Greece’s outlook after the new troika deal

It is now obvious that the next, fifth financial tranche will be paid out. An agreement with visiting officials from the European Commission, European Central Bank and International Monetary Fund — collectively known as the troika — was announced on June 3 and then relayed by Prime Minister George Papandreou to his colleague Jean-Claude Juncker in Luxembourg. The interesting detail is that Papandreou did this himself, not his finance minister, Giorgos Papaconstantinou, as in the past. Possibly the PM is taking a more assertive role, something that many having been waiting for during the past months. But even if payment of the tranche has been secured, each subsequent quarterly evaluation is becoming ever more difficult and subject to higher levels of risk (i.e. nonpayment) and conditionality (e.g. redundancies in the public sector).

The danger moving into the second half of 2011 and early 2012 is that at some stage one of the troika’s members is going to pull the plug. If I had to put my money where my mouth is, I would think that it is the IMF that is coming ever closer to withdrawing from the financing arrangement. The Washington-based fund has repeatedly warned that it could withhold the ?3 billion share of the fifth 12-billion-euro troika tranche to be paid out in July 2011. The IMF is seeking assurances that Greece is fully funded in the next 12 months and will thus not default.

But as has been the case so many times before during the past 16 months, one of the rating agencies has again downgraded Greece during an evaluation by the troika. In this case it was Moody’s, which downgraded Greek sovereign debt to Caa1, on a par with Cuba, and raised the country’s risk of default. For a sovereign rating to fall within less than two years from A to this (junk) level is entirely new territory, and not only in the eurozone.

However, in my view, the timing of the downgrade without awaiting the outcome of the evaluation is a political scandal. In a way, the three leading rating agencies? untimely but deliberate interventions suggest that they have through the back door become part of the policymaking process in Athens and beyond. Such repeated rating action and unprecedented influence must be addressed in current discussions about regulatory reform on rating agencies in Europe, as is being considered by the Commission and the EU Parliament. After all, how stable is a currency union in which member states and millions of citizens literally depend on the assessments of three private institutions who hold a monopoly over ratings and governments to ransom?

The negotiations with the troika during the past weeks in Greece have illustrated that a radical tax reduction program, as proposed by Antonis Samaras, the leader of the main opposition New Democracy party, has no support among the government, the IMF, the EU and the ECB. Samaras’s proposition for the introduction of a ?flat tax? of 15 percent misses the key structural problem of Greece, namely the improvement of collection capacity (enforcement) and the enlargement of the tax base. Government revenues fell in the first five months of 2011, creating a 2.6-billion-euro fiscal hole. Specifically, revenues for the January-May period fell to 17.9 billion euros, from 19.7 billion in the same period last year. The Finance Ministry had expected to collect 20.5 billion euros for the five-month period.

By contrast, the Papandreou government has adopted a yearly, staged corporate tax reduction roadmap, in which a 1 percent reduction will be introduced, starting this year. Corporate tax currently stands at 23 percent and is to reach 20 percent by 2014. If any further tax reductions are to be introduced this year and 2012, then I expect this to be the case in the field of reducing value-added tax (currently 23 percent) and merging existing VAT categories from three to two, 20 percent and 10 percent respectively.

A second aspect of the concluded negotiations between the Papandreou government and the troika is the gradual enlargement of its thematic focus. After one year in operation, the present framework as agreed in May 2010 between Athens and the troika is showing to have been unrealistic in substance and far too optimistic regarding the timetable (e.g. when Greece would be able to return to bond markets). Hence we are now entering the re-engineering phase of the framework. Today, both sides are discussing issues such as:

stimulus packages for the economy;

* a targeted investment component including projects in sectors such as tourism, shipping, green technology and retailing;

* the scope and range of collective bargaining agreements and to what degree employers are bound by them;

* public sector employment levels (new replacement ratio 1 for 10), merger of public organizations (schools, hospitals, insurance and pension funds) and utilities;

* broadening the tax base (reduction of tax free income threshold from 12,000 to 6,000 euros);

* privatization, the creation of an independent agency to oversee the privatization drive and how to use privatization revenue, reprofiling (different versions).

This extension of the structural reform agenda is necessary and constructive. It leads away from a far too narrow focus on spending cuts (6.4 billion euros in 2011) and austerity policies. What Greece needs, and cannot shoulder alone at present, are targeted investment projects, job creation and qualification programs, pooling of resources from the EU?s structural and regional funds with the temporal suspension of co-financing requirements and supplemented by additional funds from the European Investment Bank. Whatever you want to call such an arrangement — Greek-style Marshall Plan or Herculean Plan — it must be organized and implemented quickly, otherwise the real economy and its viable sectors risk losing their footing.

What are the political consequences and challenges resulting from these developments? First and foremost, Papandreou is seeking a broader cross-party consensus in Parliament, in particular with New Democracy. These efforts have not been successful to date. However, while he seeks such consensus between parties he risks losing consensus inside his own governing party. Sixteen PASOK deputies have recently written to the prime minister asking that Parliament be given time to properly debate the new set of austerity measures Greece is about to agree with the troika. What are possible scenarios in the short term, i.e. until end-2011?

The option of a voluntary euro exit by Greece is rejected at the political level in Greece and in the EU. However, gradually a groundswell of skepticism and even outright rejection is gaining force within parts of Greek society. The protesters from the ?Won?t Pay? movement, who refuse to pay road tolls, as well as the ?Indignant? movement currently occupying Syntagma Square articulate an undercurrent of drachma nostalgia and anti-EU/anti-euro sentiment. The composer and national icon Miki Theodorakis publically called for Greece to exit both the eurozone and the EU during a May 31 protest rally in front of Athens University, receiving long and loud applause for it. Finally, the Greek EU commissioner for fisheries, Maria Damanakis, is said to have warned that either the crisis be soon resolved or Greece should exit the euro.

A second and rather dire option concerns Greece declaring or being forced into insolvency. This option, while considered realistic by many and even essential by some commentators, is politically a nonstarter for the Papandreou government, the ECB, the EU and — so far — the IMF (see Lorenzo Bini Smaghi interview in the Financial Times on May 30, 2011).

A third perspective explicitly addresses the European dimension and eurozone responsibility. More specifically, the European members of the troika agree to foot the IMF share in case the latter — temporarily — withdraws or withholds further financial assistance for Greece. A new assistance program for Greece would then not be necessary. However the question is where would the additional financial resources come from? (i) The EU facility (EFSM) is already stretched with the Greek, Irish and Portuguese obligations. (ii) Alternatively, the EFSF could be involved in the Greek financing architecture. But this would require a mandate extension of the EFSF. The advantage of this option is that it does not require approval from national parliaments. The disadvantage is that the non-inclusion of the IMF would be particularly alarming for Germany, which has always insisted on the Washington-based lender to be involved.

A fourth scenario includes a new loan guarantee program agreed by eurozone finance ministers and the IMF to the tune of roughly 60 to 70 billion euros for Greece. But the devil is in the details to be addressed. They are manifold, complex and politically charged. Just consider the following challenge: What would be defined as a voluntary burden sharing with private bondholders in exchange for additional loan guarantees and funds? Any consensus on cooperative debt approaches, e.g. bond rollovers as a pillar of a new aid package, has to be structured in such a way that it does not trigger a so-called credit event. Investors may be given incentives such as preferred creditor status, higher coupon payments, collateral or preferential treatment in the future if another rescheduling is needed.

A German plan being considered calls for investors who hold Greek bonds maturing between 2012 and 2014 to voluntarily exchange those for new sovereign debt instruments with an extended maturity of seven years. Creditors would have to be motivated to join in such a voluntary exchange with the help of a so-called «collective action clause.» These would need to be introduced into existing bond contracts in the event that not enough private investors were prepared to take part. However, to structure a conversion of sovereign debt while avoiding the classification of a credit event by rating agencies is akin to squaring the circle. Moreover, debt rollovers may do little to reduce Greece?s rising public debt load.

In order to receive a second bailout package the range of additional conditionality that Athens has to adhere to is considerable. Further tax increases, significant downsizing of public sector employment, restructuring, merger or closure of public entities and the rationalization in entitlements are all on the agenda. What was only recently considered a red line is fast becoming the order of the day, mandated by the troika and subscribed to by the Papandreou government in June 2011.

Greece is facing the end of an era. Everybody knows it. There is nothing left in the state budget to distribute. There is no more cheap money available on international bond markets to borrow. And there is no social contract anymore between citizens/society and the state/political elites. Against this background, one group will fight tooth and nail to protect their entrenched interests. And the other group will continue meeting in ever greater numbers at Syntagma Square — under the Spanish-inspired umbrella term ?Indignant? — and shout ?Thieves? as well as ?Go away? at those sitting in Parliament. At the end of the day what we are facing today and in the coming months in Greece is the challenging and desperate attempt to formulate a new social contract between state and society, between political elites and citizens.

* Jens Bastian is visiting fellow for the political economy of Southeast Europe at St Antony?s College in Oxford, UK, and senior economic research fellow at ELIAMEP in Athens, Greece.

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