With the troika having expressed a favourable opinion on Greece's adjustment, it looks like the next tranche of the loan will be disbursed in early July. The near-term worries about Greece have revolved around such a disbursement, as the IMF needs to see that there is a funding plan in place for the next 12 months before it can approve any further payments to Greece, according to its operational rules. The original IMF adjustment programme assumed that, out of gross borrowing needs of €66.6 billion in 2012, about €26.7 billion would have to come from issuing bonds. At this stage, we think it unlikely that Greece will be able to come back to the market next year. Therefore, the Greek rescue package would have to be amended to cover this funding gap - or Greece would risk cash flow issues, with possible contagion effects in the rest of the EMU periphery and beyond.
We think it likely that the funding gap will be closed by a combination of additional loans from the European partners, the IMF, privatisation receipts and the voluntary involvement of private sector investors. However, before they agree to an additional loan programme, the European countries and the IMF have indicated that they want Greece to step up its efforts on privatisation, budget cuts and structural reforms. Hence, we believe Greece will have to assure its official creditors that its current adjustment plan is on track (an issue about which the troika seemed somewhat doubtful, in our view) and also commit to further measures in order to secure an additional rescue package.
Government Has a Majority but Needs Cross-Party Support
In order to be assured that the measures agreed in the new adjustment programme don't get derailed or watered down in the political process, the troika is encouraging the Papandreou government to seek cross-party consensus. Such consensus is even more important given that the next set of adjustment measures might meet more resistance from the ruling PASOK party. At the time of writing, the opposition, Nea Democratia party, has not yet signaled support for the overall adjustment programme. While large parts of the Greek parliamentary opposition favour additional privatisations, they seem resistant to additional austerity measures.
We think the draft law on both measures, the additional €6.4 billion of budget savings for this year and total privatisations for a total of €50 billion, will have to be passed in the Greek parliament next week. At this stage, however, there is no precise timetable and delays are possible. Beyond these two near-term measures, there are also additional initiatives, notably on labour market reforms and the detailed medium-term plan that need to be passed through the (single house) Greek parliament. The majority needed is 50% + 1 vote. We think the government is backed by an absolute majority in the parliament - despite having lost the support of four MPs over the past year. This means that, while the situation remains fluid, the government might count on at least 156 MPs in the 300-seat parliament.
In recent days, there have been reports in the Greek press (e.g., Kathimerini) about increasing criticism from within PASOK. Despite this controversy, we believe that eventually the required measures are likely to be passed. This is because Prime Minister Papandreou still has a majority in parliament and because some of the smaller opposition parties seem open to the idea of supporting the government at this juncture, albeit only on selected measures. For example, press reports (e.g., Bloomberg) suggest that the government is keen to lower the standard VAT rate (while reshuffling the items that are taxed at the standard and at the reduced rate to make up for the revenue shortfall) as a concession to the opposition. While this has not been deemed to be sufficient by the latter, there might be room for compromise in other areas, we think.
Finding a Political Common Ground
The IMF/EU are keen to see a broader consensus around the entire adjustment package, and their track record in Ireland and Portugal indicates that they may be successful at securing it. In Portugal, financial support will be provided on the basis of a policy programme including strict conditionality, which was negotiated with the Portuguese government involving the main opposition parties. Similarly, in Ireland, the (then) opposition became much more open to compromise after winning the recent elections. The risk, which we don't deem to be insurmountable at this juncture, is that the various European countries still have to go back to their parliaments to extend the loan to Greece. From this perspective, headline risk remains quite high.
On the Issue of Private Sector Involvement
We believe that European lenders may seek some form of private sector involvement in bridging the funding gap for Greece in the next two to three years. Instead of the initial idea to extend maturities (reprofiling) or the more draconian haircuts (restructuring), we think the firm opposition of the ECB to such ideas seems to have moved the discussion to encouraging private investors, notably banks, to roll over their Greek debt. The historical precedent is the so-called "Vienna" initiative from 2008, under which about 15 banks committed voluntarily to keep funding their subsidiaries in several Central and Eastern European countries that were receiving IMF/EU aid at the time. In the case of Greece, an agreement on the details of such a rollover has not been reached, and it will probably take a few more weeks to finalise the details (notably the tenor, the coupon, etc.). Given that one objective is to avoid a credit event, we believe it is unlikely that the new bonds or notes would receive preferential creditor status. The question, however, remains whether banks would be offered some positive incentives (such as higher coupons). From a political point of view, the inclusion of private investors in the new funding programme for Greece is important to ensure parliamentary passage of the new loans in some of the core countries.
With Germany and other core European countries now having backed away from the idea of a maturity extension, given the fierce intervention from the ECB on this issue, we doubt that the peripheral countries will differ on this front. In our view, the concern of the EMU periphery and of mid-tier countries such as Spain or Italy is that a maturity extension - should it eventually happen - could have a negative spillover effect into other sovereign bond markets. There is still a risk that the rollover does not get enough participation from private investors, in which case there might be a negative implication for the broader financial markets. In order to judge these risks, we think investors need to see the details of any potential rollover agreement.
Too Early for a Debt Restructuring in the Euro Area
The measures on the table are primarily aimed at improving the liquidity situation for Greece, in our view. With very few exceptions, the measures would not improve the solvency situation meaningfully in the near term. We believe that over the long term, the solvency situation will be determined by whether or not Greece manages to achieve sufficient growth and whether it is able to fund at affordable rates. Essentially, the new programme, which would remove Greece from the market for at least two more years, would buy time: Time for Greece to strengthen its economy, time for Europe to reinforce the capital base of its banks, and time to erect firewalls that would help to prevent contagion. These steps could help to manage the consequences of an eventual restructuring in the future. Alternatively, the time could be used to make further progress on a coordinated fiscal set-up of the euro area. It will likely depend on the timeframe during which the extra financial support to Greece is secured and on the perception of whether Greece can deliver on its adjustment programme and whether market worries subside for a limited or longer period of time.
Maintaining Banks' Exposure - How Could it Work?
While the ECB clearly opposes a maturity extension of the Greek debt - regardless of whether it is a voluntary or a forced one - in our view, the ECB does seem open to exploring the possibility for banks (not just Greek ones) to maintain their exposure to Greece and to roll over the debt on a voluntary basis. A similar ‘gentlemen's agreement' took place in 2008 in Eastern Europe, whereby banks publicly committed to roll over loans to their subsidiaries whenever possible and to remain in the region (i.e., not to close down their subsidiaries or significantly reduce the scale of their operations in Central and Eastern Europe).
The key feature of this initiative was that the banks publicly endorsed the IMF programmes, as there was a recognition that if each bank acted on its own there could have been a crisis of confidence that would negatively affect the chances of the IMF programmes working, currencies might have dropped to a greater extent, and the region would have faced a credit shortage even larger than had been experienced up to that point. Collective and coordinated action was needed. This initiative, decided in Vienna at the time, seems to have had beneficial effects. Given that a big proportion of debt coming due within one year was bank debt, ensuring some rollover of parent/subsidiary loans was of course very important, in addition, because short-term external debt goes into the IMF's calculation of funding needs.
Is the same (Vienna II) achievable for Greece? In principle, this could help to reduce the amount of liquidity that the government needs. With the ECB perhaps open to the idea, there is a chance that such an initiative could materialise soon - perhaps before this autumn, but not necessarily in conjunction with a final agreement on Greece's extra help, given that some European policy-makers seem focused on seeing Greece implement the new measures before making other decisions.
So, in theory, we believe that encouraging banks to commit to continuing lending part of the amount of maturing Greek debt they hold can help in the near term. However, it is somewhat more complicated in practice. For example, the simplest way is to invite the banks to buy T-Bills and roll over their positions, but this is typically vulnerable to a change in sentiment by the banks at any time, so it might not be entirely satisfactory.
In addition, some of the incentives and disincentives that are being explored seem to have some drawback for existing bonds, we think. In particular, some of the ideas to encourage banks and other investors to buy ‘new' Greek bonds could be viewed as quite negative. Here are the ideas reported by news agencies (e.g., Bloomberg):
• Offering a higher coupon: With the market interest rate already very high, this might have further negative implications for Greece's solvency. Indeed, the purpose of the IMF/EU package is to protect Greece from expensive market funding through a subsidised interest rate loan.
• Making the new bonds senior to existing bonds: For holders of existing bonds, this implies subordination and hence would constitute a credit event, without improving the government's solvency situation. Naturally, there might be some benefit if the coupon on the new bonds were very low.
• Securing the new bonds by collateral: This might be an effective incentive, in our view. Yet, this could also mean that the government would not have access to a pool of assets that could otherwise be used to repay existing debt.
• Excluding eligibility to ECB operations of existing bonds: While in principle this might be seen as a strong disincentive, we think that the practical application of this option is probably limited, given the negative implications for the banking system.
The Next Steps
To the extent that a cross-party agreement on the new measures is reached in Greece (it might already have been, given that it is a pre-condition of the disbursement of further tranches of the loan) and that the IMF/EU are willing to disburse the next loan tranche, then the next step - which has to happen in synch with the above-mentioned political negotiations and policy steps - is either upscaling EU bilateral and IMF loans or mobilising EFSF funding by up to €65 billion. Together with a reported €20 billion from private investor involvement, this brings that total package to €85 billion or so.
Fundamentally, it does not matter whether the additional loans are obtained by upscaling the bilateral loans from other EMU countries or by tapping the EFSF. In either case, Germany and Finland - the countries where the bailout fatigue is most apparent among legislators - would need to approve the rescue package in their respective national parliaments.
What's more, tapping the EFSF could potentially put the spotlight back on the fact that the EFSF has not yet been increased in size. It also adds another organisational layer to the process, we think, which is avoided when the existing package is simply upscaled. However, an issue arguing in favour of the EFSF being tapped is that individual euro area countries would have to go out and raise the funds for Greece in the market - a process that might lead to more expensive funding costs than the EFSF.
Expect noise from the core once it becomes clear that more funding has been committed to Greece. Eventually, we would expect the new programme to be passed in the national parliaments across the euro area. However, we believe that there will likely be a heated debate in some countries in the run-up to the approval. In our view, the inclusion of private sector investors in funding Greece over the next few years will help to ensure parliamentary approval in the core countries. In the case of Germany, the approval process includes both houses of parliament. In the upper house, where Chancellor Merkel no longer has a majority, she will need to secure the support of the opposition.
In our view, this should not be too difficult. Past rescue packages and rescue mechanisms have found cross-party support in the German parliament. However, it could be damaging politically for Chancellor Merkel's coalition not to muster a majority of their own in the Bundestag. Hence, she may be somewhat concerned by press reports (e.g., Bloomberg) of a backbench revolt on the issue of the permanent rescue mechanism, the ESM, which is due to be finalised this month at the European level and is planned to be put before German parliament in September. This backbench revolt within the CDU/CSU/FDP coalition - which is still slipping in the polls - could potentially extend to the increase of the loans to Greece, an issue that is contentious for the German public.
The German government needs a political olive branch to convince MPs to support the second rescue package for Greece, especially since some lawmakers believe that these rescue packages are another indirect bailout of private investors, notably banks. In this context, the idea of banks to rolling over their own Greek sovereign exposure (as opposed to a maturity extension of Greek government bonds) could be welcome.
In conclusion, while we expect the Greek package to pass in the German parliament, we are prepared for a rocky ride. It might be after the summer recess, starting on July 8 and ending on September 5, before we have parliamentary approval on the loan extension. We believe it may require some concessions by the government on other issues, e.g., the banking surcharge where the upper house is pushing for a higher tax. We remind readers that last year, when faced with resistance from a parliamentary faction, the government rather abruptly announced a ban on naked short-selling. A remaining risk to all the rescue packages relates to the various cases that have been brought in front of the German Constitutional Court (see Sovereign Debt Crisis - A Roadmap for Investors, February 8, 2011). But, in our view, these fundamental constitutional decisions are unlikely to be affected by an upscaling of the Greek programme.
Finland has also been critical of the rescue packages offered to the euro area periphery. Thus far, a second Greek package has not figured much in the discussion in Finland, which has been dominated by a prolonged government formation. The main issues hampering government formation are policies relating to tackling the budget deficit rather than the bailouts or the ESM. The strong majority backing given to the Portuguese bailout in the parliament (137 for and 49 against) gives us confidence that a second Greek bailout would also be passed in parliament. However, there is a risk that the Finnish parliament could demand further conditions. The narrow margin of difference between the three largest parties has not only made coalition formation talks difficult - and caused Social Democratic Party and Left Alliance Party to walk out of the coalition talks recently - it may also make passing unpopular measures in the parliament that don't have cross-party support more difficult, especially in the absence of a new coalition government. Parties that are against bailing out other countries, i.e., True Finns and the Left Alliance, have 39 and 14 seats respectively out of a total of 200 seats.
Netherlands - The Dutch coalition government has been able to get parliamentary support to back Greek aid. Geert Wilders, leader of the far-right Party of Freedom, which is the second-largest party in the three-party coalition government, was inclined to give no further assistance to Greece. However, the vote in the parliament in May showed that the majority of Dutch politicians were in favour of supporting Greece. Later, the Dutch finance minister, Jan Kees de Jager, mentioned to the press that Greece would need to meet all the IMF conditions in order to obtain any further support from the Netherlands. The Dutch seem to think that the Greek government should step up its reform and privatisation efforts in our view.
Risks in Greece Further Down the Line
1. What if conditionality is not respected in the future?
The upgraded programme will be subject to quarterly assessments by the troika. To the extent that funding is in place for at least the next 12 months or so, some might see the next few quarterly reviews as less important. After all, there has been some leniency over the past year, even when Greece has delivered only partially on its fiscal targets and reform goals. We disagree with this view.
Given the slippage that occurred over the past few months - not only on the tax revenue side but also on the privatisation and reform fronts - the troika might take a tougher stance towards eventual future undershoots relative to the various commitment laid out in the adjustment programme, given the political and financial efforts to commit more financial resources. Hence, there is a risk of renewed pressures on Greece - if the targets are not being met further down the line - and markets might again worry about the pace and direction of Greece's fiscal consolidation and structural reform around the review dates (i.e., September 2011, December 2011, etc.).
2. The Issue of Technical Assistance
The troika has pledged to provide further technical assistance to Greece - if needed. This might also mean that foreign technical experts could be embedded into the Greek administration on a more permanent basis to help move the agenda along, especially on collecting taxes and combating fraud. There has been some progress in these areas. But the progress is perhaps too limited relative to expectations, especially at the lower levels of government. Hence, additional technical expertise drawn in from outside Greece could perhaps contribute to improve compliance with the various demands of the adjustment programme on the implementation side, in our view.
3. More Independence from Political Pressure
In addition to drawing in external expertise, another important step to lower the implementation risk would be to remove some areas of policy-making from political influence. One area where this has been discussed already is the management of the privatisation effort. But other areas such as deregulation, for instance, might also benefit from greater independence from political interference.
4. Privatisations in the Face of Uncertain Revenues
Greece plans to privatise assets for €50 billion over 2011-15, in line with the demands of the troika. We think that the relevance of such a request goes beyond the fiscal dimension, i.e., attempting to secure an additional revenue stream over time. The effort is to engineer a structural change in the overall economy and its markets to boost domestic competition and external competitiveness. It seems that one key request by the troika is that the pool of assets has to be managed by an independent entity.
It is not yet clear whether the troika representatives will be able to have a say over the new entity's decisions and to be able to block eventual manoeuvres in case of disagreement, though several press reports (e.g., Kathimerini) have suggested that the independent entity will be managed by Greek representatives. However, full clarity on whether the Greek government will have its own representatives is lacking at this time. What matter the most, perhaps, is that the goal to limit political interference has to be reached.
While different levels of external involvement might be acceptable at different times, conditional upon the broader economic/political context, the near-term risks of the privatisation plan have more to do with a possibly too optimistic projection of the future revenue stream. Admittedly, this is a highly uncertain, especially given the various changes on the regulation of many protected sectors, worries on Greece's cash situation, the ongoing debate in the market around feasible means to reduce the debt burden, and concerns about the contagion effect on other sovereigns and across the European banking system. Without additional information on the detailed financial situation of the several non-listed companies included in the privatisation plan, there is probably room to remain cautious. What's more, a good portion of the total €50 billion to be privatised over time (around €35 billion) has to do with a portfolio of real estate assets - with few details available so far. While we agree with the view of some policy-makers that additional assets can eventually be mobilised, we also think that the risk of delay in implementation is high, especially given administrative hurdles - such as an incomplete land registry (which makes it less certain that the Greek government is fully entitled to the land it claims to own).
5. What a Slower Core European Economy Means
The renewed deceleration in growth that we - unlike the consensus - expect in 2H this year and early next year could put Greece, and indeed many other peripheral countries, under pressure. The upside growth surprises in core European countries in 1Q may have marked the strongest pace of expansion in this cyclical phase. In particular, we expect economic growth to decelerate from 2% in 2011 to 1.2% in 2012 for the euro area as a whole (see A More Pronounced Slowdown Lies Ahead, June 1, 2011). Germany, but also France and several other core countries, should slow down - we estimate 1.6% next year from 3.2% in 2011. This deceleration, along with the additional belt-tightening measures that Greece has to implement to achieve its fiscal targets this year, is likely to keep the Greek economy in recession not only in 2011, but also next year. What's more, the materialisation of any possible downside risk relative to our cautious forecast might make it harder to achieve Greece's ambitious budget targets.
Press reports (e.g., Kathimerini) have argued that some relief might eventually come from EU structural funds, for about €20 billion. The money could be used to co-finance infrastructure projects, for instance, which might create job opportunities. However, it is not clear at this stage whether the above-mentioned amount is new cash, or just the remaining part of the €20 billion allocated to Greece - but not used - over 2007-13.
6. Politics - Constrained Options in the Near Term...
Greece's next national election is scheduled for October 2013. While signs of a certain ‘adjustment fatigue' seem to emerge both between the parliamentary majority and the opposition and within the ruling party PASOK, a near-term snap election doesn't seem to be a desired outcome - according to public declaration of major government officials. What's more, we think that - with the two main political parties having roughly the same support according to the polls - calling for a snap election would be too risky, especially because the proportion of undecided voters, according to the press, seems quite high.
What's more, a referendum - despite some market speculations on its likelihood - does not seem a probable scenario either. Indeed, no major policy-maker seems to have called for a referendum and - even if some were to favour this possibility - the constitution says that no referendum is possible on budget matters. Therefore, the question that would be asked in this hypothetical scenario would need to be quite generic. But would that be a real choice? We think not. Greece still has a primary budget deficit and is therefore dependent on external help. So, the choice is complying with the requests of the IMF/EU Commission or facing near-term cash problems, perhaps even to pay wages and pensions in the near term.
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