The Eurogroup is asking Greece to do something unprecedented

13/4/2017

By Matthew C Klein

Historical experience—not just Greece’s experience, but that of a typical advanced country—is inconsistent with the primary surplus paths that would make Greece’s current debt sustainable.

–“Does Greece Need More Official Debt Relief? If So, How Much?” by Jeromin Zettelmeyer, Eike Kreplin, and Ugo Panizza, April 2017

The Greek government owes roughly €326 billion*.

Thanks to concessional financing from the Greek Loan Facility, the European Financial Stability Facility, and the European Stability Mechanism, it currently pays an effective interest rate of just under 2 per cent. Were Greece to lock in this interest expense for a sustained period, its debt burden would gradually decline. All that would be needed would be for the economy’s nominal growth rate to stay above 2 per cent and for the budget excluding interest to remain in slight surplus.

(Whether that would be enough to repair a society that’s suffered more than almost any other country in peacetime is a different question…)

Things would be much more precarious if the Greek government couldn’t continue relying on concessional financing and had to borrow from the markets. The Italian government pays an effective interest cost of about 2.7 per cent and the Portuguese state pays 3.3 per cent. Applying 3 per cent, the average of those (low) numbers, to Greece would increase its total interest bill by more than half, nearly doubling the government’s total deficit.

If the Greek government had to pay a premium relative to those countries on its obligations, perhaps because it weren’t included in the European Central Bank’s bond-buying programme, total borrowing needs could easily triple. Without a commensurate increase in its budget surplus before interest, the Greek government’s debt would balloon, both in absolute terms and relative to gross domestic product.

This is why the International Monetary Fund has vocally recommended drastic cuts in the present value of the amount demanded by Europe’s “official sector” creditors by, among other methods, locking in the current interest burden for decades. (The IMF hasn’t volunteered to reduce its claims on Greece, however.)

At the opposite end are Europeans, led by German finance minister Wolfgang Schaeuble, who say no changes are needed and the Greeks can afford to pay. He has also said further debt relief would only be possible if Greece left the single currency. Replacing concessional financing with market borrowing starting next year would be fine, in this view, because there is scope for the Greek state to tighten fiscal policy further. (The official position of the Eurogroup is somewhere in the middle.)

New research from Jeromin Zettelmeyer, Eike Kreplin, and Ugo Panizza suggests Schaeuble is wrong: there is no reasonable likelihood that the Greek government can continue without significant further debt relief. Kreplin’s participation is particularly notable since he is an economist with German federal government.

They find that the sustained budget surpluses (before interest payments) envisioned by the Eurogroup are simply unprecedented. Betting the Greek government will be able to do something no other state has done before, at a time when its legitimacy is fragile and its economy is still in tatters, therefore seems unwise.

The trio followed up on an earlier study by Panizza and Barry Eichengreen, who found that sustained budget surpluses implied by the euro area’s “fiscal compact” were extremely rare, and therefore unlikely. (That study in turn was based on research from the IMF on the history of fiscal tightening and covers 48 countries between 1955 and 2015.)

The new paper focuses on applying this history to the situation in Greece. That situation is unusual, so the trick is to parse the data in a useful way. They go through several different methodologies, the most straightforward of which is to look at the implied odds that a given budget surplus (before interest) is sustained for a given period of time once it’s been reached. They further split up their sample into countries starting out with government debt greater than 60 per cent of gross domestic product and those with less debt.

Past experience suggests the fiscal policy expected by Schaeuble — a budget surplus before interest payments worth 3.5 per cent of GDP, sustained for 16 years — has literally no chance of happening even if Greece were able to start generating a 3.5 per cent primary surplus by 2018, as per the targeted schedule:

In other words, even if Greece manages a 3.5 per cent primary surplus in 2018, the changes of sustaining it for another 15 years is basically zero.

Critics might point out this kind of analysis is unfair. What matters isn’t the budget surplus in any given year, but the average surplus over the full period. Zettelmeyer et al looked at this too, and it isn’t much more encouraging:

The implied odds of success for Greece are somewhere between 15 and 20 per cent. As they note:

International evidence does not support an adjustment path that envisages a primary surplus of above 3.5 percent for more than three to four years on a continuous basis and for more than seven years on an average basis.

Put another way, there is no way to make the Greek government debt sustainable without further debt relief, whether that means nominal haircuts or significant changes in the terms of official loans. (Excluding countries from their sample that successfully lowered their indebtedness with austerity in fewer than seven years doesn’t change these results.)

The final section of their paper looks at what kinds of changes in terms might generate the desired results while also remaining consistent with past statements from the Eurogroup. It turns out there is no good solution:

The probability of maintaining a declining debt-to-GDP ratio is above 50 percent but below 60 percent. In that sense, debt is sustainable in these scenarios but not with high probability.

Perhaps these results could be considered good enough—but there is a hitch. The consequence of granting very low amortization rates and further interest deferrals is not only that Greece will continue to owe money to the EFSF for a very long time but also that Greece’s debts to the EFSF will continue to grow as long as interest is deferred…Greece’s debts to the EFSF would more than double to about €278 billion in 2050, when interest deferral is assumed to end, and then begin a slow decline, but the outstanding amount in 2080 would still be higher than it is today.

Although interest deferrals are part of the arsenal of debt relief measures described by the Eurogroup, an increase in exposure of this size—equivalent to new large-scale lending by the EFSF—is politically implausible.

While there are a few things that could be done to improve the outlook, such as refinancing the original bilateral loans from 2010 and the relatively expensive IMF loans with cheaper ESM funding, as well as locking in relatively low interest rates for the EFSF and ESM, none of these would be sufficient.

The biggest constraint, in their view, is the belief that there should be no more concessional lending after 2018. The current level of interest rates on Greek government bonds implies a big uptick in funding costs as concessional loans are replaced by market financing. Delaying this shift until market interest rates have dropped “would maximize the impact of a given amount of debt relief in net present value terms—or alternatively, minimize the need for debt relief for a given amount of fiscal adjustment in Greece.”

Zettelmeyer et al therefore recommend an additional €100 billion loan from the ESM to tide the Greek government over until the early 2030s, at which point the difference between the yield on GGBs and the ESM’s funding costs will hopefully be small. Compared to the alternative of deferring EFSF interest payments for decades, this would slightly reduce official sector creditor exposure to the Greek government. It might prove insufficient to make the government’s debt sustainable, but it stands a better chance than the current plan:

If the objective is to allow Greece to return to capital markets in the second half of 2018, the question of how much debt relief Greece can expect must be credibly answered first. Delaying a clear answer to the debt relief question beyond 2018 is feasible only if the creditors are prepared to extend ESM financing beyond 2018.

And feasible does not necessarily mean optimal: In the context of continued ESM financing, the best approach to rekindle growth may well be to combine some upfront debt relief in 2018 with promises of additional debt relief if Greece complies with agreed policies and refrains from expensive borrowing from the private sector.

That would look something like this:

No matter how it’s structured, “Greece does indeed need substantial debt relief beyond what has already been extended in past years”. The new research suggests the Eurogroup needs to abandon previously-made deals that required unprecedented and unsustainable budgetary tightening.

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