JPM Sees IMF Greece's Knight In Shining Armor When The Greek Liquidity Crisis Hits In Two Months

From JP Morgan

The EU and Greece: a little bit of carrot and a lot of stick

  • EU keeps the pressure on Greece: this week brings not only more stick, but also more clarity on the stick
  • No further details provided on the carrot
  • March 16 key date for Greece to deliver

Over the past week, EU leaders have made their views on the Greek situation fairly clear. On the one hand, the rest of the region requires Greece to make an appropriate fiscal adjustment, which will be measured by the achievement of a fiscal deficit of 8.7% of GDP this year and a fiscal deficit of below 3% of GDP by 2012. On the other hand, the fiscal capacity of the region as a whole will be used, if needed, to safeguard financial stability in the Euro area. EU leaders clearly feel that the monetary union is under some kind of attack, and they will act accordingly to protect it. However, what does this expression of support mean for Greece itself?One way to think about this is to consider what the road map ahead might look like.

By March 16, Greece needs to present a report explaining  how the budgetary measures for 2010 are being implemented. This report has to explain what additional measures will be taken in the event that the fiscal adjustment is not tracking the target, either due to slow implementation, weaker-than-expected growth, or higher-than-expected borrowing costs.

If Greece complies with all of the demands from the rest of the EU by implementing the fiscal measures that the rest of the region wants, and then experiences a genuine liquidity crisis in April and May, as it seeks to continue to finance its deficit and roll over the debt that is maturing, then the rest of the EU will provide financial support. The precise mechanism has not been laid out; it could be either areawide loans, credit lines, and guarantees, or bilateral loans, credit lines, and guarantees. [We are curious how many days of all out strikes it will take the government to throw the Austerity plan into the trash heap. Our over/under is at 20].

We do not envisage any legal or logistical problems with the rest of the region providing ad hoc support. If Greece fails to comply with all of the demands from the rest of the EU, and then experiences a genuine liquidity crisis in April and May, the most obvious next step for the region is to push Greece into the arms of the IMF. The IMF would then provide a program of financial support, with appropriate amounts of conditionality, to give Greece a couple of years to implement the appropriate fiscal adjustment. The alternative to this would be that the rest of the EU provides financial support for Greece with additional surveillance and possibly suspension of Greek voting rights in EU decision-making bodies such as the Council of Ministers. In our view, this would be a suboptimal response—if we were to get to that point, it would suggest that pressure from the rest of the EU was insufficient to get Greece to do what was needed. The appetite in the rest of the region to provide financial help to Greece in the event that the Greeks were not behaving appropriately would be very limited. As this week’s statement from the region’s finance ministers made clear: Greece is threatening the stability of the monetary union.

An IMF program would give the Greek government a decent window in which to make appropriate adjustments away from the pressure of financial markets. What would happen if, several years down the road, Greece is still running a huge fiscal deficit? The IMF always has the option of refusing to provide additional help, which then leaves the country to default. This provides an incentive to countries to take the appropriate measures, because default is very painful. But what is the ultimate sanction for a country within the Euro area? Euro area sovereigns are too large and interconnected to be allowed to default. At some point, the rest of the region might decide that Greece should be ejected from the Euro area. Participants in EMU have responsibilities to behave in an way that ensures the stability of the region as a whole. As this week’s EU statement makes clear, Greece has passed a critical point in this respect. Presumably the forbearance of the rest of the region will not last forever. However, at the moment, there is no legal mechanism for a member state to be expelled from the EU or EMU.

In December 2009, the ECB published a legal working paper entitled “Withdrawal and expulsion from the EU and EMU: some reflections.” This paper argues that the Lisbon Treaty makes provision for a voluntary secession of a member state from the EU, but it does not create a legal mechanism to expel a member state. The paper discusses the various sanctions in the treaty that are intended to encourage memberstates to comply with their treaty obligations. However, the ultimate question remains as to how the region would treat a member state that persistently refused to abide by the requirements of the treaty. Our view is that necessity would become the mother of invention.

We doubt that we will ever get to such a situation. Policymakers are capable of taking difficult decisions if the alternative is considered worse. EU leaders are not comfortable with providing financial support to Greece, but the alternative of contagion to other sovereigns and financial institutions is considered worse. EU leaders would feel embarrassed by a full IMF program for Greece, but the alternative of an ineffective fiscal fudge could be considered worse. Similarly, EU leaders would never feel comfortable ejecting a country from EMU, but the alternative of allowing the proper functioning of EMU to be persistently jeopardized might be considered worse. What has been missing so far is a clear sense of what the alternative for Greece might be if the country persistently fails to abide by the rules governing the monetary union. Last week’s statement from the EU heads of state hinted that broader IMF involvement might be acceptable as an additional sanction. This week’s statement from EU finance ministers highlights that jeopardizing the proper functioning of EMU is not acceptable. The message to Greece couldn’t be clearer. We believe that Greece will deliver the necessary fiscal adjustment; it will be painful but it will not be intolerable. The alternative could ultimately be a lot worse. In the EU’s approach of carrot and stick, the full nature of the stick is becoming clearer.

Tracking the Greek adjustment

One critical feature of the ECOFIN council statement this week was the requirement for the Greek government to submit a report by March 16th setting out the timetable for implementing the budget measures for 2010. The council statement goes on to say:

“To the extent that a number of risks associated with the specified deficit and debt ceilings materialise, Greece shall announce, in the report to be presented by 16 March 2010, additional measures to ensure that the 2010 budgetary target is met.” (Council of the European Union press release, 16th February)

This raises a critical question: how will we know whether the 2010 budget target—a deficit of 8.7% of GDP—is likely to be missed? In the coming months it will be important to assess whether the Greek public finances are tracking. We have three data sources to do this: monthly central government data on a cash basis from the Bank of Greece and the Ministry of Finance, with a reasonable history of data for both series; and a new series of monthly central government data on an accrual basis from the Ministry of Finance, but with no history. In many years, the two cash measures have a similar track record in giving an accurate impression of theannual general government data, which the government is targeting (see chart below). But, since 2003, the Bank of Greece data have done better overall. Thus far, we only have a January reading for the Ministry of Finance accrual data: this shows a surplus of €574 million in January this year, compared with a deficit of €1554 million in January 2009.