IKA funding proposal is poor economics
In the context of reforming the country’s main social security system, the Greek government unveiled last week its multi-year plan to shore up the finances of the main pension fund (IKA). It is clear that the plan attempts to deal with IKA’s current and future financing needs without inflating the general government budget deficit and debt at the same time as it minimizes political costs. The financing proposal though, fails to recognize that markets are forward-looking and therefore tend to discount the hidden costs, if any, of such plans. Therefore, it should not come as a surprise if Greek taxpayers and companies are called upon to pay the hidden costs of this plan. In the proposal set out by Finance Minister Nikos Christodoulakis and Labor Minister Dimitris Reppas, funds amounting to 1 percent of GDP will be committed each year to financing IKA’s deficit from 2003 to 2032. In addition to this, the state will pay IKA a total of 9.6 billion euros to finance past state obligations to IKA as well as honor IKA’s obligations to other state agencies. The money will come from the securitization of future pension contributions and the issuance of government bonds. Moreover, the state will start issuing non-marketable, zero-coupon bonds, offering a yield-to-maturity of 3 percent in real terms, from 2008 to set up an IKA reserve fund to help IKA meet future obligations. These bonds will be redeemed in 2023. By choosing to disregard the impact of adverse demographics on the country’s social security system and focusing instead on the issue of financing IKA’s projected 2003-2032 deficit, the government has succeeded in avoiding a political land mine but at the expense of future economic growth. The IKA plan and accompanying reform proposals, namely a change in the calculation of the base salary on which pensions will be calculated and a gradual decrease in pension benefits to 70 percent from the present 80 percent of public sector employees’ base salary from 2008 do little to address concerns about the viability of the present social security system given other concessions made to workers who entered the work force from 1993 onwards. The system’s long-term deficit, namely the present value of future unfunded liabilities, was estimated to rise to 300 percent of GDP in 2005 by the UK government actuaries last year, and is the highest in the EU. Although the government has stated that the IKA plan will not have an effect on the general government budget, this is not entirely correct. Indeed, the general government budget will be unaffected because the increase in the central government budget deficit will be offset by the decrease in the IKA deficit. Moreover, the general government debt will be unaffected for a number of years since government bonds held by IKA are categorized as intergovernmental debt, but not forever. At some point in the future, the government will have to borrow funds to redeem the maturing IKA bonds, therefore adding to the public debt. This is something markets cannot ignore. Already knowing that Greece’s general government debt may be augmented if the EU Commission decides to add to it last year’s proceeds from securitization and exchangeable bonds, amounting to about 5.8 billion euros, there should be no doubt that the markets will take this into consideration when pricing Greek assets, namely bonds and stocks. Moreover, international credit agencies, such as Moody’s and Standard & Poor’s, will be more reluctant than before to upgrade the country’s sovereign rating, given its failure to seriously address the shortcomings of the present pension fund system. This in turn will have negative consequences on the state’s future cost of borrowing because the new BIS rules on bank capital adequacy require the bond issuer to have a credit rating of AA- in order not to lose the present zero-risk weighting advantage. Under current BIS rules, bonds issued by OECD countries are treated in the same way, that is, banks are not required to set aside some reserves when they buy these bonds (zero weighting). Under the new rules, banks will have to set aside reserves when they buy bonds from issuers rated AA- or higher. As SSB’s Miranda Xafa notes, Greece needs to be upgraded two notches to get to AA- in order to avoid losing the zero-risk weighting advantage. If it fails to do so, it will face a higher cost of borrowing. Since a credit upgrade is directly linked to structural economic reforms, it should be clear by now that the present proposals to reform the pension system, however suitable politically, are economically inadequate. For Greek taxpayers and businesses not to be called upon to pay the hidden costs of the plan in the form of higher cost of borrowing and slower economic growth in the future, the government should review its current reform proposals with an open mind. The fate of electrification is also uncertain. The basic problems here are tight time limits for the sub-contract and the likelihood that the budget will have been spent long before this project begins.
