Greece
Request for Extended Arrangement Under the Extended Fund Facility: Staff Report; Staff Supplement; Press Release on the Executive Board Discussion; and Statement by the Executive Director for Greece.

This paper presents the staff report for Greece’s request for an Extended Arrangement under the Extended Fund Facility. The Greek economy fell into deep twin structural deficits after euro adoption. Easy access to financing at low interest rates fuelled rapid borrowing by the private and public sectors. Between euro accession in 2001 and 2009, private sector credit almost doubled in percent of GDP, financed mainly through the domestic banking system. Massive sovereign borrowing from international bond markets pushed government debt from 100 percent of GDP to about 130 percent of GDP during this timeframe.

Abstract

This paper presents the staff report for Greece’s request for an Extended Arrangement under the Extended Fund Facility. The Greek economy fell into deep twin structural deficits after euro adoption. Easy access to financing at low interest rates fuelled rapid borrowing by the private and public sectors. Between euro accession in 2001 and 2009, private sector credit almost doubled in percent of GDP, financed mainly through the domestic banking system. Massive sovereign borrowing from international bond markets pushed government debt from 100 percent of GDP to about 130 percent of GDP during this timeframe.

I. Introduction

1. The Greek authorities have requested a new 4 year Extended Arrangement with evenly phased purchases and notified the Fund of their cancelation of the existing SBA. The coalition government that assumed power in November 2011 was mandated to reach understandings with the EC/ECB/IMF on a new successor arrangement and to complete a PSI deal with private creditors. The two processes have moved in parallel since December, given the need to match program policies to program financing. Adaptations have been necessary given the evolving macro outlook for Greece and Europe, and the need to reinvigorate the reform agenda and deliver swifter adjustment. With the completion of the debt exchange, and proposed approval of the program, the Greek authorities are expected to call elections to establish a new government mandate. However, the precise electoral dynamics remain uncertain, with up to five parties garnering double-digit support in recent polls, suggesting a continuing coalition. The leaders of the two main parties in the existing coalition—a third smaller party dropped out during program negotiations—have provided assurances to Fund management that they are committed to the objectives and main policies of the program.

2. Greece has made some progress towards the ambitious objectives set for the SBA, but remains some distance from achieving them. The SBA included a set of ambitious policies and reforms aimed at (i) securing fiscal sustainability; (ii) restoring competitiveness and growth; and (iii) preserving financial stability. Performance under the SBA was initially good with a number of accomplishments, but became uneven beginning in late 2010 due to increasing political and social tensions, problems with implementation capacity, and strong recessionary headwinds (Tables 12). Overall, while Greece made some progress towards its objectives, it has been unable to realize the necessarily ambitious pace of fiscal adjustment and structural reforms, while macroeconomic outturns have been worse than projected, and market access was not restored as hoped.

Table 1.

Greece: Quantitative Performance Criteria

(Billions of Euro, unless otherwise indicated)

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Cumulatively from January 1, 2011 (unless otherwise indicated).

Applies on a continuous basis from program approval (May 9, 2010).

Cumulatively from January 1, 2011.

Calculated on a cumulative basis from January 1, 2010 and applied on a continuous basis from program approval (May 9, 2010).

Table 2.

Greece: Structural Benchmarks Under the SBA, 2010–11 (1 of 2)

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Source: IMF staff.

II. The Economic Setting for the New Program

3. The Greek economy fell into deep twin structural deficits after euro adoption. Easy access to financing at low interest rates fuelled rapid borrowing by the private and public sectors. Between euro accession in 2001 and 2009, private sector credit almost doubled in percent of GDP, financed mainly through the domestic banking system. Massive sovereign borrowing from international bond markets pushed government debt from 100 to about 130 percent of GDP during this timeframe. Rapid government spending growth—the structural primary balance deteriorated from a surplus of 4½ percent of GDP to a deficit of 14¼ percent of GDP—pushed the economy well beyond its potential, leading to wage increases beyond productivity growth, and inflation consistently above the level in Greece’s trading partners. Competitiveness deteriorated—the REER overvaluation reached an estimated 20–30 percent in 2009—while the current account deficit exceeded 14½ percent of GDP in 2007–08.

4. Since 2009, Greece has been unwinding imbalances, but through deeper recession and slow improvements in competitiveness (Table 3):

Table 3.

Greece: Selected Economic Indicators, 2007–12

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Sources: National Statistical Service; Ministry of Economy and Finance; Bank of Greece; and IMF staff projections.

Based on Labor Force Survey.

Core prices exclude energy, food, alcohol, and tobacco.

  • Real GDP has declined by more than 13 percent since 2009 significantly undershooting SBA projections (Figure 1). Private investment led the downturn in 2009, while public retrenchment started only in 2010. With falling incomes and employment, private consumption took over as the main driver of the recession in 2011. Current and leading indicators suggest that domestic demand continues to contract sharply: retail trade volume shrank by around 11 percent year-on-year in the fourth quarter; industrial production declined by 11 percent year-on-year in the fourth quarter; the manufacturing PMI has fallen to close to historical lows; and industrial new orders declined by 8 percent in the fourth quarter of 2011. After robust growth earlier in the year, non-oil exports declined in November and December 2011, tourism turnover declined in the fourth quarter, and so far pre-bookings for 2012 have been below expectations.

  • HICP inflation only fell below the Euro area average in mid-2011, sticking above SBA program projections. Even accounting for the impact of indirect tax changes, the adjustment is modest in comparison with other crisis countries, and in light of Greece’s deep recession (Figure 2). This reflects still pervasive price rigidities in oligopolistic product and highly regulated service markets, coupled with inadequate flexibility in the labor market.

  • Competitiveness gains are not yet evident on an economy-wide basis (Figure 3). The deflator-based real effective exchange rate has shown no improvement since 2009, owing to still high inflation. However, total economy unit labor costs (ULC) have fallen by about 9½ percent since their peak in early 2010, built on a cumulative 10-12 percent fall in hourly wages and a 7 percent decline in hours worked. Productivity growth has turned positive only at end-2011, as labor market adjustment has gathered speed, but this has come at the cost of rapidly rising unemployment. Overall, the slow adjustment despite deep recession again owes much to wage and price rigidities in labor and product markets.

  • The current account deficit has remained close to10 percent of GDP, a level well above SBA program projections, despite the deeper recession (Figure 4). Greece’s low share of exports in output (on average 14 percent of GDP from 2007–11, excluding shipping), has stood in the way of a more rapid improvement, even given the small improvements in competitiveness. And the sharp import compression that generally accompanies a crisis has been avoided due to Greece’s participation in a currency union (which has allowed fairly elastic external financing through the availability of ECB refinancing of the banking system). This has allowed significant consumption smoothing by the private sector (a sharp decline in savings), offsetting improvements in the public sector savings-investment balance.

Figure 1.
Figure 1.

Greece: Selected Economic Indicators

(Year-on-year percent change, unless otherwise indicated)

Citation: IMF Staff Country Reports 2012, 057; 10.5089/9781475502442.002.A001

Sources: National Statistical Service; Eurostat; and IMF staff calculations and estimates.
Figure 2.
Figure 2.

Greece: Inflation Developments

Citation: IMF Staff Country Reports 2012, 057; 10.5089/9781475502442.002.A001

Sources: ElStat; Eurostat; WEO; Babecky et al, 2010, Bank of Greece WP No 11; Druant et al, 2009, ECB WP No. 1084.
Figure 3.
Figure 3.

Greece: Competitiveness Indicators

(Year-on-year percent change, unless otherwise indicated)

Citation: IMF Staff Country Reports 2012, 057; 10.5089/9781475502442.002.A001

Sources: Eurostat; Elstat; and IMF staff calculations.
Figure 4.
Figure 4.

Greece: Balance of Payments Developments

Citation: IMF Staff Country Reports 2012, 057; 10.5089/9781475502442.002.A001

Sources: Bank of Greece; and IMF staff calculations.

Greece: Saving-Investment Balance, 2008–11

(in percent of GDP)

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Source: IMF staff calculations.

5. Market sentiment has collapsed since the onset of the crisis (Figure 5). Sovereign spreads, which had risen to almost 10 percent before program inception, narrowed markedly in the first few months of the program, helped by ECB bond purchases under the SMP. However, worsening fundamentals, further adverse data revisions and, not least, public calls for a sovereign debt restructuring mechanism for the eurozone, sent bond and sovereign CDS spreads soaring in the last quarter of 2010. The restoration of market access, envisioned for late 2011 and 2012, became a distant prospect. Indeed, uncertainty related to the details of private sector involvement (PSI), first announced in June 2011, resulted in ever higher and more volatile spreads. By mid February 2012, 10-year bond spreads exceeded 3,200 bps and CDS spreads skyrocketed. After many months of discussions between the Greek authorities and an IIF-led creditor group, an agreement on the voluntary PSI was reached. The authorities announced the key terms of the debt exchange on February 21, 2012 and the exchange offer successfully closed on March 8, 2012 (with a short extension given to holders of foreign law bonds)(Box 1). Market reaction was muted, despite the immediate declaration by ISDA of a credit event.

Figure 5.
Figure 5.

Greece: Financial Indicators

Citation: IMF Staff Country Reports 2012, 057; 10.5089/9781475502442.002.A001

Sources: Bloomberg; and Moody’s Creditedge.

6. The recession and losses from government debt exposures have taken a deep toll on the banking system, undermining financial stability and necessitating a change in strategy (Tables 45; Figure 6):

  • Bank solvency has become an acute problem. Banks will no longer be able to delay recognition of losses on their government bond holdings, as the PSI deal will trigger impairments of about €22 billion, compared to system Tier 1 capital of €23.8 billion in September 2011. Regulatory capital will be wiped out for four banks representing 44 percent of system assets, while the remaining banks would end up significantly undercapitalized. The recession is also taking its toll, with nonperforming loans having reached 14.7 percent of total loans at end-September 2011 (the bulk being concentrated in the corporate and SME sectors). To assess loan quality looking forward, an independent international advisory firm (BlackRock) conducted a diagnostic exercise last year. Staff’s preliminary estimates for stress scenarios, using a similar methodology, point to system-wide loan losses over a three-year horizon in the range of €30–35 billion (before provisioning and future profits).

  • System liquidity remains exceptionally tight. From end-2009 Greek banks have lost close to 30 percent of their deposit base (including 6.4 from end-2011). The steady outflows—a major deposit run has been avoided—appear driven by private sector dissaving as well as by capital flight to safe-havens outside of Greece (the latter representing about a quarter of total withdrawals). The Euro system has stepped into the breach and by end-2011 had provided nearly €130 billion (or 60 percent of GDP) in support. Initial heavy reliance on Eurosystem liquidity support (with Eurosystem exposure peaking at €103 billion in mid-2011) is gradually being replaced by Emergency Liquidity Assistance (ELA) from the Bank of Greece (BoG). The switch to ELA is imposing additional costs on banks, as the interest rate and fees are higher than under the ECB window, but this remains an inexpensive form of financing for banks.

  • Banks have been deleveraging at an increasing pace. Banks initially focused on asset disposals, selling non-core foreign assets (realizing €950 million in sales of loan portfolios), cutting claims on foreign financial institutions, and reducing security holdings. But they have also reduced credit to the private sector, with new corporate credit lines having largely dried up by late 2008, and total credit being on the decline since mid-2010. Sole proprietors and consumer credit have been affected the most (-6½ percent in 2011), and, as of September 2011, credit to corporations also turned negative. While credit demand has also contracted, industry and banking surveys suggest that tight credit supply and lack of trade credit are the main constraining factors, generating a negative feedback loop through the economy that has put further pressure on the banking system.

  • Banks have also been making efforts to raise capital under difficult market conditions. A few large banks are taking steps to implement plans mixing liability management exercises (buybacks of hybrids or subordinated debt), issuance of preferred shares to the state (in exchange for PSI-exempt government bonds), and recapitalization by foreign parent banks. In total, these efforts have raised approximately €4.3 billion of Core Tier 1 capital, or percent of the pre-PSI system Core Tier I capital. A merger previously announced between Alpha Bank and EFG Bank, supported by a sovereign wealth fund, has been called off by Alpha Bank.

  • In light of the evolving situation in the banking system, the authorities’ efforts have shifted from backstopping private banks to strengthening the framework for recapitalization and resolution. The HFSF was established at the outset of the SBA in 2010 as a capital backstop for viable banks (in case they could not raise capital through the markets). As the situation has deteriorated, the authorities strengthened the resolution framework, introducing additional tools in Q4 2011 to allow orderly resolution, including purchase and assumption transactions, and bridge banks, and made plans to set aside markedly more funds for bank recapitalization.

Table 4.

Greece: Monetary Survey, 2006–11

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Source: Bank of Greece and IMF staff estimates and projections.

As of June 2010, securitised assets are no longer derecognised from the balance sheet of banks that have adopted the International Accounting Standards. The counterpart of these assets is recorded on the liabilities side as deposit liabilities to non-euro area residents.

Holdings of securities other than shares and derivatives.

Credit to domestic non-MFI residents by domestic MFIs excluding the Bank of Greece, including securitized loans and corporate bonds.

Growth rates are calculated from differences in outstanding amounts adjusted for revaluations, exchange rate valuation differences, reclassifications and any other changes which do not arise from transactions.

Table 5.

Greece: Financial Soundness Indicators, 2005–11

(percent)

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Source: Bank of Greece.

Data on a consolidated basis.

On an aggregate resident-based approach (i.e. commercial banks, cooperative banks and foreign branches).

On a non-consolidated basis. From 2004 in accordance with IFRS.

Based on revised figures from 2002 onwards.

Figure 6.
Figure 6.

Greece: Money and Banking Indicators

Citation: IMF Staff Country Reports 2012, 057; 10.5089/9781475502442.002.A001

Sources: National Statistical Service; Bank of Greece; Bloomberg; ECB; and IMF staff calculations.

7. The fiscal deficit has improved considerably, but remains large (Table 6; Figure 7).

Table 6.

Greece: Modified General Government Cash Balance, 2012–15

(in billions of Euro)

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Sources: Ministry of Finance; and IMF staff projections.
Figure 7.
Figure 7.

Greece: Budget Execution up to end-2011

(Millions of euro)

Citation: IMF Staff Country Reports 2012, 057; 10.5089/9781475502442.002.A001

Sources: National authorities; and IMF staff calculations.
  • Greece achieved a cumulative improvement in the primary balance of 8¼ percentage points of GDP between 2009 and 2011, on the back of VAT, income and property tax increases, and cuts in wages, pensions, and public employment. Still, the primary deficit achieved in 2011—2½ percent of GDP—fell short of the initial program target for 2011 by some 1½ percent of GDP. It remains well below the long-run debt stabilizing level of a 1½ percent of GDP primary surplus. The deeper recession, uneven policy implementation, and revisions to 2009 base data have all played a role in this shortfall. The most recent results for 2011 have been a continuation of earlier trends, with a slight shortfall in performance (a ¼ percent of GDP overrun versus the revised overall deficit target). The 2011 data point in particular to a continuing arrears problem (in part due to tight government liquidity constraints), and a growing revenue collection problem, centered in weak social contribution compliance. Final 2011 data are due in April, and there is a risk of upward revisions in arrears and the general government deficit.

  • While there has been progress with fiscal consolidation, the imbalance between the size of the state and its capacity to collect revenue remains a key problem. Greece spends about as much as other Euro area countries (relative to GDP), but its revenue ratio, while high in absolute terms, remains well below other European countries. The problem can be traced to poor direct tax collections, reflecting a narrow base and widespread tax evasion. But this is an enduring problem in Greece. The massive deterioration in the underlying fiscal position over the last decade can be largely attributed to an expansion of social spending (particularly health and pension expenditures), of over 6 percent of GDP. Since 2009, the authorities have managed to both raise total revenues and cut total spending, but there has been no progress in lifting direct tax collections. And while the authorities have undertaken a pension reform with very beneficial long-term impacts, there have been limited reductions in existing social transfers.

A01ufig01

Public sector: central government deposits in the banking system and arrears

(in billion of Euro)

Citation: IMF Staff Country Reports 2012, 057; 10.5089/9781475502442.002.A001

A01ufig02

Social Security Contribution Collection Shortfalls

(in percent of assessed amount)

Citation: IMF Staff Country Reports 2012, 057; 10.5089/9781475502442.002.A001

Greece: Revenues and expenditures compared to EU average.

(in percent of GDP)

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Averages for sub-categories of expenditure refer to the 2008–09 period.

8. Strengthening of fiscal institutions is well underway, but is proving to be a complex and time-consuming task (Table 7).

Table 7.

Greece: Status of Fiscal-Structural Reforms, 2012

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Source: IMF Staff
  • Greece entered the crisis with a dysfunctional revenue administration. Problems plague all stages of the collection process. The VAT gap and the shadow economy are the highest in the EU, while collection of tax debt and verifications of tax payers are among the lowest in the OECD. In 2010, the authorities started to implement a medium-term revenue administration reform plan. New central units have been established for audits, debt collection, and large taxpayers. However, the framework is not yet functional. There have been long delays in hiring auditors and establishing basic operational functions such as collection enforcement. Audits of large taxpayers fell below the 2011 annual targets, and the quality of audits remained low. Limited political support and strong institutional resistance have contributed to delays. Overall, gains from the reforms have been modest to date.

Greece. Tax Evasion and Revenue Administration Performance

(percentage values)

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Sources: OECD 2010, EC 2009, Schneider 2010.
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