The Albatross for European Markets

Greece:  A Little Good News, But….

by Elliott Morss, Morss Global Finance

Introduction

Tsipras won the election, guaranteeing at least be some continuity in negotiations with other Eurozone countries going forward. But it will be far from “smooth sailing.” This article highlights the problems and argues that the only lasting solution for Greece is to leave the Eurozone.

A Quick Review

The first bailout program for Greece was in 2010 for €110 billion, with an IMF Stand-By providing €30 billion (27%) and Eurogroup countries providing €80 billion (73%). In 2012, it was cancelled after €73.7 billion had been disbursed.

It was replaced by a new IMF Extended Fund Facility (EFF) and additional Eurogroup support. The EFF was to provide quarterly payments of €6.2 billion into 2016 totaling €28 billion, provided Greece achieved numerous qualitative and quantitative performance targets. The Eurogroup promised €144 billion over the 2012 – 2014 period.

In 2011, Greece and its creditors agreed to what was effectively a 75% debt reduction. Additional support for Greece has been provided by the European Central Bank (ECB). The ECB has been buying Greek debt to keep rates from skyrocketing. And finally this summer, the Eurogroup agreed to a third bailout agreement in July worth up to €86 billion.

The above is what gets the headlines. And it sounds good: agreement on a new bailout program. But some very dark clouds remain:

• There are a set of conditions – what Greece has to do to get the bailout money.
• And the IMF is unhappy: it has refused to participate financially in this latest bailout until agreements to reduce the Greek debt burden for a second time are in place.

The Changing Policy Stances of the IMF

The IMF’s view on what should be done in Greece has changed several times. In 2010, it supported austerity and developed a huge number of structural reforms intended to make Greece competitive. But in 2011, it realized that its austerity program was causing Greek unemployment to skyrocket way above what it had estimated. To its credit, the IMF admitted “austerity was not working and gave up on it, much to the chagrin of Germany. So the first bailout program was ended early. The second program focused on “growth” and structural reforms to make Greece more competitive. As will be pointed out below, the Fund’s competitive requirements as unworkable. In addition, many of them will require either a reduction in government expenditures or an increase in taxes bringing us back to unemployment-generating austerity.

So what are the Eurogroup and the IMF really saying in emphasizing growth and competitiveness moving forward? They are saying Greece must get their costs down so it can compete with Germany. How to get there? Greece is going to be “remade” so it can compete with Germany. What? This is not going to happen, and as long as Greece uses the Euro as its currency, Greece will continue to run out of Euros and it imports more products than it exports. This is not a sustainable situation.

In the meantime, Greece’s outlook is worsening. FocusEconomics panelists have cut their 2015 forecasts by 1.1 percentage points as the situation deteriorates. The panel now expects the economy to contract 1.2% in 2015. And the unemployment estimate has increased as well – 26.3% up from 25.4% 90 days back.

The Required Structural Reforms

The 3rd bailout Memorandum of Understanding (MoU) that Greece just signed copies in full the required structural reforms from earlier bailout agreements. The called-for reforms can be summarized under the following headings:

• streamlining the VAT system and broadening the tax base to increase revenue;
• comprehensive pension reform;
• implementing safeguards for the legal independence of the national statistical institution (ELSTAT);
• making a “fiscal watchdog” (the Fiscal Council) operational;
• adopting a code of civil procedure to make the justice system more efficient;
• implementing the EU Bank Recovery and Resolution Directive (BRRD);
• adoption of more ambitious product market reforms;
• privatizing many state agencies;
• undertaking rigorous reviews and modernization of collective bargaining and labor market policies;
• adopting steps to strengthen the financial sector, including decisive action on non-performing loans and measures to strengthen governance of the Hellenic Financial Stability Fund (HFSF) and the banks.
• two austerity measures: a reduction of 100,000 in government employment and a government surplus of 3.5% of GDP in 2018.

But these are only the summary descriptions of what Greece must do. They give no sense of the details of what is being asked – the enormity of the task. And for this, I offer a few summary tables from the IMF’s Fifth Review of the EFF with Greece. Running 75 pages, these conditions have been carried over into the latest agreement.

Table 1 is a summary of “structural benchmarks”. As can be seen, there are many “loose ends” resulting in part from the on-again, off-again negotiations and in part from the political reluctance of the Greek government to implement these measures.

Table 1. – Structural Benchmarks, September – December 2013

Source: IMF

Table 2 provides details on what is required by profession. These measures, if approved, would fundamentally change how these professions operate. Two important points are clear:

• There are powerful groups in Greece that are benefiting from the current structures. They reap great benefit from current market imperfections and will fight hard to keep them from changing.
• The IMF and the Eurogroup are pressing to change in great detail how Greece functions.

Table 2. – Changes in Regulated Professions
Source: IMF (Click table to enlarge.)

In 2013, an OECD team of experts in co-operation with officials from Greek Public Administration completed a report on competition in certain Greek sectors. Some of its recommendations were included in the conditions set by the EU/IMF for Greece (Table 3). And as with reforms for professions in Table 2, these will be fought strenuously by vested interests.

Yanis Varoufakis, the ousted Finance Minister, said the former Prime Minister, Antonis Samaras, weathered an earlier round of “conditions” by “feigning allegiance to the troika while stonewalling and petitioning the troika for laxity, lest the SYRIZA party win the government. That option is no longer available.

Table 3. – OECD Study Results Incorporated in EU/IMF Conditions

Source: IMF

IMF Insistence on Debt Reduction

The IMF recently completed a “Debt Sustainability Analysis” for Greece. It noted: “By late summer 2014, with interest rates having declined further, it appeared that no further debt relief would have been needed if the program were to have been implemented as agreed. So what happened?

• lower growth than projected;
• larger government deficits than projected;
• lower privatization proceeds;
• delays in implementing agreed-on conditions, with
• the consequence of much higher debt.

As a result, The IMF has concluded that no Greek recovery is sustainable unless the Greek debt burden is cut significantly. From Managing Director Christine Lagarde:

“…I remain firmly of the view that Greece’s debt has become unsustainable and that Greece cannot restore debt sustainability solely through actions on its own. Thus, it is equally critical for medium and long-term debt sustainability that Greece’s European partners make concrete commitments …to provide significant debt relief, well beyond what has been considered so far.”

An IMF spokesman added this: “The dramatic deterioration in debt sustainability points to the need for debt relief on a scale that would need to go well beyond what has been under consideration to date-and what has been proposed by the European Stability Mechanism (ESM). There are several options. If Europe prefers to again provide debt relief through maturity extension, there would have to be a very dramatic extension with grace periods of, say, 30 years on the entire stock of European debt, including new assistance. Other options include explicit annual transfers to the Greek budget or deep upfront haircuts. The choice between the various options is for Greece and its European partners to decide.”

And to put weight behind its position, the IMF has made it clear it will not provide more financial assistance to Greece until meaningful debt reduction has been incorporated into the agreement. And IMF assistance has been significant, averaging about 30% in earlier bailouts.

The EU countries response appears in its latest MoU with Greece:

“Against this background, in the context of a possible future ESM programme, and in line with the spirit of the Eurogroup statement of November 2012, the Eurogroup stands ready to consider, if necessary, possible additional measures (possible longer grace and payment periods) aiming at ensuring that gross financing needs remain at a sustainable level. These measures will be conditional upon full implementation of the measures to be agreed in a possible new programme and will be considered after the first positive completion of a review. The Euro Summit stresses that nominal haircuts on the debt cannot be undertaken.”

This matter remains unresolved.

Conclusions

Certainly, news that the EU government has reached an agreement with Greece on the 3rd bailout sounds good. But as described above, serious barriers for success remain. While the Greek government has signed on, the special interest groups in Greece have not. And in all probability, the implementation negotiations will follow the same path of earlier ones: they will stall and lead nowhere. In the meantime, the Greek economy will worsen, particularly as the austerity measures in the agreement start to bite.

Greece will never be made as productive as Germany and other Eurozone countries. The only lasting solution is for Greece to leave the Eurozone and return to its own currency. That way, currency rates will adjust for competitive differences, just as the dollar weakened relative to the yen (¥360/$ in 1971, ¥120/$ in 2015).

Investment Implications

One might think that with the new agreement signed, the Eurozone is improving and that is the time to invest there via ETF vehicles such as iShares MSCI Eurozone (EZU). It should be clear from the above that this would make no sense: turmoil will continue in the Eurozone for the indefinite future. Far better to invest in the US where the recovery from the global recession continues and the only uncertainty the pundits discuss is when will the Fed raise interest rates.