European leaders on Friday received some interesting weekend reading.
FT Alphaville has also taken a look at “Greece: Debt Sustainability Analysis”, an assessment prepared by European Commission economists for discussion on Friday among European finance ministers. We’ve put it in the usual place (and extensively quoted excerpts below).
The headline: it suggests private bondholders will be pushed to take 50 or 60 per cent haircuts.
From the report’s summary:
Greece: Debt Sustainability Analysis October 21, 2011
Since the fourth review, the situation in Greece has taken a turn for the worse, with the economy increasingly adjusting through recession and related wage-price channels, rather than through structural reform driven increases in productivity. The authorities have also struggled to meet their policy commitments against these headwinds. For the purpose of the debt sustainability assessment, a revised baseline has been specified, which takes into account the implications of these developments for future growth and for likely policy outcomes. It has been extended through 2030 to fully capture long term growth dynamics, and possible financing implications.
The assessment shows that debt will remain high for the entire forecast horizon. While it would decline at a slow rate given heavy official support at low interest rates (through the EFSF as agreed at the July 21 Summit), this trajectory is not robust to a range of shocks. Making debt sustainable will require an ambitious combination of official support and private sector involvement (PSI). Even with much stronger PSI, large official sector support would be needed for an extended period. In this sense, ultimately sustainability depends on the strength of the official sector commitment to Greece.
Here are the starting assumptions made by the report’s authors:
A slower recovery. In keeping with experience to date under the program, it is assumed that Greece takes longer to implement structural reforms, and that a longer timeframe is necessary for them to yield macroeconomic dividends (e.g. due to complementarities). A longer and more severe recession is thus assumed, with output contracting by 5½ percent in 2011, and by 3 percent in 2012. Growth then averages about 1¼ percent per year in 2013-14, 2⅔ percent in 2015-20 (as a cyclical rebound kicks in, and structural reforms start to pay off); and 1⅔ percent per year in 2021-30 (as the economy reverts to potential growth, which is constrained by demographic trends). All told, real output growth is projected to be cumulatively 7¼ percent lower through 2020, versus the projections made at the time of the 4th Review.
Lower privatization proceeds. Given the adverse market conditions and technical constraints faced by Greece, a more conservative but still suitably ambitious path is assumed for privatization proceeds for the purpose of the debt sustainability analysis. Receipts rise from 1½ percent of GDP in 2012 to 2 percent of GDP for the period 2013-14, and peak at 2½ percent of GDP during 2015-17. They fall back at 2 percent of GDP per year for 2018-20. Through 2020, total privatization proceeds would amount to €46 billion, instead of the €66 billion assumed in the program (i.e. the original target of €50 billion plus an additional amount reflecting the fact that bank recapitalization will likely create additional assets to be disposed of).
Reduced fiscal adjustment needs. The nominal fiscal targets are maintained through the program (mid-2013) and after that, the primary surplus is assumed to improve further until it reaches 4½ percent of GDP for the period 2014-16. The primary surplus steps down to 4¼ percent of GDP in 2017-20 and to 4 percent of GDP in 2021-25 (a level which in the past Greece has been able to sustain). Since few countries have been able to sustain a 4 percent primary surplus, it is assumed that from 2026 onwards, the primary surplus is maintained at 3½ percent of GDP. Under this path, which requires sustained and unwavering commitment to fiscal prudence by the Greek authorities, the overall fiscal balance would not drop below 3 percent of GDP until 2020.
Delayed access to market financing. The PSI agreed at the July 21 Summit is assumed to be put into place. The issue of when market financing will be restored is inherently uncertain. For the purposes of this analysis, new market financing is assumed to become available only once Greece has achieved 3 years of growth, three years of primary surpluses above the debt stabilizing level, and once debt drops below 150 percent of GDP. This is admittedly an arbitrary rule, and is used for illustrative purposes to give an indication of the scale of official support that could be needed to fill any financing gap until market access is restored in 2021.
All of the above leads them to conclude, of course, that the status quo is unsustainable:
Under these assumptions, Greece’s debt peaks at very high levels and would decline at a very slow rate pointing to the need for further debt relief to ensure sustainability. Debt (net of collateral required for PSI) would peak at 186 percent of GDP in 2013 and decline only to 152 percent of GDP by end-2020 and to 130 percent of GDP by end-2030. The financing package agreed on July 21(especially lower rates on EFSF loans) does help the debt trajectory, but its impact is more than offset by the revised macro and policy framework. Greece would not return to the market until 2021 under the market access assumptions used, and cumulatively official additional financing needs (beyond what remains in the present program, and including the eventual rollover of existing official loans) could amount to some €252 billion from the present through to 2020.
The report then goes on to assess several “shocks” that could further blow the trajectory off-course. Given all these, it concludes:
Making Greek debt sustainable requires an appropriate combination of new official support on generous terms and additional debt relief from private creditors: · Large, long-term, and sufficiently generous official support will be necessary for Greece to remain current on its debt service payments and to facilitate a declining debt trajectory. The commitments given at the July 21 Summit—that euro area partners would continue to support countries under adjustment programs, like Greece, for as long as it takes to regain market access (provided the program is implemented) —represent an important breakthrough, and the credibility of this commitment is critical to a sustainable Greek debt position. The revised baseline does indeed rely on additional official support beyond the amounts tabled during the July 21 Summit, to give the Greek government time to adjust until market access is successfully restored. As noted, the precise timing of market re-access is inherently uncertain. Under the assumptions used, the time required to get back to market could be significant, generating a potential need for additional official financing ranging up to €440 billion (i.e. under the worst case of the scenarios studied here, the faster macro adjustment shock).
And this, which is perhaps the killer paragraph. It assess how far 50 and 60 per cent haircuts on PSI would take you (our emphasis):
Deeper PSI, which is now being contemplated, also has a vital role in establishing the sustainability of Greece’s debt1. To assess the potential magnitude of improvements in the debt trajectory, and potential implications for official financing, illustrative scenarios can be considered using discount bonds with an assumed yield of 6 percent and no collateral. The results show that debt can be brought to just above120 percent of GDP by end-2020 if 50 percent discounts are applied. Given still-delayed market access, large scale additional official financing requirements would remain, estimated at some €114 billion (under the market access assumptions used). To get the debt down further would require a larger private sector contribution (for instance, to reduce debt below 110 percent of GDP by 2020 would require a face value reduction of at least 60 percent and/or more concessional official sector financing terms). Additional official financing requirements could be reduced to an estimated €109 billion in this instance. Of course, it must be noted that the estimated costs to the official sector exclude any contagion-related costs.
All in all, the report is a depressingly realistic analysis of Greece’s predicament; anyone who thinks it can grow its way out of its current problems is talking out of their high-hat. The report suggests that even with a 50 per cent haircut by private bondholders, Greece will require further and sustained support by public international lenders.
Depressing, sure — but also necessary and achievable, though it’ll still take more than what’s in this document.
For what the report doesn’t seem to cover is — unsurpisingly — the role of official creditors. As UBS economists noted earlier this week, even 50 or 60 per cent haircuts won’t be enough. A 110-120 per cent debt to GDP by 2020 (as suggested in the scenario) remains highly dangerous.
Indeed, there appears to be concern, to put it lightly, at the ECB about the scenarios used in the report. Scenarios that get a little close to home, perhaps. Here’s an interesting footnote to the last quoted paragraph:
The ECB does not agree with the inclusion of these illustrative scenarios concerning a deeper PSI in this report.
Because, as FT Alphaville’s Joseph Cotterill adds in an email to us, “either the official creditors take haircuts too (ha!) OR they’ll be discussing 90-100 per cent private haircuts soon enough.”