The risks of the escrow account

The sustainability of Greek public debt may be a point of contention but it looks unlikely to derail a deal on the exchange of Greek bonds, known as PSI (Private Sector Involvement), at Monday?s Eurogroup meeting. In this context, the imposition of an escrow account for the bailout funds to be disbursed to Greece sought by eurozone officials may turn out to be a two-edged sword instead of an effective enforcement tool.

We argued a few weeks ago that Greek public debt is likely to undergo another restructuring in the future in order to be put on a sustainable path. Our assumption took into account both the debt sustainability analysis carried out by the International Monetary Fund in its fifth review of the first Greek economic adjustment program, the deteriorating economic conditions and most importantly their impact on the country?s growth potential ahead.

Even more importantly, we do not share the view a debt-to-gross domestic product ratio of 120 percent in 2020 will lead to a sustainable position for a country like Greece — with a chronic current account deficit and a public debt held mostly by foreigners. Unfortunately, Greece is not Japan, which features a bigger public debt-to-GDP ratio but runs a current account surplus and a large chunk of its debt is in domestic hands.

According to various press reports, the IMF?s revised debt sustainability analysis, to be presented to eurozone finance ministers on Monday, is based on more realistic assumptions, leading to a debt-to-GDP ratio of 129 percent in 2020. This creates a financing gap which has to be filled by concessions from the official sector — mainly the European Central Bank and the national central banks — and others in order to bring down the ratio to the targeted 120 percent of GDP in 2020.

Having said that, one should recognize the big contribution of PSI to make the Greek public debt sustainable in the medium-term, assuming it is implemented and high participation in excess of 90 percent is attained, leading to a debt reduction of about 100 billion euros. Moreover, PSI will improve the country?s cashflows since the coupon on the new bonds is estimated around 3.4 percent with a likely step-up structure depending on Greek GDP performance, producing significant annual interest budget savings.

Although PSI is a prerequisite for official financing in Greece?s second European Union/IMF bailout package of at least 130 billion euros, it does not mean that the EU and the IMF will continue to fund the country if it does not honor the conditions of the second economic program.

Reflecting the lack of confidence in the country?s political elite and public administration, the EU has reportedly sought the establishment of a separate escrow account for the bailout funds to exert maximum pressure on the Greek side to honor its part of the deal. Most likely, bailout money earmarked for debt repayment from each disbursement will be kept in the escrow account, but the rest of the money destined to cover budgetary and other needs will not be released unless Greece meets the conditionality criteria of the new economic program.

Apparently, the EU officials think investors will be assured they will get paid regardless of Greece?s honoring its commitments after each troika review. This way, the market will be appeased and uncertainty will recede, helping contain contagion to other eurozone countries.

On the other hand, Greece will come under pressure to conform to the demands of its official lenders because it will not receive the part of the tranche financing primary expenditures such as wages to civil servants and others, and will be deprived of the default option.

Although it looks good from the lenders? point of view, the special escrow account is not without risks:

First, domestic economic conditions will likely get worse if the government is unable to pay wages, pensions etc. This may fuel social unrest and further undermine the execution of the program.

Second, withholding bailout funds will play into the hands of local politicians and others who argue that the EU/IMF package aims primarily at rescuing lenders rather than ordinary Greeks.

Third, Greece ran an estimated 5.2 billion-euro primary budget deficit in 2011 from more than 10 billion in 2010, meaning it was short 5.2 billion euros to cover all expenditures except for interest expenses on the debt last year. The primary budget deficit is projected to be cut in half in 2012 and turn into a surplus in 2013. In other words, the time approaches when the government will be able to fully cover primary budget expenditures via revenues and therefore will be less dependent on bailout funds. So, the escrow account cannot be used to put pressure on the country for long.

Moreover, the Greek government may feel less pressure to produce large primary budget surpluses in the future if it knows bondholders will be paid anyway by the EU/IMF.

Fourth, bondholders are intelligent enough to understand the risks of a Greek internal default to the wider market despite the presence of the escrow account. After all, the EU/IMF cannot keep on repaying the debt of a country that amasses even more debt as its economy heads deeper and deeper into recession partly thanks to the withholding of bailout funds.

So, the creation of a special escrow account for Greek bailout funds has some merits but it may also contain the seeds of a large-scale Greek internal default. The latter will put at risk the ongoing rescue effort and undermine market confidence in both the country and the EU leaders and institutions, spreading contagion.