EUR 24bn in the first half of next year, plus the financing needed to cover the budget deficit over the entire period. Supported by this amount of official financing, Greece should be able to raise its additional funding on the market at least for a few months – its ability to do so over an extended period will of course depend on whether it fulfills the EU and IMF conditions. Notice that this will be a multi-year program, and Rehn explicitly indicated that financing for further years would be determined during the program negotiations. This confirms that Greece has a longer-term problem that does not disappear in virtue of today’s announcement.

At what price? The bottom line is that EU fixed-rate loans would be extended for a 3-year maturity at approximately 5% interest rate. This is arrived at by taking 3-year Euribor swap rates as a benchmark and adding a 300bp spread plus an additional 50bp spread to cover operational expenses. Variable rate loans would carry similar spreads over 3M Euribor, which is currently at about 0.64%. It is not clear to what extent this mechanism might constrain the ECB’s exit strategy. The loans will as usual be disbursed in tranches. To the extent that they are at flexible rates, they would of course reflect movements in the 3-month Euribor rate, which is now extremely low. If they are at fixed rates, either the rate is determined based on the Euribor prevailing when the tranche is disbursed, in which case they may rise well above 5%, or the rate is determined based on the Euribor prevailing when the program is activated. But in the latter case, the rate would fall further and further below market levels. In other words, if the ECB proceeds to push market rates up, then either Greece will face higher rates on the EU loans, endangering debt sustainability, or the subsidy element will increase, endangering political sustainability of the arrangement.

Rehn and Juncker were adamant in stating that 5% is not concessional, and not a subsidy. The Orwellian rationale provided in the press conference is that the rate is above that charged by the IMF, and since IMF rates are arguably concessional, something higher is not. Yet 5% is well below current market rates, which means that some residual political and social resistance in Germany cannot be ruled out. However, 5% at 3-years is a high rate: Germany pays about 1.3%, Italy about 1.8%, Portugal about 2.4% and Ireland about 2.3%. In this sense, it is fair to say that while the loans are concessional, they are extended at a rate that still provides a strong incentive for Greece to put its house in order and win back the market’s confidence to at least the same extent that Ireland has.

Another way of looking at it is that even with the EU’s help, Greece will need to implement tough actions to both reduce the fiscal deficit and restore competitiveness if it wants to bring its debt back on a sustainable path.

In other words, the medium-term debt sustainability challenge remains intact. Greece seems relatively well positioned to meet the EU fiscal targets for 2010. But that just means that at the end of this year the country will be in a deeper recession (at least -4% GDP contraction), with a budget deficit still close to 9% of GDP, and having done little to restore competitiveness. The challenge of combining robust economic growth with draconian fiscal adjustment, both essential to reach debt sustainability, remains a formidable one. The relatively high rate is also a powerful signal that Germany is serious: together with the highly visible and transparent process of IMF reviews, it guarantees that Greece will really need to abide by the agreed conditions or risk a cutting off of the official financing – it is hard to see Germany agreeing to a renewal of EU loans in case Greece’s program veers substantially off track.

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