With the second bailout agreement for Greece announced on Friday (July 22), the EU has stumbled toward a new level of institutional development. However, Greece still does not have a sustainable funding package in place; and the easing of contagion pressures on other Euro-zone members may be short-lived.
Let's start with Greek Bailout #2, valued at €109 billion. The full details will be hammered out between now and mid-September, but it appears that about two-thirds of the total will come from the European Financial Stability Fund (EFSF) and the remainder from the IMF. The whole amount will be in addition to last year's €110 billion package. The deal includes cash for budget needs and for recapitalization of the Greek banks, an as-yet-undefined sovereign debt buyback scheme, and "collateral enhancements" from other Euro-zone governments. The latter reportedly will total €35 billion and will try to encourage investors to swap into new 30-year Greek bonds by backing them with AAA-rated securities. The EFSF loans to Greece will be extended to 15 years from the current 7.5 and the interest rate will be lowered to around 3.5% from the current 4.5-5.8%. Finally, there is an expectation that Athens will raise something like €50 billion from privatization during the time of the two funding programs.
The other side of the Greek bailout deal is the involvement of the private sector creditors, who will be offered four options - three separate bond exchange offers plus the aforementioned rollover into 30-year debt - as well as the bond buyback scheme. The Institute of International Finance, which helped negotiate the creditor details, says it anticipates 90% participation in the plan, which will result in private creditors taking a loss of about 21% in the net present value of their Greek sovereign debt holdings.
French President Sarkozy declared on Friday that the plan in its entirety will reduce Greece's sovereign debt burden from 150% of GDP to about 126%. The deal certainly goes much farther than most of us external observers had expected, but is highly unlikely to be the final answer in putting Greek public finances back on a sustainable path. Reducing the debt to 126% of GDP will require that everything go exactly according to plan, from the level of private-sector participation in the restructuring to the amount that the government can raise from privatization to the willingness of the Greek electorate to keep swallowing ever-nastier austerity measures.
The Greek economy has dropped into recession, with real GDP contracting 7.4% on the year in Q4 2010 and another 4.8% in Q1 2011. With leading indicators pointing to a renewed slowdown in the rest of the Euro-zone, and severe spending cuts underway, there is a risk that the Greek economy will not return to growth by 2012. The weaker the economy, the harder it will be to get the headline deficit and debt ratios under control.
And even if Bailout #2 does go according to plan, a public debt burden of 126% of GDP will not be sustainable for Greece. Although the economy enjoyed real GDP growth that averaged an annual rate of over 4.0% between 2001 and 2007, the expansion was fuelled by hefty increases in public and private borrowing. The underlying economy remains chronically uncompetitive - as evidenced by the current account deficit, which averaged over 8% of GDP in the same period, and jumped to near 15% in 2008. Add in the negative near-term impact of hefty spending cuts and a massive restructuring program, and it becomes apparent that Greece needs to see a reduction in its public debt burden to somewhere below 100% of GDP in order to get back on its feet.
All of this suggests that we will be re-visiting the issue of Greek debt sustainability and the need for another "debt deal" within the year - possibly sooner, as the markets digest the details and do the math. Which takes us to the contagion issue. Recall that the whole point of Bailout #1 was to allow Greece to return to the markets in 2013; and that the subsequent lending programs put in place for Ireland and Portugal make similar assumptions. Recall, also, that market fears that these aims were unrealistic sent bond yields soaring in early July, including in much larger Euro-zone countries. Italian ten-year yields jumping past 6.0% concentrated the collective Euro-zone mind wonderfully and led to last week's summit agreement. The various zone players had to come up with a way to ensure that such contagion would not hit again. ECB Governor Trichet, by insisting that the ECB would not accept defaulted Greek government debt as collateral in funding operations for the beleaguered Greek banks, had drawn a line in the sand - the central bank wanted to get out of the business of helping fiscally insolvent members and back to the business of being a central bank.
The solution hammered out last week uses the EFSF - and its permanent successor from mid-2013, the European Stability Mechanism (ESM) - to try to head off contagion pressures for other sovereigns. Although the size of the EFSF has not been increased (yet?), its remit has been expanded in three very significant ways, allowing it to:
- intervene earlier with precautionary loans (i.e., before states are locked out of the markets) where countries have "good economic policies" but face contagion pressures;
- recapitalize banks via loans to governments even if there is no formal EU/IMF support program in place;
- buy sovereign debt directly on the secondary bond market, if the ECB gives the go-ahead and declares "exceptional circumstances".
The precautionary lending measure makes the EFSF/ESM sound like an IMF-lite for the Euro-zone. The latter two steps take the pressure off the ECB for averting contagion and supporting struggling national banking sectors. They are essentially a back-door way for stronger 'zone states to make funding transfers to weaker members without having to admit such to the taxpayers or to rewrite EU rules.
Assuming all is approved as outlined, then the likelihood of Ireland and Portugal each needing a second bailout package is probably reduced, with Ireland in particular looking considerably less vulnerable than it did a week ago. Recall, Dublin's big problem is the burden of its banking sector's woes. If it can get additional EFSF help in the bank recap process if needed, then its vulnerabilities are much reduced. An extension in the terms of its €67.5 billion in EFSF borrowings and a reduction in the interest rates will further help ease the burden. It is not inconceivable that Ireland may return to the markets in some limited fashion next year - if all goes according to plan.
Portugal's issues are more structural and medium-term, more to do with an underlying lack of economic competitiveness. An expanded EFSF could be of some assistance, but the biggest help to Portugal may be the cheaper and longer-term loans. The need for a second Portuguese bailout package has not been eliminated but may be reduced.
But the key phrase here is "if all goes according to plan." There are three major areas of risk to monitor going forward, any one of which could raise serious questions about the feasibility of Bailout #2 and potentially also the ability of the beefed-up EFSF/ESM to function as planned.
First, the devil will be in the details. The EU has a history of coming up with sweeping proposals that get stymied because one member state balks at something, requiring a tortuous period of re-negotiation and compromise resulting in a final deal that is in some way weaker than the initial proposal. Watch for domestic political pressures in one of the 17 Euro-zone members to throw a wrench into the works.
Second, a great deal is riding on the ability of Greek politicians (and to a lesser extent, on the politicians in Ireland, Portugal, Spain and Italy) to keep up the reform process. If reform implementation falters, questions about the sustainability of Bailout #2 will quickly surface.
Finally, there's the outlook for the Euro-zone economy as a whole. The Belgian business confidence index - a leading indicator for Euro-zone growth about six months out - dropped for the fourth consecutive month in July, to a nine-month low. Germany's Ifo business sentiment survey also fell to a nine-month low this month, indicating a slowdown is coming for the Euro-zone's star economy. Weaker economic growth will make it harder for everyone to get their respective fiscal houses in order.