Some government officials are suggesting that the second memorandum provides for the ECB to refund all income earned on Greek bonds acquired via the terminated SMP bond buying program in the past.

By Dimitris Kontogiannis

Greece is likely to suppress its twin deficits more next year by continuing to implement restrictive economic policies, but will not regain the confidence of international markets if the debt sustainability issue is not dealt with effectively. Unfortunately, it looks as if this may have to wait until after the German elections next year.

New data on public finances and the external accounts show considerable progress, paving the way for achieving a stable equilibrium at some point in 2014. What are perhaps the most impressive figures are coming from the current account balance, with the deficit shrinking by 66 percent year-on-year or 9.1 billion euros to 4.6 billion in the January-August period.

The sharp compression of the gap was aided by the drop in interest payments abroad to the tune of 3.3 billion euros, thanks to this spring’s debt restructuring. Given the trend, it is likely the current account deficit will be confined below 10 billion euros for the whole year, from 21 billion in 2011 and 23 billion in 2010.

The state budget deficit stood at 12.7 billion euros to end-September compared to a target of 13.5 billion and 20 billion euros over the same period in 2011. Of course, growing state arrears to the private sector continue to cloud progress while cuts in public investment budget spending darken the quality of the improvement. Still, the deficit reduction is sizable despite a deeper-than-projected recession of 4.8 percent.

The new austerity measures of some 9 billion euros along with the restrictive effects of labor reforms on incomes promise both another deep recession and continuing compression in the country’s twin deficits in 2013. In this regard, the current account deficit may fall below 4 percent of GDP next year while the primary budget balance is likely to produce a small surplus, ranging from 1 to 3 billion euros.

If the estimates are right, this will be Greece’s first primary budget surplus – it does not include interest payments on its debt – since early 2000 but is likely to fall short of the 3.6 billion euros or 1.8 percent of GDP projected in the second economic adjustment program back in February-March. Of course, the much anticipated two-year fiscal extension will likely be approved by the EU leaders, allowing for a smoother fiscal consolidation path till 2016.

However, this is not going to solve the debt sustainability problem and this in turn will likely continue to block Greece’s foreseen access to capital markets in 2015 for the first time since spring 2010. Readers are reminded that the country is projected to resume market financing to the order of 10 billion euros in 2015-16. If this does not materialize fully, the funding gap linked to the fiscal extension will get bigger.

Moreover, a primary budget surplus equal to 4.5 percent of GDP – necessary for making debt sustainable over the long term by the troika – will constitute an obstacle to the country’s economic growth potential in the future. This is so because excessive resources are diverted from the real economy to the service of the public debt.

In this regard, the debt sustainability analysis will have to become more realistic and credible in the eyes of the markets, assuming a much lower primary surplus over the long term. A primary surplus, between 2 and 3 percent of GDP depending on the ups and downs of the economy, looks both more feasible and credible. This in turn means a much bigger intervention than envisaged by the EU at this point to bring down the debt-to-GDP ratio to below the arbitrary 120 percent level in 2020.

According to various sources and Finance Minister Yannis Stournaras’s speech in arliament last week, the EU is willing to look into decreasing the margin over Euribor, the interbank reference rate, Greece pays on its EU bilateral loans amounting to about 55 billion euros. It is also willing to discuss the rollover of their maturities but understandably no haircuts. However, we strongly doubt whether these measures alone can drive Greece’s debt below 120 percent of GDP in 2020 even if the primary surplus is assumed at 4.5 percent from 2016 onward.

The case is definitely strengthened if the ECB refunds all income earned on Greek bonds acquired via the terminated SMP bond buying program in the past with some government officials suggesting this is foreseen in the second memorandum.

Even so, we don’t think the market will consider the Greek debt sustainable and allow the country access to the markets unless two things happen. First, the projected primary surplus will have to be revised down, between 2 and 3 percent of GDP in the long run, to make the case for sustainable growth more convincing.

Second, debt reduction initiatives will have to be enriched to include more than an interest rate decrease, the rollover of maturities and the ECB’s return of income on Greek bonds. Since a haircut on official loans is deemed politically unacceptable, the only other routes left are a big buyback bond program to cut the debt load and the recapitalization of banks by the ESM.

Is there enough political boldness to adopt all these debt reduction initiatives at once and adjust the Greek primary budget surplus to lower, more realistic levels? EU politics shows this is not likely before the German election next year and only after Greece has achieved a good track record on program implementation. Still, this is the only way for Greece to restart market funding and the unprecedented fiscal consolidation efforts to pay off. The sooner it is understood by policymakers, the better.