Greece Takes Key Step Foward

Greece Takes Key Step Towards Activation Of Support Mechanism

The agreement last weekend of some key details of the Greek support mechanism has failed to calm market sentiment in the way that many politicians and policymakers had hoped. As a consequence, yesterday the Greek Finance Minister wrote a letter (available on the Greek Finance Ministry’s website) to the European Commission, the European Central Bank and the IMF saying:

“In accordance with the statement of 11 April 2010 on the support to Greece by euro-Area Member States, the Greek authorities are requesting discussions with the European Commission, the ECB and the IMF on a multi-year programme of economic policies building on the Ecofin conclusions of February that could be supported with financial assistance from the euro-area Member States and the IMF, if the Greek authorities were to decide to request such assistance.”

This looks like a pretty key step towards activating the mechanism. According to press reports, a joint European and IMF mission is due in Greece on Monday to continue negotiations. In our view, the support mechanism could be activated at any time.

The key reason why sentiment towards Greece has continued to deteriorate is that investors' concerns have quickly moved on from near-term liquidity issues to medium-term solvency issues. The Euro area agreement reached last weekend was a significant step to ease liquidity stress, but it does nothing to resolve the medium-term issue of whether Greece can achieve debt sustainability. Many investors now think that a debt restructuring (with or without default) is quite likely. Indeed, it is striking that the further you move away from Europe, the greater the conviction that a debt restructuring is almost inevitable.

In terms of the medium term outlook, there are only three options: the Greeks achieve debt sustainability via fiscal consolidation (with or without short-term liquidity loans); the Greeks achieve debt sustainability but only by writing off the bilateral loans from the rest of the region (which would effectively be a permanent fiscal transfer); or the Greeks restructure their publicly-held debt to reduce its net present value. The first option is very painful for Greece; the second option would be politically very difficult for the region; and the third option would be economically and financially painful, and politically very embarrassing, not only for the Greeks but for the region as a whole.

The difficulty of the Greeks achieving debt sustainability can be seen by looking at the fiscal arithmetic. Last year, the Greeks were running a primary fiscal deficit of almost 8% of GDP. Pretty much everyone would agree that in order to achieve debt sustainability they would need to run a primary surplus of at least 3% of GDP. A move in the primary position of 11%pts of GDP is huge, especially in a weak growth environment. Indeed, it would be an unprecedented move over a three year horizon. The largest three year fiscal improvement that any Euro area country has seen before has been 8.5%pts in Finland (from 1995-1998).

Liquidity support from the rest of the Euro area and the IMF do not really change the medium-term debt dynamics. The key issue for the debt dynamics is the size of the fiscal deficit, not the marginal borrowing cost. Investors know this, which is why last weekend's announcement had so little impact on the longer end of the bond market.

The end game of all this is very unclear. If Greece were a stand alone sovereign, you would have to assume a significant likelihood of a default and debt restructuring. But, being part of the Euro area complicates the situation significantly. We would never underestimate the Euro area's inclination to keep kicking the can down the road for as long as possible. This inclination clearly gives Greece more time to achieve the consolidation that is needed. A failure to achieve this is almost too awful to contemplate in terms of the economic, financial and political stress the region would be under.

ENDS

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