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Hold Your Nose and Offer Greece Debt Relief Conditioned on Reform



It didn't have to be this way, with Greece in default to the International Monetary Fund (IMF) and facing possible default on the European Central Bank (ECB) and consequently at risk of being forced to print its own money and exit the euro. The projections in my book last June showed the ratio of public debt to GDP falling from 175 percent of GDP in 2014 to 127 percent by 2020. Thanks to low interest rates on loans from the European official sector, the interest burden would have been arguably manageable at an average of 5 percent of GDP in 2015–20. I concluded then that more relief might be necessary for Greece to regain financial market access by 2020, but that financial markets might instead look through the overstated debt numbers and begin to return—as they had begun to do by September of last year. Greece turned the corner back to positive growth last year (0.8 percent), and private forecasts had anticipated growth of 1.8 percent this year. But the populist, confrontational policies of the Syriza government have spoiled growth prospects for this year (private forecasts are now down to zero) and have raised serious doubts about future prospects.

As the impasse over Greece's future deepened this summer, the IMF issued an important new analysis on debt sustainability , suggesting a path for Greece back to stability and recovery. The report, issued on July 2, found that "by late summer 2014 … it appeared that no further debt relief would have been needed…. But significant changes in policy since then—not least, lower primary surpluses and a weak reform effort that will weigh on growth and privatization—are leading to substantial new financing needs" (p. 10). As a consequence the new report reduced its projected average growth rate in 2015–20 from 3.3 percent per year to 2.0 percent and cut its projected average primary fiscal surplus (i.e., excluding interest payments) from 4.1 percent of GDP to 2.8 percent of GDP. Not surprisingly, the report finds that under these conditions more relief is needed.

Nonetheless, the Fund's new analysis finds Greek debt would be sustainable if the debt due to the European official sector were stretched out in maturity and if interest due were rolled over at concessional rates, averting the need to replace this debt service with high-interest private sector borrowing (see pp. 11–12 of the report). Three-fourths of the debt coming due in the next three years is owed to either the IMF (€10 billion) or the Eurosystem (€14 billion). The IMF suggested maturities on EU loans be doubled and payments coming due in 2015–18 be refinanced on concessional terms.

In a bow to political circumstances and, likely, concerns about excessive austerity in the face of still high unemployment, the new projections call for a primary surplus of only 1 percent of GDP in 2015 and 2 percent in 2016, down from 3 percent and 4.5 percent respectively in the previous program. The primary surplus would rise to 3 percent in 2017 and 3.5 percent thereafter. As suggested by my colleague Paolo Mauro's parallel blog post, such a target should not be insurmountable. In comparison, the average primary surplus maintained by Italy during its fiscal adjustment in 1993–2000 was 4 percent of GDP, and the medium-term primary surpluses being pursued in current adjustment programs are 3.1 percent of GDP in Portugal and 3.7 percent in Ireland. Moreover, other work at the IMF has found that for 24 advanced economies in 1950–2011, the median primary surplus in the highest 5-year moving average (illustrative of an adjustment period) was 4 percent of GDP (here , p. 25).

In the Fund's new baseline, after stagnation this year, real growth in Greece would average 2.5 percent in 2016–19, about the rate private forecasts were projecting for 2016 at the beginning of this year. Recovery from an output gap of 7 percent of GDP should spur growth initially. The Fund baseline then sees growth easing to a plateau of 1.5 percent annually over the longer term. I suspect this projection is too conservative because growth averaged 3 percent in 1990–2007.

The debt-to-GDP ratio would fall to 128 percent by 2030 in the baseline and 116 percent with the concessional lending and stretchout. But the debt ratio would overstate the debt burden because the bulk of the debt would be at concessional rates. With the package of concessional lending and maturity extension, gross financing needs would average only about 8 percent of GDP in 2020–30, well within a range the Fund considers sustainable. The interest burden of the debt would decline from an average of 4.3 percent of GDP in 2015–30 in the baseline to 3.3 percent with the relief package, which would place it at the 75th percentile for advanced economies in 1950–2011.

Mr. Tsipras should now offer further commitments on reform, including on pensions (which cost 17 percent of GDP, compared to 12 percent in Spain and Germany) and privatization. In return, the Eurogroup should make a commitment in principle to provide the kind of concessional rollovers just described (and already envisioned in the December 2012 agreement; see here , pp. 190, 194) so that the Greek public can be assured there is light at the end of the tunnel. The extra support should be phased in and conditioned on achievement of the pledged reforms. In the absence of an agreement the alternative seems likely to be a Greek exit from the euro area—or Grexit—with severe damage to Greece. The euro area would also face damages from Grexit in the dimension of public sector losses potentially on the order of €300 billion (€26 billion in remaining ECB holdings of Greek debt, €90 billion in ECB lending through Emergency Liquidity Assistance, €53 billion to the European Union in the Greek Lending Facility, and about €140 billion to the euro area; see the data here , p. 198) , even if contagion is minimal.

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