Extension fits Merkel’s strategy

Greece may not ask for an extension to its economic program when Prime Minister Antonis Samaras meets German Chancellor Angela Merkel and other European leaders next week, but it will certainly do so officially at a European summit later on.

Assuming the country comes up with the 11.5 billion euros in spending cuts, the assessment of the so-called troika — as Greece?s international creditors, the European Commission, European Central Bank and International Monetary Fund, are collectively known — is overall positive and the privatization program is revived, it would be unfair to deny the country an extension of the adjustment program by two years to the end of 2016. This is especially so because it fits Merkel?s game plan for the eurozone, while calculations show it improves Greek debt dynamics and the funding gap can be covered by other sources without the approval of national parliaments.    

Recent media reports in Greece and abroad want Samaras to ask Merkel, French President Francois Hollande and others for an extension of the adjustment period for the Greek economy by two years through 2016 when he meets them next week. Although the issue may come up in the discussions, we consider it very unlikely that the premier would risk doing something like that at this juncture.

Samaras seems to be fully aware of the low credibility of the Greek political elite in eurozone decision-making circles and — rightly so — would like to have some cards to play before submitting an official request at an EU summit. Agreeing with the troika on the 11.5-billion-euro package of expenditure cuts is just a first step. In addition, speeding up the first round of mergers and acquisitions activity in the local banking sector and finalizing the long-awaited terms of their recapitalization will help, along with one or two high-profile moves on the privatization front and more progress in slashing the budget deficit.

But the Greek side cannot plan by simply focusing on its own agenda and wishes. We think the country?s officials understand they cannot bring up an important issue, such as the extension of the adjustment program by two years, before Spain and Italy have reached a deal with the Germans and the EU authorities in general, giving the green light to the ECB to deploy its firepower in the bond markets and bring down the Spanish and Italian sovereign yields.

However, Greece has every right to provide the economic arguments in favor of extending the program by two years. In our view, the German chancellor wants to buy time to transfer sovereignty to Brussels in exchange for Germany and other core countries assuming additional liabilities, i.e. via Eurobonds. Recent support for ECB President Mario Draghi to intervene in the markets and buy peripheral bonds should be seen in this context.

Nevertheless, Greece has some strong points favoring the extension. As recent FT stories have pointed out, a debt sustainability analysis conducted by the Greek government — the first ever — shows an extension would improve public debt dynamics compared to leaving the program untouched. In other words, the debt-to-GDP ratio will fall to 132 percent in 2020 if the country implements the 11.5-billion-euro spending cuts and extends the program through 2016 compared to an estimated 147 percent when applying the same measures in 2013 and 2014 only. It is noted the IMF report projected the debt ratio at 116 percent in 2020 back in March when the debt restructuring took place. Worsening macroeconomic trends account to a large extent for the sharp deterioration in debt dynamics since then.  

The impact on economic activity will be milder because the spending cuts will be spread out over four years instead of two, giving some breathing space to the economy, which has lost some 20 percent of its output since 2009. Readers are reminded that the so-called second memorandum, which spans the 2012-14 period, aims at an annual reduction of the deficit by 2.5 percentage points in 2013 and 2014. Assuming the program is extended, the annual decrease of the deficit will be 1.5 percentage points.

The proponents of the two-year extension, namely Finance Minister Yannis Stournaras and the prime minister?s chief economic adviser, Yiannis Mourmouras, also propose the inclusion of a recession clause in the adjustment program. They argue in favor of targeting the structural deficit or variables in money terms and in percentage of GDP terms among other technical ways to delink recession and fiscal consolidation. 

But the Greek side is well aware that a lot will hinge on the ensuing funding gap since the country?s low credibility among its partners and the public resistance to providing further loans to Greece in some key countries, namely Germany, make the issue politically sensitive. According to Greek officials, the gap is estimated at around 20 billion euros although others put it higher.

They argue there are ways, such as T-bill issuance and the realignment of the terms of the EU bilateral loans in the first bailout package with the terms of the EFSF loans in the second rescue package, to fund the gap without recourse to other sources requiring parliamentary approval in eurozone countries.

With the unemployment rate at 23 percent and rising and the economy in a state of depression, no reasonable person would deny Greece an extension of the program by two years on three conditions. First, that it does its homework and delivers on the fiscal front and privatizations, second, that the extension improves the debt dynamics, as the Greek government argues, and, third, that the funding gap will be covered without causing a political embarrassment to other governments. Assuming all of the above conditions are met, Greece should not be denied the extension. This is more so since the extension also fits Chancellor Merkel?s game plan for the euro.