The Economist Intelligence Unit affirmed on Friday its BBB rating for Greece's sovereign risk with a negative outlook.
Greece's poor rating—two bands lower than the median of its eurozone peers—reflects structural problems in the public finances which have come to a head with the recession and global financial crisis, the EIU said.
The fiscal deficit is set to widen to almost 13% of GDP in 2009 and doubts about debt sustainability are pushing up funding costs.
The recently elected centre–left Panhellenic Socialist Movement (Pasok) government has announced measures to cut spending and raise revenue.
It has a majority in parliament and a mandate for change but it will need to show political will to push through reforms in the face of strikes and possible social unrest.
The public finances
Greece's failure to manage its public finances prudently during the boom years has left it needing to take austerity measures in an unfavourable climate.
In 2003–2007, a period when the economy was growing strongly, the fiscal deficit averaged 5% of GDP (far above the 3% ceiling established by the EU Growth and Stability Pact).
Although the public debt/GDP ratio declined by five percentage points over this period, it remained high, at 92% at the end of 2007.
As the economy slowed in 2008 and went into recession this year, the impact on the public finances has been severe.
The deficit is set to widen to €34bn (almost 13% of GDP) from €13bn (5.3% of GDP) in 2008. The primary balance, which had been in slight surplus, will swing into a deficit of around €17bn.
The public debt stock jumped from €210 (92% of GDP) in 2007 to €240bn (100% of GDP) in 2008. The public debt/GDP ratio now exceeds 110% and a further sizeable increase is likely in 2010–11 even if the government's efforts to rein in the deficit are successful.
The government responded to a sell–off of Greek government bonds in recent weeks by announcing an austerity package on 14th December.
The package is designed to cut the deficit by four percentage points to 8.7% of GDP in 2010 and to bring the deficit below the EU ceiling of 3% of GDP by 2013.
Measures include freezing public–sector salaries above €2,000 a month, a 10% cut in allowances for better–paid civil servants, and a crackdown on corruption in government procurement and tax collection.
The package has been criticised for a lack of detail, and some of the proposals to cut spending have been announced in the past, to little effect. It has been compared unfavourably with the drastic steps taken by the Irish government.
However, the government appears to realise the gravity of Greece's problems and has committed itself to making the necessary cuts across the public administration, encompassing reductions in operating costs, spending on pensions and social security and investment.
In line with its electoral pledge of income redistribution, it will try to safeguard the more vulnerable parts of society.
The government will need to meet its targets to restore Greece's credibility, which has been damaged by a tendency of successive governments to overshoot targets, understate deficits and be less than transparent in their use of data.
The previous New Democracy government had indicated as recently as September 2009 that the deficit would exceed by only €2.3bn a target of 3.7% of GDP set by the European Commission.
And just before the October elections, it had estimated that the budget deficit would reach 6% of GDP.
The extent of the fiscal hole came to light only after PASOK took office.
Financing
Despite the poor state of Greece's public finances, the government was able to raise financing on fine terms for much of the past decade.
The spread of 10-year Greek government bonds over equivalent German bunds averaged only 22 basis points in 2007.
With the onset of the crisis and an increase in risk aversion spreads started to widen, reaching 71 basis points in 2008 and 187 basis points in January-November of this year.
In December they widened further following Dubai's announcement of a debt standstill and Fitch's downgrade of Greece to BBB+.
They continued to rise following the announcement of the government's fiscal package, reaching 270 basis points.
It should be noted that if spreads stay at these levels, they imply a yield of around 5.8% on 10-year bonds, enough to maintain pressure on the government but without triggering an imminent financing crisis.
The impact of the increase in borrowing costs will take time to feed through into the public finances because the average maturity of the debt is quite long, at around seven years.
The government faces about €40bn of maturing medium- and long-term debt in 2010.
The bulk of the issuance will be in the first half of the year when maturities are bunched, particularly in April and May.
This is a challenging issuance schedule in the current climate although Greece did manage to issue €42bn in the first half of 2009 through six syndicated deals which were priced at spreads of 10-15 basis points over the secondary market.
Two days after announcing its austerity package the government sold EUR 2 bln of floating rate bonds at 2.5 percentage points over Euribor, up from 1.3 percentage points for a similar issue in May.
In addition to roll–overs, the government will need to fund its deficit and refinance Treasury bills.
It is estimated that foreign investors hold as much as three-quarters of Greek government bonds, a higher proportion than in most eurozone countries.
Greek banks hold the bulk of the remainder.
Even with the attraction of higher yields, footloose foreign investors may be unwilling to absorb new issuance and could sell some of their existing holdings to reduce risk.
Domestic banks should in principle be a more stable source of financing. However, their capacity to absorb government debt is limited by their size.
And although they do not have exposure to toxic US securitised assets and are not reliant on wholesale funding, they are facing an increase in non–performing loans in the domestic market and are taking write–downs on their exposure to markets in Eastern Europe.
Moreover, they have been buying Greek government bonds with cheap funds provided under the ECB's emergency liquidity facility.
They may need to sell some of these bonds now that the ECB is winding down the liquidity facility.
Financial assistance
Might Greece benefit from financial support from the EU or the IMF? Such a contingency is not covered in the relevant EU treaties, and the ECB has been trying to discourage moral hazard by laying the responsibility firmly with the Greek government for its finances.
However, given the damage that a default by a founder member of the eurozone would do to the euro's standing and to other member states through contagion, it's unlikely that the EU would stand by and let Greece default.
The EIU says it would expect assistance to be provided, subject to strict conditionality, possibly under the auspices of an IMF programme. Another question is whether a country could default and stay in the eurozone.
Technically this might be possible. But if a eurozone country were to default, this would suggest that it could not cope with the constraints inherent in membership of the single currency and would need a devaluation to restore competitiveness.
A lack of competitiveness is a problem for Greece. Increases in labour costs have far outstripped those in Germany over the past decade.
The loss of competitiveness is reflected in large current–account deficits, which exceeded 14% of GDP in 2007 and 2008.
In addition to measures to put the public finances on a sustainable footing, structural reforms in labour and product and service markets are needed to restore competititiveness, particularly given the current strength of the euro.
THE BOTTOM LINE
The EIU expects financing pressures to force the Pasok government to make the fiscal adjustment that its predecessors have shied away from. This will delay economic recovery and provoke strikes and possible social unrest.
But a majority of Greek society is likely to support some of the main reforms, particularly curbs on the pay and benefits of better paid civil servants.
The threat of a debt crisis will give the government a pretext for implementing unpopular measures.
That said, it is unclear whether the adjustment will be sufficient given the scale of Greece's fiscal and broader economic challenges.
The Economist Intelligence Unit will keep a negative outlook on its BBB rating until firm evidence emerges that the government is making progress in consolidating the public finances, and addressing structural weaknesses.
OVERVIEW
Greece’s rating remains at BBB, with a score of 335 and a negative outlook.
The Economist Intelligence Unit reviews the risk ratings of 100 emerging markets on a monthly basis, and 20 rich industrialised countries twice a year. Countries are assessed on a scale of 0 to 100, with 0 least risky and 100 most risky.
Economist Intelligence Unit Ltd. www.eiu.com
