News that Greece has reached an agreement on 20 February with its European creditors to extend the bailout programme for four months seems to have cheered up markets. Yields on 10-year Greek government bonds have fallen by more than a percentage point in the two subsequent trading days, said QNB Group in a press release on Sunday. Meanwhile, Greek stocks jumped by almost 10% the day after Athens submitted its list of reform plans to the European Commission. The details of the deal are yet to be finalised, and further negotiations are expected to take place in the coming months. However, we expect little global spillover effects from the ongoing drama in Greece.
The first act of the story was at the start of the Greek crisis in 2009. Back then, the Greek budget deficit reached 15.6% of GDP; the primary deficit (which excludes interest payments) ran at 10.5% of GDP; and public debt was 130% of GDP and rising. Markets were getting nervous about the sustainability of Greek public finances and Greece began to find it hard to raise additional debt to meet its financing needs. The situation deteriorated until a large bailout package materialised involving the European Central Bank, the European Commission and the International Monetary Fund (IMF).
The bailout deal involved providing funds for Greece to meet its debt obligations. In return, Greece was required to restore its public finances to a more sustainable fiscal path. In particular, Greece was obliged to make sufficient savings to run down its debt. The main requirement was to turn the large Greek primary fiscal deficit into a surplus by reducing spending and increasing revenue.
The required fiscal consolidation proved very painful. The cumulative decline in Greek real GDP between 2009 and 2013 was 21.0% as Greece turned its primary deficit of 10.5% of GDP into a small surplus of 0.8%. Unemployment soared to 27.3% in 2013 and was much higher among the youth. The pain was not expected to end any time soon as Greece was required to continue its fiscal consolidation for the foreseeable future.
No wonder that after five years of depression, the Greek public decided to vote for a left wing party that promised to reverse some of the austerity measures. Greek bond yields shot up as the Syriza party won a near absolute majority in the Greek parliament following the elections on 25 January, and fears about a possible Greek exit from the Euro Area were re-ignited.
Negotiations then began between Greece and its European creditors on how to reduce the pain of adjustment while also acknowledging the need for fiscal sustainability. Things came to a head when Greece demanded running annual primary surpluses of 1.5% of GDP from 2015 instead of the currently required surpluses of 3.0% in 2015 and 4.5% of GDP from 2016 onwards. At stake was the release of EUR172bn from the bailout programme, which the Greek government needed to meet its short term obligations.
A breakthrough occurred on 20 February when Greece requested a four-month extension of the current bailout programme. This was followed by its submission of a reform list on 23 February, which has reportedly been well received by the European Commission. The terms of the agreement are yet to be finalised but the creditors seem open to "take the economic circumstances into account" when potentially setting a new primary deficit target for Greece. In return, the Greek authorities have committed to refrain from unilaterally reversing some of the measures taken by the previous administration.
The deal seems to have calmed concerns about the possibility of a Greek exit from the Euro Area. It is also likely to stop deposit outflows from Greece to the rest of the Euro Area, which were triggered by fears of an exit and denomination of Greek deposits into a new but lower exchange rate. The risk of a Greek exit is remote, but even if it happens, it poses less risks to the global economy than it did in 2012. The direct exposure of the Euro Area countries to Greece through the Eurosystem is relatively small at 3.5% of the region’s GDP. The exposure of European banks is even smaller and has fallen to about 40% of the 2012 level. While the Greek saga may continue, other items are expected to dominate the global economic agenda in the coming months, most notably the expected tightening of the US monetary policy.