EU Reaches A Deal On Greece

EU Reaches A Deal On Greece

The agreement on a Greek support mechanism reached last night at the EU summit appears to give something to everyone:

The Germans get co-funding with the IMF;

The French get a commitment to “a strong coordination of economic policies in Europe”;

And the Greeks get a sufficiently detailed mechanism to hopefully bring spreads down ahead of the refinancing of the next couple of months.

It is important to stress that what has been agreed is a support mechanism, not a package of loans to be made to Greece now. Whether or not this mechanism is ever activated remains to be seen. It will depend on how Greece fares in the capital markets in the coming months. It is certainly possible that no money ever changes hands.

The details of the EU statement suggest that the Germans have largely stuck to their position, in four respects:

First, the support mechanism has to be considered “ultima ratio”, which means that market financing is insufficient. Any decision on disbursement of financing will be decided by unanimity, which means each country has a veto, and subject to strong conditionality. The European Commission and ECB will play a role in advising on whether disbursement is appropriate.

Second, the mechanism would not provide financing at a concessional interest rate. The borrowing cost would be set at a level to incentivise Greece to return to capital markets as soon as possible.

Third, any support would involve a “substantial” IMF contribution, albeit with the majority of money coming in the form of coordinated bilateral loans from the rest of the Euro area (determined by relative size as measured by capital positions at the ECB). Apparently, French President Sarkozy said that the proportions would be one-third IMF and two-thirds Euro area.

Fourth, there will be a task force to consider how to strengthen and complement the existing framework to ensure fiscal sustainability in the Euro area. This task force is required to report back to the EU council with some proposals before the end of the year.

The EU statement makes it clear that the mechanism agreed yesterday is not being activated now. Whether it is or not depends on how Greece fares in the capital markets in the coming months.

The other Euro area countries suffering some sovereign stress at the moment are unlikely to view the Greek mechanism as any kind of attractive panacea. If this support mechanism is activated, the conditionality will be no less than what the Greeks have already signed up to. It is worth highlighting that the Greeks are committing to a fiscal tightening this year that is six times larger than what is in the Portuguese stability programme and three times larger than what is in the Spanish stability program. If the Spanish and Portuguese can get through with their current programs, they would be well advised to do so.

The Greek fiscal crisis may be over for now, but sovereign stress is likely to remain a huge issue in the Euro area for years to come. In order to achieve debt sustainability, the Greeks need to run a primary surplus on a sustained basis. This is a big task, but not an impossible one. Last year’s primary deficit was 7.7% of GDP, and the average primary position since 1970 has been a deficit of 1.1% of GDP. But, the Greeks did manage to achieve a sustained primary surplus from 1994 to 2002, averaging 2.7% of GDP. However, this position was helped by strong economic growth: Greek GDP growth averaged over 3% during that period. Growth will not be as strong in the coming few years. Nevertheless, what is required here is a very big stretch, but not an impossible task.

If the Greeks fail to achieve debt sustainability through generating a primary surplus, then there are only three options left: either the rest of the region would have to give a permanent fiscal transfer to Greece, or Greece would have to default and restructure its debt, or Greece would have to leave the Euro area (but this could still involve a default and debt restructuring). The first option would create huge political stress in the region, while the latter two options would create massive financial and economic stress, not only in Greece but in the region as a whole. Thus, there is still a huge amount resting on whether the Greeks achieve fiscal sustainability or not.

ENDS

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