IIF RESEARCH NOTE

Greece: Debt Sustainability Improved

August 3, 2011

Jeffrey Anderson
DIRECTOR European Department

Government debt is now projected to be 98 percent of GDP in 2020, net of financial assets linked to the bond exchange Lower interest rates and much longer maturity on both official and private financing should contribute to improving Greeces debt sustainability and fiscal outlook Fiscal adjustment and structural reforms will be key to achieving lower debt-to-GDP ratios over time

1-202-857-3636 janderson@iif.com

Georgios Moschovis
SENIOR ECONOMIST European Department 1-202-857-3317 gmoschovis@iif.com

EXECUTIVE SUMMARY The various components of the agreement reached on July 21 by the Euro Area governments and private sector investors should help strengthen Greeces government debt dynamics. Both the sustainability of government debt and the fiscal outlook will improve, assuming the government implements its comprehensive adjustment and reform program in full and on time. Government debt will decline to 122 percent of GDP by 2015 and 98 percent of GDP by the end of 2020 from 142 percent at the end of 2010, net of financial assets, such as the cash buffers, bank recapitalization funds and collateral and escrow account linked to the bond exchanges. These estimates take into account the underlying assumptions of the July 21 agreement and compare with a reduction to 124 percent by 2020, as calculated on the same basis, under the projections published by the IMF in early July, prior to the agreement. Much of the larger reduction now in prospect reflects decreased interest payments by 2.6 percentage points of GDP on average after mid-decade; with primary surpluses at 66.5 percent of GDP, as assumed by the EU/IMF program, lower interest payments will result in overall surpluses after 2015. In addition, the average maturity of bonds held by private investors is set to increase to 11 years from 6 years. To this end, new market borrowing at higher interest rates now is likely to be about 50 billion through 2020. The governments structural reforms agenda and its full implementation hold the potential to resolve long-standing structural weaknesses that have hampered the efficiency, competitiveness and productive capacity of the Greek economy. Were real GDP to grow 1 percent a year faster as a result of the improved debt sustainability and fiscal outlook, success in advancing structural reforms and expanded support from the EU for infrastructure development, government debt net of financial assets linked to the agreement could decline to 90 percent by 2020.
Success in advancing planned structural reforms remains the key challenge for the government Government debt will decline to 98 percent of GDP by the end of 2020, net of financial assets

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Greece: Debt Sustainability Improved

Chart 1 Debt Maturity Profile Pre-July 21 billion 50 45 40 35 30 25 20 15 10 5 0 2011 2015 2020 2025 2030

Chart 2 Debt Maturity Profile Post-July 21 billion 50 45 40 35 30 25 20 15 10 5 0 2011 2015 2020

2025

2030

LONGER MATURITIES COMBINED WITH LOWER BORROWING COSTS The combined effects of the various components of the agreement reached on July 21 by the Euro Area heads of states and governments and private sector investors hold the potential to strengthen significantly Greeces debt dynamics. As a result, the agreement should bolster both the sustainability of government debt and the medium-term fiscal outlook. The timely implementation of the comprehensive adjustment and reform program by the government as planned remains key for success.1 The improved sustainability of the government debt and fiscal outlook reflect in large part sizable reductions in future interest costs on debt owed to official and private creditors from what was considered likely prior to July 21. Eurozone government creditors will provide roughly twice the 80 billion envisioned earlier, with maturities increased from 4.5-10 years to 10-30 years, for the entire official financing package. Funding costs, in addition, will be reduced to fixed interest rates averaging 3.5-4 percent, set without penalty margins, from floating interest rates set with penalty margins that had been projected to increase to more than 5.5 percent by mid-decade. Together with expanded official financing at reduced interest costs for longer maturities, the bond exchanges provided for in the July 21 agreements (and lower deficits thanks to lower interest costs) will displace all but about 50 billion of the roughly 460 billion in new market borrowing that IMF projections done in early July appear to have assumed. Interest rates on the 135 billion of old debt (according to the private sector target participation rate of 90 percent, of the estimated 150 billion of Greek government bonds held by private sector investors), assumed to be exchanged
Bond exchanges will displace all but 50 billion of the roughly 460 billion in new market borrowing assumed prior to the agreement

The government is assumed to enact fully the fiscal measures called for under the program, achieving the targeted primary surpluses of 6-6.5 percent of GDP, to complete privatization projects as scheduled, thereby realizing the full 50 billion in receipts targeted by 2015, and to implement in full the structural reforms needed to assure that growth accelerates to more than 2.5 percent a year during the latter half of the current decade.

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IIF RESEARCH NOTE

Greece: Debt Sustainability Improved

through 2020, will average 5.4 percent during the latter half of the decade rather than the roughly 8 percent assumed in the IMFs recent report. In addition to this assured financing, the exchange of existing bonds for new ones will increase the average maturity of bonds held by private sector investors to 11 years from 6 years (Charts 1 and 2). Lower average interest rates on a smaller amount of debt should reduce interest payments by an average of 2.6 percentage points a year for the period from 2015 to 2020 compared to the IMFs early July projections. The net result, assuming primary surpluses in line with the EU/IMF program, would be overall fiscal surpluses beginning in 2016. These reductions in projected interest outlays to official and private lenders should be accompanied by reductions in private creditors claims. The discount bonds would result in debt reduction equivalent to 13.5 billion, under the assumption of the July 21 agreement that they are selected by half of the 90 percent of private sector bondholders expected to participate in the bond exchanges. In addition, the financing proposal includes provisions for a debt buyback facility funded with 20 billion of low interest loans borrowed from official lenders. Were these used to buy back debt with an average secondary market price of 60 cents, government debt would be reduced by an additional 13.3 billion. The current average market price of government long-term bonds is around 50 cents. Taken together with the effect of the discount bond exchange, private sector claims would be reduced by roughly 12 percent of Greek GDP. Borrowing to finance the collateral and escrow accounts needed to enhance the bond exchanges would add as much as 41 billion to gross debt, equivalent to 18 percent of GDP. The interest cost of this borrowing would be fully offset, however, by interest earnings (on the ESA95 accruals basis used for deficit reporting in the EU).2 Increased as a result of borrowing to purchase the collateral, however, the level of gross debt will be less reflective of the Greek government's debt burden than the level of debt netted of the financial assets, which will be reduced considerably by the discount bond exchanges. The debt burden will be further eased by the lower interest rates that collateral will enable the par bond exchange to assure.3
Increased as a result of borrowing to purchase the collateral, gross debt will be less reflective of the actual debt burden Lower interest payments, with primary surpluses in line with the EU/IMF program, will result in a fiscal surplus in 2016

The cash deficit would be larger than the accruals deficit, because cash interest outlays for debt borrowed to buy the collateral would not be offset by interest that accrues but is not paid in cash on the zero-coupon AAA-rated bonds used for collateral. Measuring the collateral on an accrued basis, however, adding interest accruing each year of the amortized cost value of the collateral, net debt as defined above would decrease to less than 95 percent of GDP by 2020.

3 Gross debt will also be increased by borrowing from official creditors to build cash buffers and to set aside contingency funding for bank recapitalization, should it be needed. Because these assets will increase financial flexibility by enabling the government to meet its own liquidity needs and to fund bank support costs, borrowing to fund them will add far less to the governments debt burden than borrowing to finance budget deficits.

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Greece: Debt Sustainability Improved

Chart 3 Net General Government Debt percent GDP 180 170 160 150 140 130 120 110 100 90 80 2010 2012 2014

IMF Staff Report July 2011 123.6 IIF Baseline Scenario IIF Faster Growth Scenario 2016 2018 98.2 89.9 2020

Chart 4 Gross General Government Debt percent GDP 180 170 IMF Staff 160 Report 150 July 2011 140 130 IIF Baseline 120 Scenario 110 100 90 80 2010 2012 2014 2016 2018

130.0

120.8

2020

The combination of lower interest outlays and the reduction of debt due to the discount bond exchanges and the discounted debt buybacks should help improve Greek government debt dynamics significantly over the years to come. Measured net of financial assets, in particular cash buffers, bank recapitalization funds and collateral and escrow linked to the credit enhancements, general government debt should decline from 142 percent of GDP at the end of 2010 to 122 percent by the end of 2015 and 98 percent by the end of 2020 (Table 1 and Chart 3). These estimates compare with reductions to 139 percent by 2015 and 124 percent by 2020, measured on the same net basis, in the most recent projections published by the IMF in early July. Government debt should be reduced by 20 percentage points of GDP from 2011 through 2015 and by 44 percentage points from 2011 through 2020. This compares with reductions of 3 and 19 percentage points of GDP over the same time periods on the same basis under the IMFs latest projections. Measured in gross terms, Greek government debt should decrease now at a much faster pace than the IMF had projected in early July. Gross debt-to-GDP ratio should now decrease by an average of 5.4 percentage points of GDP a year through 2020, compared with 4 percentage points of GDP a year under the IMF projections (Chart 4).
Gross debt-to-GDP ratio should also decrease faster than estimated prior to the agreement

IMPROVED GROWTH OUTLOOK CONTRIBUTES TO FASTER ADJUSTMENT The deep structural reforms the government has agreed under its EU/IMF program hold the potential to resolve long-standing structural weaknesses that have hampered the efficiency, competitiveness and productive capacity of the Greek economy. Thoroughgoing reform initiatives began last year, including a far-reaching pension reform and the liberalization of labor markets, road transport and regulated professions. Together with a wide-ranging privatization program and measures to scale back regulation and improve the business
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IIF RESEARCH NOTE

Greece: Debt Sustainability Improved

environment, expanded support from the EU for infrastructure development (as was discussed at the July 21 summit as a potential European Marshall Plan for Greece) could bolster the economys growth potential. Progress advancing structural reforms and improving the investment climate could yield substantial dividends, coupled with the brighter debt sustainability and fiscal outlook afforded by the July 21 decision. Were these factors and improved confidence to enable real GDP to grow 1 percent a year faster than the EU/IMF program has assumed through 2020, net government debt would decline to 111 percent of GDP by 2015 and to 90 percent by 2020.4 These outcomes would be, respectively, 4 and 10 percentage points of GDP lower than under the baseline scenario. However, a number of factors can adversely affect the implementation of the governments adjustment program, ranging from external shocks to less benign macroeconomic outlook, which would result in delays in restoring consumer and investor confidence and prolonged difficulties in accessing the capital markets. Should a less favorable macroeconomic outlook prevail over the decade, with real GDP growing by 1 percent a year slower than the baseline assumptions, net government debt as defined in this note would decline to 126 percent of GDP by 2015 and to 107 percent of GDP by 2020.
Government debt would decline by 10 percentage points of GDP more by 2020, should the European Marshall Plan improve Greeces economic outlook

4 This assumes that the primary surplus is kept at 6-6.5 percent of GDP and that government spending is adjusted upwards in line with stronger revenue gains due to stronger real GDP growth.

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Greece: Debt Sustainability Improved

Table 1 General Government Debt 2010-2020 billion

0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 -0.1 -0.1

Gross Debt (% GDP) Net Debt1 (% GDP) Deficit (% GDP) Deficit/Debt Adjustments (% GDP) Of which: Privatizations HFSF Settlement of Arrears Health Sector Arrears Cash and Deposits Debt Buyback Facility Discounted Bonds Exchange Collateral Escrow Other

2010 328.6 328.6 (142.9) 327.1 (142.2) 24.2 (10.5) 5.9 (2.6)

2011 381.0 381.0 (169.5) 319.3 (142.1) 17.3 (7.7) 35.1 (15.6)

2012 397.5 397.5 (174.6) 325.5 (143.0) 13.0 (5.7) 3.5 (1.5)

2013 408.9 408.9 (174.2) 329.8 (140.5) 8.4 (3.6) 3.0 (1.3)

2014 389.4 389.4 (160.6) 319.8 (131.9) 1.6 (0.7) -21.2 (-8.7)

2015 380.7 380.7 (151.6) 306.4 (122.0) 0.4 (0.1) -9.1 (-3.6)

2016 371.5 371.5 (142.2) 307.3 (117.7) -0.4 (-0.2) -8.8 (-3.4)

2017 371.6 371.6 (136.4) 307.9 (113.0) -1.0 (-0.4) 1.1 (0.4)

2018 373.9 373.9 (131.4) 308.1 (108.3) -1.2 (-0.4) 3.5 (1.2)

2019 376.1 376.2 (126.3) 307.6 (103.3) -2.0 (-0.7) 4.4 (1.5)

2020 377.0 377.1 (120.8) 306.6 (98.2) -2.6 (-0.8) 3.5 (1.1)

0.0 1.5 0.0 1.2 0.0 0.0 0.0 0.0 3.2

-5.0 22.3 1.4 4.2 6.5 -13.3 -13.5 31.4 1.1

-10.0 6.2 2.0 0.0 2.5 0.0 0.0 1.6 1.2

-7.0 0.0 1.8 0.0 6.0 0.0 0.0 1.1 1.1

-13.0 -10.0 0.0 0.0 -1.1 0.0 0.0 1.6 1.3

-15.0 -10.0 0.0 0.0 13.6 0.0 0.0 1.0 1.3

0.0 0.0 0.0 0.0 -10.9 0.0 0.0 0.8 1.3

0.0 0.0 0.0 0.0 -1.5 0.0 0.0 1.1 1.5

0.0 0.0 0.0 0.0 1.6 0.0 0.0 0.5 1.5

0.0 0.0 0.0 0.0 1.7 0.0 0.0 1.2 1.5

0.0 0.0 0.0 0.0 1.6 0.0 0.0 0.3 1.6

Interest Payments (% GDP) Net Interest Savings vs July IMF Projections (% GDP) Primary Deficit (% GDP) Memoranda: Real GDP Growth Rate (%) GDP Deflator Nominal GDP Growth Rate (%) Implicit Interest Rate on Debt (%) Nominal GDP

12.3 (5.3)

15.7 (7.0)

16.5 (7.2)

17.4 (7.4)

17.5 (7.2)

17.3 (6.9)

17.0 (6.5)

17.2 (6.3)

17.6 (6.2)

17.8 (6.0)

17.9 (5.7)

0.0 (0.0) 11.9 (5.2)

0.5 (0.2) 1.9 (0.8)

-1.2 (-0.5) -2.8 (-1.2)

-2.1 (-0.9) -8.1 (-3.4)

-2.8 (-1.2) -14.8 (-6.1)

-6.7 (-2.7) -16.0 (-6.4)

-7.6 (-2.9) -16.6 (-6.3)

-7.8 (-2.9) -17.5 (-6.4)

-7.7 (-2.7) -18.2 (-6.4)

-7.6 (-2.5) -19.2 (-6.4)

-6.3 (-2.0) -19.9 (-6.4)

-4.4 2.5 -1.9

-3.8 1.5 -2.3 4.7

0.6 0.7 1.3 4.5 228

2.1 1.0 3.1 4.6 235

2.3 1.0 3.3 4.7 242

2.7 0.9 3.6 4.8 251

2.9 1.1 4.0 4.9 261

3.0 1.3 4.3 5.0 272

3.0 1.4 4.4 5.1 284

3.0 1.7 4.7 5.2 298

3.0 1.8 4.8 5.2 312

230

225

Gross debt less cash buffers, bank restructuring fund assets and collateral and escrow accounts.

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