Greece debt plan may work if growth returns

PARIS Wed Apr 14, 2010 2:08pm EDT

PARIS (Reuters) - Aid from European governments will give Greece a good chance of success in its struggle to curb its national debt, but only if it can emerge from recession in no more than two years, Reuters calculations suggest.

A simple spreadsheet model of Greece's economy and debt, prepared to test different scenarios for growth, borrowing costs and fiscal austerity measures, indicates the emergency aid plan announced by European governments this week could tip the balance in Greece's favor.

Under the European aid package, euro zone governments would provide up to 30 billion euros of three-year loans in the first year at a rate of roughly 5 percent. The International Monetary Fund would chip in an additional 10 billion euros or more.

Greece has not said if it will request such aid, which would come with tough fiscal conditions. It is unclear how quickly and willingly governments such as Germany, where public opinion opposes helping Greece, would approve disbursement of the money.

But the Reuters calculations suggest the aid package, if obtained, could bring Greece's borrowing costs down far enough to help it come very close to meeting public debt targets in the economic plan which it has agreed with the European Union.

The plan sees the ratio of debt to gross domestic product, which was 113.4 percent last year, surging to 120.4 percent this year but rising only marginally to 120.6 percent next year, and then falling to 117.7 percent in 2012 and 113.4 percent in 2013.

BORROWING COSTS

Before the aid package was announced, soaring borrowing costs were a major threat to Greece -- its three-year government bond yield hit 7.6 percent last week, far above debt service interest rates of below 5 percent assumed by the Greek plan for the next four years.

But if Greece can borrow at 5.0 percent from the aid package, its outlook improves greatly.

Plugging that number into the model, and using growth, inflation and budget assumptions in the Greek plan, produces debt-to-GDP ratios of 120.7 percent this year, 121.1 percent next year, 118.7 percent in 2012, and 114.7 percent in 2013.

That result would only be slightly worse than the debt reduction course envisaged by Greece's plan, and would not change the year in which the debt ratio began to fall: 2012.

Greece, which has said it will need to borrow a total of about 53 billion euros this year, could probably not expect to obtain all its funding over several years from the aid package; it would likely have to borrow some money from the markets at a higher rate.

But even assuming an effective debt service interest rate of 6.0 percent, the debt ratio would still begin dropping in 2012. It would come in at 121.5 percent this year, 123.0 percent in 2011, 121.5 percent in 2012 and 118.5 percent in 2013.

BUDGET BALANCE

One big source of risk for Greece, however, is the chance of a political backlash against the government's austerity measures which could eventually block spending and revenue reforms needed to meet the plan's targets for annual budget deficits.

Analysts think the government has probably done enough to succeed in moving its primary budget balance, essentially the gap between current government spending and revenue, to minus 3.5 percent this year from minus 7.7 percent last year.

It aims for minus 0.2 percent next year, plus 2.6 percent in 2012 and plus 3.2 percent in 2013. Fresh austerity steps will be needed to reach those targets, and the model shows the debt situation deteriorates considerably if they are missed.

For example, if the primary budget balance only improves to minus 1.5 percent next year and stays at that level for the following two years, the debt-to-GDP ratio continues rising through 2013, hitting 123.6 percent in that year.

GROWTH

And the model's debt numbers start to look much worse if the austerity measures cause a deeper recession than the government is assuming.

The central bank is already predicting a 2 percent drop in real GDP this year, compared to the government's forecast of a fall of only 0.3 percent.

Former IMF chief economist Simon Johnson says it is not unreasonable to speculate that Greece's real GDP might shrink 3 percent this year, followed by falls of 7 percent in 2011 and 1 percent in 2012, before it rebounds 3 percent in 2013.

Plugging those numbers into the model, and assuming an effective debt service interest rate of 6.0 percent, Greece's debt ratio would rise much higher -- to 135.4 percent in 2012 -- and start falling one year later than planned, in 2013.

It is unclear whether the financial markets would be willing to wait that additional year for Greece's debt mountain to start shrinking -- or whether they would again panic and push up its borrowing costs, making fiscal consolidation even harder.

European governments extending emergency loans to Greece might also lose patience.

The simple model does not capture other risks for Greece. It does not show how different inputs into the debt calculation might affect each other; for example, a deep recession could hurt tax revenues more than the government assumes, preventing Athens from hitting targets for its primary budget balance.

And while Greece would pay an interest rate of about 5 percent on emergency loans in the first year of the aid package, eventual monetary tightening by the European Central Bank could make any later loans more expensive.

In the 1980s and 1990s, Sweden managed fiscal consolidations of a similar scale to the one now required for Greece, and Greece itself managed one in the 1990s before it was locked into a common currency, notes Organization for Economic Co-operation and Development economist Philip Bagnoli.

"The message that this conveys is that it is doable, but the challenge is daunting," he says.

(Editing by Andrew Torchia)