A roadmap to decode Greece negotiations

There are other relevant areas pending agreement such as labour market reforms and the privatization agenda; however, we think an agreement on these could be postponed until the third programme is discussed in the coming weeks. The imminent objective is to agree the bare minimum required to provide liquidity to the Greek Treasury and avoid default in the coming weeks.

Bottom line. Negotiations are gathering pace, nonetheless the gap is still substantial and we believe that bridging it may take longer than many expect. Moreover, we think a compromise on policies by the Greek government will carry a non-negligible political cost for the Syriza-led government (Greece: a crisis to avert a crisis, 21 May 2015) and could trigger a political crisis that could accelerate deposit outflow and result in the imposition of administrative controls on Greek banks (Greece: the risks of capital controls, 3 June 2015). But, if progress continues, we believe Europe will find a way to release some funds (even prior to a full-programme agreement) in order to avoid a default. The cash could come from the EUR10.9bn bank recapitalization funds (this would require the agreement of the ESM board, ie, a 85% majority vote) or the release of c. EUR2bn of SMP profits (which is part of the remaining €7.2bn of the last tranche). In any case, we do not believe that the crisis will be solved before the summer break, and it is very likely that Greece will remain a major uncertainty after the summer as the government and the institutions will need to agree on a third bailout, probably including a debt restructuring (OSI). Moreover, should a political crisis result in snap elections after the summer, which we think is a possibility, it would delay the process even further.

1) The fiscal gap

Since Q4 14, the economy has been in reverse; consumer and investor confidence has dropped, while tax revenue has fallen short of programme targets. May PMI signals a contraction of the manufacturing sector, though at a decelerating rate (48.0 from 46.5 in April). While the fall in the production and the new‐orders sub‐indices decelerated, new export orders declined sharply for the third consecutive month. Unlike in other periphery economies, where unemployment continues to drop, in Greece unemployment stayed at 25.6% in March 2015. Overall, economic data are consistent with a GDP contraction in Q2 15 of about 0.25%. For 2015 as a whole, we forecast the Greek economy to shrink c. 0.5%.

The disappointing economic data are translating into disappointing tax revenues in January-April. Thus far the government is dealing with the weakness in tax revenue by expenditure under-execution and increasing arrears to public sector suppliers. There have also been some one-offs that are helping the state primary balance, including non-tax and public investment revenue receipts. We estimate that the overall primary balance is likely to slide further into a deficit and will reach -0.5% to -1% of GDP under a scenario of no-additional-policies in H2 15.

The bottom line is that the Greek government will need to agree imminently with the Institutions on nearly EUR3.5bn of measures for H2 15, in order to improve the primary balance from -0.75% of GDP (our baseline without further measures) to +1% of GDP for 2015 – a target that we deem agreeable to both sides. However, it is not so much agreeing on that target what will be hard; rather, what will be very difficult to agree on is the fiscal measures required to meet that target. Greece has already delivered a fiscal swing of c. 15% of GDP in cyclically-adjusted terms over the last four years – one of the biggest fiscal efforts in recent history. Fiscal fatigue seems to leave very little space for more meaningful fiscal measures. Beyond measures to fight tax evasion and raise taxes on the more wealthy, the question of new VAT rates remains a controversial issue.

2) The pension gap

On pensions, not much progress has been achieved. Pensions in Greece still require an annual fiscal expenditure of c. 8.5% of GDP, among the highest in EU. The average effective retirement age is 59, one of the lowest in the EU. The pension reforms of recent years under the EU-IMF programme are certainly steps into the right direction to realigned contributions and retributions. The new statutory retirement age is 67 years and the minimum retirement age is 62 years. The reform provides the right incentives for increased labour force participation and to enforce stricter eligibility conditions for those receiving invalidity pensions. The reform also includes a correction factor establishing a link to life-expectancy, which would correct pensions automatically going forward (from 2021 onwards).

However, a key problem is the “phasing-out” period for the generous older pensions; ie, the liabilities inherited prior to the introduction of the reforms, which create significant financial pressures on the system and require large annual transfers from the budget.  As with the fiscal discussions, we do not anticipate a quick and easy agreement on pensions.