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IIF Research Staff Note

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An IIF Staff Research Note September 22, 2011
This note, circulated today to IIF members, provides an updated analysis of the key Support Package for Greece that was agreed and announced in Brussels on July 21, 2011. The IIF’s Press Release of that date can be found at This paper responds to many questions that the IIF has received in recent weeks from investors and from the media. Accordingly, the paper details the decisions that have been taken, the exchange offer options that have been announced, the scale of adjustment made by Greece and its current efforts, the impact of the program on cash-flow and debt sustainability, and the current status and timetable.

The July 21, 2011 Support Package for Greece: Key Elements, Likely Impact and Benefits for Debt Sustainability
On July 21, 2011, the Euro Area Heads of State/Government and EU Institutions announced in Brussels a comprehensive support package for Greece. The package consists of three integral components: i) Committed financing support by the Euro Area (EA) and the IMF; ii) Voluntary private sector contribution to the package via a debt exchange and buyback program; and iii) Continued progress by Greece in implementing fiscal and structural reform programs. Official sector financing support
The official sector part of the July 21 package includes the following:

An extension of the maturity of the European Financial Stability Facility (EFSF) lending to 15-30 years, with a grace period of 10 years, and a lowering of the interest rate charge to close to the EFSF funding costs (then estimated at around 3.5 percent for 10-year maturities)—applicable to Greece and other program countries; and An increase in the flexibility and a broadening of the scope of operations of the EFSF and the European Stability Mechanism (ESM) in order to improve their effectiveness and address contagion through: 1

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precautionary programs; the financing of the recapitalization of financial institutions through loans to government including non-program countries; intervention in the secondary sovereign bond markets on the basis of ECB analysis; and A commitment to continue to provide support to countries under programs until they have regained markets access.

The EA authorities have also committed to providing the resources for Greece to acquire the AAA, zero-coupon bonds for use as collateral in the bond exchange program, estimated to be worth about €41 billion €20 billion to fund a debt buyback scheme. This and the upfront discounts resulting from the debt exchange should reduce net government debt by 12 percent of GDP when implemented, contributing to improving Greece’s debt sustainability.

Voluntary private sector involvement The process of formulating the private sector involvement (PSI), as well as its content and operational modalities are an example of applying in practice the core guidelines of the Principles for Stable Capital Flows and Fair Debt Restructuring - open dialogue, transparency, good faith negotiations, voluntary participation, and fair treatment of all private creditors. The IIF Task Force on Greece In mid-June 2011, the Eurogroup Working Group (EWG)—composed of senior officials from Euro Area countries and European institutions (headed by Vittorio Grilli, Director General of the Italian Treasury)––invited the IIF to engage in a dialogue on the appropriate form and volume of voluntary PSI. To this end, an IIF Task Force on Greece (TFG), composed of senior representatives of some 30 large private investors in Greek government bonds (GGBs), was established. The IIF Board’s endorsement of a statement on July 1 on the willingness of the IIF members to participate in discussions on a voluntary private sector involvement in support of Greece was critical in reassuring the Eurogroup and the IMF about covering Greece’s funding needs and facilitated the successful completion in early July of the fourth review of Greece’s performance by the troika (the European Commission, the ECB and the IMF). During the subsequent period to July 21, the TFG held several meetings with the EWG. The elements of a possible approach to PSI were developed and were finally agreed with key Euro Area and Greek Officials, and eventually with the Heads of the Euro Area States/Governments and EU Institutions/IMF at their meeting of July 21, following negotiations led by IIF Board Chairman Josef Ackermann.


The IIF Financing Offer The IIF Proposal (Financing Offer for Greece) reflects a willingness of a broad range of private sector investors in Greek sovereign bonds to participate in a voluntary program of debt exchange or rollover of maturing debt during the nine-year period to 2020 and a debt buyback scheme, designed to provide significant cash-flow support to Greece and at the same time make a major contribution to improving Greece’s debt sustainability. The IIF Financing Offer played a catalytic role in facilitating the July 21 agreement and forms an integral part of a comprehensive package in support of Greece announced by the Euro Area Heads of State or Government and EU Institutions on July 21, 2011 in Brussels. The new debt instruments will include credit enhancements and carry coupons that are well below the currently elevated secondary market yields on GGBs. The credit enhancements in the forms of AAA zero-coupon long-term bonds will amount to approximately €41 billion, and will be acquired by Greece and financed by the EA authorities. The four options of debt exchange The options are as follows, based on a target participation rate of 90%: 1. A Par Bond Exchange into a 30-year instrument, with the principal collateralized by a 30-year zero-coupon AAA-rated bond and coupons (based on the market rates prevailing on July 21) of 4% for years 1 to 5, 4.5% for years 6 to10 and 5% for years 11 to 30. 2. A Par Bond Offered at Par Value under a Committed Financing Facility involving the rolling over at maturity into a new 30-year Greek debt instrument, with the principal collateralized by a 30-year zero-coupon AAA-rated bond and coupons (based on the market rates prevailing on July 21) of 4% for years 1 to5, 4.5% for years 6 to10 and 5% for years 11 to 30. 3. A Discount Bond Exchange offered at 80% of par value into a new 30-year Greek debt instrument, with the principal collateralized by a 30-year zero-coupon AAA-rated bond and coupons (based on the market rates prevailing on July 21) of 6% for years 1 to5, 6.5% for years 6 to10 and 6.8% for years 11 to 30. This option will involve an up-front debt reduction for Greece. 4. A Discount Bond Exchange offered at 80% of par value into a new 15-year Greek debt instrument, with a single coupon of (based on the market rates prevailing on July 21) 5.9%. The principal will be partially collateralized with 80% of losses being covered up to a maximum of 40% of the nominal value of the new instrument. This option will also involve an up-front debt reduction for Greece.


Common NPV reduction All options have been negotiated to produce a net present value of 79% for the new instruments, based on an assumed 9% discount rate (implying a normalization of the Greek yield curve from the current elevated market levels) for the coupon payments and the prevailing market yield of the AAA-rated 30-year zero-coupon bonds (around 3.8% on July 21) for the discounting of the principal. This would give rise to a NPV reduction of 21%. It is estimated that, with an assumed 90% participation rate by private sector investors holding GGBs eligible for exchange, the PSI would amount to some €130 billion during the period from end-June 2011 to end-2020. In this context, it is important to note that many financial institutions have decided to report impairments on their holding of GGBs in their financial statements for the end of the second quarter, 2011––ranging from 21% to 38% or more. The extent of markdown depends inter alia on how the institutions had classified their holding of GGBs––Held-to-Maturity, Available-for-Sale, or Held-for-Trading. Debt Buyback These debt exchange options are to be complemented by a debt buyback scheme, which will be launched at the same time as the debt exchange with an initial financing of €20 billion committed by Euro Area countries. The objective of the buyback scheme is to take advantage of the existing large discounts on Greek sovereign bonds in the secondary market and allow Greece to lower upfront on a net basis its outstanding nominal stock of debt, thus kick-starting, along with the debt reduction options, movement toward debt sustainability. Options are being explored for possible augmentation of the resources for debt buyback operations through financing from nonEuropean governments under co-financing arrangements with the IMF. Continued efforts by Greece To address fiscal slippages in 2011 (relative to the budget deficit target of 7.6% of GDP) and their impact on the 2012 budget, the Greek government announced in midSeptember a set of additional fiscal measures with immediate effect, including:
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a reduction in the threshold for the tax-exempted annual income from €10,000 to €5,000 per year; a 20% reduction in pensions exceeding €1,200 per month; a 40% reduction in pensions for pensioners below 55; the placement of 30,000 public sector employees in non-paid reserve; and an extension of the tax on real estate announced in early September to the period to 2014.

The net revenue yield from these measures is under discussion with the Troika as part of the process of completing the fifth review of Greece’s program, with disbursement


expected in mid-October. The 2011 slippage reflected largely the sharper-than-expected contraction in real GDP, the delay in implementing the committed reduction in interest rates on Euro Area loans to Greece, a shortfall in revenue collection and delays in implementing structural fiscal reforms. Nevertheless, in a broader sense, it is important to recognize how significant Greece’s adjustment effort has been to date over the first 18 months of the program. By end-2011, Greece will have implemented on a cyclically-adjusted basis an unprecedented fiscal tightening of about 12½ percent of GDP over 2010 and 2011 (or about 7 percent of GDP on a non-adjusted basis). This degree of fiscal consolidation is in line with the May 2010 EU-IMF program. Consolidation measures implemented to date included the following: • • • • cuts in public wages averaging more than 15 percent in nominal terms, which have reduced the public wage bill by almost 2 percent of GDP since 2009; sizable reductions in operational and administrative expenses and in military procurement amounting to 1.5 percent of GDP in 2010 with further cuts of 0.6 percent of GDP targeted for 2011; moves to restructure state-owned enterprises to scale back losses, and to reduce local governments’ employment and wage costs; and reductions in broad-based social benefits, such as family allowances.

Adjustment efforts have also been supported by a variety of tax measures including: • • • successive increases in VAT and excise rates,; the imposition of new taxes on high-income households and real estate; an extraordinary tax on enterprises that were highly profitable in 2009 and 2010.

In terms of structural reform, the second-half of 2010 saw an energetic pace of activity. Perhaps the most important of these was a far-reaching pension reform that scaled back opportunities for early retirement and extended the statutory retirement age to 65 years, reducing the projected increase in pension outlays through 2060 from 12.5 percent of GDP to the EU average of 2.5 percent and thus enhancing longer-term fiscal sustainability. Also important was the merger of health insurance schemes into a single national entity and the establishment of centralized procurement for medical goods and services, reforms that facilitated reductions in healthcare costs and improved control over spending commitments Major labor market reforms were initiated as well despite delays in taking the administrative measures needed to open 141 closed professions. Reforms that were implemented included: • revised mediation and arbitration,; 5

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the granting of precedence to firm-level collective bargaining agreements over sectoral and occupational ones; the introduction of sub-minima to the national minimum wage; increased limits on the number of layoffs firms can make each month; reduced requirements for severance pay; and more flexible employment contracts.

Important steps were also made to improve the business and investment environment. These entailed: • • • • • creation of a ‘Fast Track’ legal framework to attract and expedite large-scale investments; scaling back of licensing procedures; provision of tax incentives valid for eight to ten years; deregulation of road haulage; and implementation of key parts of the EU services directive.

However, in 2011 the structural reform effort has slackened. Therefore, in order to meet performance targets, the tempo of reform seen last year needs to be revived and accelerated. Equally important is an intensified effort against tax evasion. With tax rates already above the EU average, additional increases in statutory rates would worsen tax evasion and avoidance while weakening further already fragile outlooks for private consumption and investment. Going forward, Greece needs to resolutely implement a host of additional reforms, including to further liberalize labor markets, deregulate many sectors such as tourism, retail trade, energy and others, further improve business and investment environment as well as tackling judicial reform. Overall, the approval and eventual success of the package is predicated on Greece’s ability to continue to achieve progress in reducing the budget deficit, implement structural reforms to improve the competitiveness and growth potential of the economy, including an ambitious privatization program––slated to raise €50 billion by 2015 to be part of the financing envelope. Impact of the July 21 package on cash flow and debt sustainability The voluntary private sector involvement in Greece will provide €300 billion of cash flow savings during the period to 2020.1 Discounts resulting from the debt exchange and buyback should reduce net government debt2 by €27 billion this year, or 12 percent of GDP, from what would have been the case in their absence, to €319 billion or 144 percent of GDP. 1 Compared with projections made by the IMF in early July. 2 Net government debt is defined as the gross debt of the general government net of cash reserves, bank
recapitalization funds and collateral acquired as part of the debt exchange.


At the core of the cash flow savings are €54 billion in interest savings. These result mainly from locking in much longer-term financing from private creditors at much lower interest costs than official projections have assumed. Net government debt should then decline to 122 percent of GDP by 2015 and 98 percent by 2020 as the result of a combination of interest savings, a shift to primary surplus, privatization receipts and renewed output growth. Together with debt reduction resulting from the discounted bond exchanges and debt buybacks, these interest savings should reduce net government debt to 144 percent of GDP at the end of 2011 from what would have been 156 percent of GDP without the July 21 agreements (Table 1).3

Table 1

Debt Sustainability O

3 This projection assumes that real GDP growth recovers in line with official projections after 2012

(averaging 2.2 percent a year from 2012 to 2020), the primary fiscal balance shifts to a surplus above 6 percent of GDP by 2014 and €50 billion in privatization proceeds are achieved as targeted by 2015.

General Government

PSI under the July 21 agreement will unlock substantial additional cash flow benefits for Greece, including €109 billion or more of financing from official creditors to cover deficit financing needs, and the costs of credit enhancements and potential bank recapitalization. Maturity extensions because of the bond exchanges and longer repayment periods on EU credits should combine with interest savings to lower new market borrowing needs from the €300 billion the IMF projected for 2012-2020 in early July to only about €50 billion. Maturity extensions because of the bond exchanges will also lengthen the average maturity of government debt to 11 years from about 6 years at present.

Cash flow savings and the discounted debt reduction outlined above would translate into a significantly improved outlook for debt sustainability as follows: • Some €13 billion in interest savings should accrue from 2012 through 2015, reducing the government deficit over the same period by the same amount to €32 billion. Deficits cumulating to this €32 billion from 2012 through 2015 would be financed by €45 billon of privatization proceeds over the same time frame (assuming another €5 billion are achieved as targeted during 2011). Some €13 billion of privatization proceeds would be left over to pay down debt, decreasing net government debt by the same amount to €306 billion by the end of 2015, or 122 percent of GDP. Another €42 billion of interest savings should be realized from 2016 through 2020 compared with the IMF projections published in early July. Interest payments would then be reduced to roughly equal the primary surplus from 2016 to 2020, shifting the overall government deficit to rough balance.4 With the overall balance in rough balance, net government debt would be little changed from 2015 at €307 billion to the end of 2020. Relative to GDP, net debt would decrease to 98 percent, assuming real GDP growth averaging 3 percent a year from 2016 through 2020.

• • •

Debt Sustainability Determinants In order to comprehend more fully the improvement in debt sustainability the July 21 decisions should facilitate, attention needs to be focused on these marked declines in net government debt. These decreases, made possible by both the debt discounts and interest savings, give a much clearer view of the actual burden posed by government debt than do 4 The overall balance here would include some €7 billion in “other borrowing” assumed by the IMF for the
same period, mainly reflecting outlays to pay off called guarantees of debt owed by state enterprises and other companies categorized outside the general government.


change in gross debt, which will rise this year and next because of borrowing to fund the acquisition of financial assets, including cash reserves, bank recapitalization funds and collateral acquired as part of the debt exchange. Net debt provides a better measure of the government’s actual debt burden than gross debt because it omits debt incurred to acquire assets such as these that will increase financial flexibility and resilience. For that reason, this debt is qualitatively different from that incurred to finance government deficits or to assume called debt guarantees, which decreases financial flexibility, provides no partially offsetting income and increases rather than decreases financial risks. Cash reserves and bank recapitalization funds, by contrast, should yield future income sufficient to offset at least part of the interest payments on the debt incurred to finance them. Collateral and escrow funds limit risks for holders of exchanged bonds, limiting risks going forward for the Greek government. More fundamentally, the collateral should also facilitate significant debt reduction via the discount bond exchange and the exchange of most maturing debt for new bonds maturing in 30 years. The collateral, moreover, is integral to the PSI, which, in turn, was the political key necessary to unlock lower interest costs and greatly extended maturities from Greece’s Euro Area official lenders. Net debt reduced to 122 percent in 2015 and 98 percent in 2020 will firmly place Greece on a path toward debt sustainability. Much will depend on financing needs, which the July 21 decisions should reduce by a lot for a long time. The experience of other countries, moreover, suggests that a more important measure of debt sustainability is whether the debt has been rising, stabilizing or declining and what trend looks likely in future. In this respect, the large increases in the ratio of Greek debt to GDP registered since 2008 are likely to have been a more significant driver of worries about the sustainability of Greek government debt than the currently elevated level of debt. These increases have been driven mostly by large primary deficits and by contracting GDP. Whether debt declines by 5 percent of GDP a year on average through 2020 will depend on whether the assumptions underpinning the IMF’s early July projections prove accurate: primary balances shifting to surpluses of 6 percent or more after 2014, growth recovering to 2.2 percent a year on average through 2020 and privatization proceeds amounting €50 billion by 2015. Interest savings are more certain, by comparison, at least on outstanding debt. Other countries, it should be noted, have succeeded in sustaining sizable primary budget surpluses for extended periods of time. Most prominent among those, perhaps, are Denmark and Belgium. Denmark maintained primary fiscal surpluses averaging 8.1 percent of GDP for the seven years from 1984 to 1990 and 5.9 percent of GDP for the five years from 2004 to 2008. Belgium’s primary surplus averaged 6.0 percent of GDP for the seven years from 1997 to 2003.5 5 - Denmark maintained primary fiscal surpluses averaging 8.1 percent of GDP for the seven years from
1984 to 1990 and 5.9 percent of GDP for the five years from 2004 to 2008. - Belgium’s primary surplus averaged 6.0 percent of GDP for the seven years from 1997 to 2003.


Both emerging and advanced economies, moreover, have demonstrated that large primary surpluses need not necessarily be sustained for long periods of time to restore market access and accelerate the movement toward debt sustainability. Where the emergence of sizable surpluses trigger recoveries of confidence, upturns in household and business soon follow in response to easing financial pressures and lower borrowing costs. Latin American economies participating in Brady Plan debt exchanges experienced similar, if not considerably stronger, improvements in response to debt exchanges that helped reduce debt and remove debt overhangs. Mexico, for example, saw average annual GDP growth increase by 3.4 percentage points in the 10 years following the conclusion of its Brady Plan debt restructurings compared with the preceding 10-year period. Beneficial effects should also be forthcoming in Greece, assuming the government stays the course on fiscal adjustment and continues forward with longoverdue structural reforms, including privatization. Privatization, indeed, could be key to accelerating growth if deregulation and key reforms to labor and product markets succeed in improving the business environment and spurring the new investments in tourism, transport and energy needed to accelerate potential growth. The massive reduction in financing needs should have important positive effects. Principal refinancing needs stand to be reduced by nearly €250 billion thanks to the PSI (due to the exchange of existing bonds for new ones with 30-year bullet maturities), longer maturities on EU loans (15-30 years rather than 3-5 years originally) and reduced refinancing needs later in the decade because of sharply reduced amounts of expensive new market borrowing. Current Status and Timetable At present, the official component of the July 21 package (concerning changes in the EFSF) is undergoing Parliamentary approval in the EA member countries. This process is currently expected to be concluded by end-September/early October. Regarding the PSI, Greece has sent a Letter of Inquiry to regulated financial institutions in Europe and elsewhere, via their national Finance Ministries, to gather information about GGB holdings and to gauge the interest of investors in participating in each of the four options, on a non-binding basis. Informal information meetings with investors have been organized and hosted by various European national regulators to allow the dealer/managers of the Debt Exchange to disseminate information about the Exchange and the options. Such meetings will continue to take place for the remainder of
- Bulgaria’s 6.4 percent for the eight years from 1994 to 2001. - Primary surpluses averaged 5.9 percent of GDP in Finland for the nine years from 2000 to 2008 and the same in Sweden for the seven years from 1984 to 1990. Sweden’s surplus also averaged 5.0 percent of GDP for the five years from 1997 to 2001 while Italy’s amounted to 4.9 percent over the seven years from 1995 to 2001. - Ireland ran primary surpluses averaging 5.4 percent of GDP for the five years from 1996 to 2000 while, further afield, Canada had surpluses averaging 7.0 percent of GDP for the 12 years from 1996 to 2007, and Japan had surpluses averaging 4.9 percent of GDP for the five years from 1988 to 1992.


September. So far, there has been good attendance at those meetings with encouraging indications of strong participation in the exchange. Right after the conclusion of the Parliamentary approval process, a formal Debt Exchange Offer will be launched by Greece, together with a debt buyback scheme, and will be closed after a transaction period. After the closing date, investor participation in the Exchange will be finalized and new instruments (together with the credit enhancements) will be issued to implement the Exchange.