BoG report: Eurogroup decision offers opportunity for inclusion of Greek bonds in ECB’s QE program
The Bank of Greece’s (BoG) first official reaction to last month’s Eurogroup agreement – debt relief measures, the country’s post-bailout supervision- came on Monday, echoing a view by creditors that the Greek debt is now sustainable in the medium term and that a normal return to the markets is guaranteed.
Moreover, the BoG report says “enhanced supervision” leaves open the possibility of maintaining a waiver and including Greek bonds in the ECB’s QE program.
The report was eagerly awaited, given that a feud between the leftist-rightist government and BoG Gov. Yannis Stournaras resurfaced last week.
The BoG report stated:
Today, in accordance with its Statute, the Bank of Greece submitted its Monetary Policy Report 2017-2018 to the Speaker of the Greek Parliament and the Cabinet.
Completion of the third programme and future challenges
The present Report on Monetary Policy is submitted by the Bank of Greece just after the successful completion of the fourth and final review of Greece’s economic adjustment programme. 20 August 2018 will mark the formal conclusion of the programme.
The sustainable return of the Greek State to the international sovereign bond markets will be the ultimate and definitive proof that the economy has overcome the crisis. Any other outcome would undermine the growth prospects and give rise to serious problems. As shown by the recent political crisis in Italy and the ensuing increase in Greek government bond yields, the Greek economy is still vulnerable, as a sharp increase in the cost of borrowing could derail both the economic recovery and debt servicing costs. Thus, in order to bolster market confidence, Greece must continue with the implementation of reforms, especially those concerning public administration and the strengthening of independent institutions.
The Eurogroup decision of 21 June 2018 can be expected to contribute significantly on both fronts, i.e. Greece’s smooth return to the markets and the continuation of the reform effort, for the following reasons:
First, it provides for enhanced post-programme surveillance and conditionality, to ensure that fiscal policy does not go off-track and that the reform effort is not abandoned. The European Institutions, together with the IMF, will monitor fiscal developments and progress with reforms and submit quarterly reports to the Eurogroup and the European Parliament. These reports will be made public, and the markets’ reaction will provide a rough indicator of actual progress or delay of reforms. Furthermore, these quarterly assessments will serve as a basis for the Eurogroup to decide on the activation of measures that are subject to conditionality, such as the return of profits on Greek bonds held by the central banks of the Eurosystem.
Second, the Eurogroup decision ensures the sustainability of Greek public debt, at least in the medium term, which will have a positive impact on the markets and boost confidence in the future of the Greek economy. Long-term sustainability, however, hinges crucially on maintaining the fiscal and reform effort over a long period, as well as on the commitment of the Eurogroup to consider further debt relief measures for the long term in the event of an unexpectedly more adverse scenario. As shown in Box V.1., Bank of Greece staff analysis suggests that an increase in interest rates of 100 basis points and a relaxation of the fiscal effort by 0.7% of GDP annually, compared with the baseline scenario, would push Greece’s borrowing needs above the debt sustainability threshold beyond 2032. The Eurogroup agreement envisages primary surpluses of 3.5% of GDP until 2022 and 2.2% of GDP on average in the period from 2023 to 2060. No other country in the world, with the possible exception of oil producing countries, has ever achieved such large primary surpluses over such a protracted period of time. This assumption therefore constitutes the greatest risk in the analysis of long-term debt sustainability. It is also a reminder that the economic policy mistakes of the distant or more recent past, which drove public debt to such high levels, will continue to burden future generations with such large primary surpluses.
More specifically, apart from the medium-term beneficial impact, public debt sustainability could also have immediate benefits, as it would enable the ECB to use its discretion to consider keeping the waiver on Greek government bonds in place, so that the latter remain eligible as collateral in Eurosystem monetary policy operations; and to allow for their inclusion in the ECB’s asset purchase programme (both in its regular duration and during the reinvestment period) on the grounds that, in essence, the prerequisites for keeping the waiver in place, i.e. enhanced surveillance and conditionality, have been included in the Eurogroup decision of 21 June 2018. In such an event, some of the benefits which – according to Bank of Greece estimates – could ensue from the establishment of a precautionary credit line, especially in terms of lower financing costs for the economy, could be ensured. The Bank of Greece had recommended the establishment of a precautionary credit line so that the waiver could be maintained and Greek government bonds could be included in the ECB’s asset purchase programme. This would lower borrowing costs for the State and banks, with the benefits passing through to the real economy. In addition, the build-up of a large buffer, which weighs heavily on public debt and on government financing costs, would be avoided.
The recovery is export-led
Economic activity returned to positive growth rates in 2017, with GDP increasing by 1.4%. The key drivers of growth were exports of goods and services and investment.
The rebound of economic activity continued for the fifth consecutive quarter. In particular, in the first quarter of 2018 real GDP rose by 0.8% quarter-on-quarter and by 2.3% year-on-year, the highest annual increase since 2008. The growth of economic activity is mainly attributed to the strong performance of exports of goods and services. Based on available hard data and leading indicators of economic activity, such as the manufacturing PMI and the economic sentiment indicator, the pace of recovery is expected to pick up in 2018.
Positive developments in public finances and in the financial sector
As regards public finances, the better-than-anticipated budgetary performance in 2017 for the third consecutive year has enhanced Greece’s credibility, in terms of its ability to honour its commitments. Nonetheless, the fact that this overperformance was mainly supported by a heavier-than-expected tax burden and by cuts in investment expenditure has had negative repercussions on economic activity.
The financial sector has seen positive developments: bank deposits of the non-financial private sector are on the rise. Since June 2015, when capital controls were introduced, total deposits with Greek banks have increased by €14.6 billion (or roughly 9%). Bank credit to non-financial corporations has stabilised. In addition, the four significant Greek banks were, for the first time since 2014, able to raise funds totalling €2,250 million from international capital markets through covered bond issues. Capital controls have been relaxed, and banks’ reliance on central bank funding has decreased significantly, with the Emergency Liquidity Assistance (ELA) ceiling having been lowered to €10.9 billion from €90 billion in July 2015. Despite these developments, financial conditions are still tight and bank lending rates are high. Also, the stock of non-performing loans remains the most important challenge for the whole banking system.
Greek government bond yields declined significantly and the yield curve has largely normalised. However, government bonds are still five notches below investment grade, while the recent turmoil in international financial markets triggered by the political uncertainty in Italy exerted upward pressure on Greek bond yields.
Economic activity is forecast to accelerate
According to Bank of Greece estimates, economic activity is expected to pick up in the medium term, with GDP growth projected at 2.0% and 2.3%, respectively, for 2018 and 2019. This outlook should be supported by business investment, exports and a slight upturn in private consumption. Employment growth is anticipated to continue, owing to the return of the economy to positive growth rates. As a result, the unemployment rate is forecast to fall below 20% in 2018.
The upward path of HICP inflation is expected to continue in 2018, albeit at slightly more moderate rates than in 2017, as the base effects from the latest increases in indirect taxation fade away.
The growth outlook is surrounded by considerable uncertainties. Among the domestic risks, delays in the implementation of reforms and privatisations, combined with excessive taxation, could slow down the recovery of the economy. The risks arising from the external environment are mainly associated with an increase in trade protectionism worldwide, geopolitical developments, but also the risk aversion of investors as a result of financial market turbulence. Finally, any deterioration in the refugee crisis and increase in migrant-refugee flows could pose downside risks to the economic outlook.
Banks’ fundamentals are improving
Greek banks posted lower losses in 2017 and returned to profitability in the first quarter of 2018, although profitability is still weak. Capital adequacy ratios remain high, funding sources have been diversified, while the reduction of non-performing exposures (NPE) continues in line with the targets set.
Bank resilience was confirmed by the results of the recent stress test exercise
In terms of capital adequacy, the Common Equity Tier 1 (CET1) ratio on a consolidated basis and the Capital Adequacy Ratio remain high (at 15.8% and 16.4%, respectively, in March 2018). In the first months of this year, as part of the 2018 EU-wide stress test exercise conducted according to European Banking Authority (EBA) methodology, the four significant Greek banks were stress tested. The purpose of the stress test was to assess bank resilience to hypothetical economic and financial shocks over the period 2018-2020, using as starting point data the figures as of 31 December 2017, adjusted for the impact of International Financial Reporting Standard 9 (IFRS 9).
Overall, on average, the Common Equity Tier 1 (CET1) ratio under the adverse scenario fell by 9 percentage points, which correspond to a decline of €15.5 billion in capital in the banking system. It should be noted that the exercise did not entail any pass-fail threshold. Rather, the results for each bank will be used as input in the Supervisory Review and Evaluation Process (SREP) by the Single Supervisory Mechanism (SSM), based on which the supervisor may ask the bank to hold additional capital and/or set qualitative requirements (usually referred to as “Pillar II”). However, the exercise identified no capital shortfall.
Non-performing exposures are gradually declining
Greek banks made progress with the major challenge they continue to face, i.e. non-performing exposures (NPEs), as they managed to reduce the stock of NPEs by roughly 10% in the course of 2017. NPEs at end-2017 amounted to €94.4 billion, about €11 billion less than at end-2016 (with banks overshooting their NPE reduction targets by about €1.6 billion). NPE reduction during 2017 was driven mainly by loan write-offs (€6.5 billion) and loan sales (€3.6 billion).
According to March 2018 data, the stock of NPEs was further reduced by 2.1% relative to end-December 2017, to €92.4 billion or 48.5% of total exposures. The reduction in the first quarter of 2018 mainly reflected loan write-offs, amounting to €1.7 billion. The performance in collections, liquidations and sales was slightly worse compared to the previous quarter. An improved picture is expected in the future, as banks have already announced and in some cases proceeded to sales of loans.
The provision coverage ratio for the banking system as a whole has significantly increased, to 49.0% in March 2018 from 46.2% in December 2017. Including the value of collaterals (reported up to the gross value of the loan), NPEs coverage exceeds 100%. The increase in provision coverage was mainly achieved through the setting aside of new provisions, in the context of the introduction of International Financial Reporting Standard 9 (IFRS 9).
In September 2017, Greek banks submitted their revised targets for NPE reduction. The NPE volume target at end-2019 is set at €64.6 billion (down from an initial target of €66.4 billion). This improvement is expected to be driven by an acceleration of loan sales, particularly in the business portfolio, and to a lesser extent in the consumer portfolio, and also by increased write-offs, mainly in the retail portfolio. Despite the anticipated decrease in the stock of NPLs, the NPE ratio is expected to increase to 35.2% by end-2019 (compared with an initial target of 33.9%), reflecting a downward revision of estimates for credit expansion and higher volumes of loan write-offs and sales. This points to a need to overachieve the present NPE reduction targets and to step up efforts to improve bank asset quality.
Challenges and requirements for a transition to a sustainable extrovert growth model
Over the past eight years, Greece has implemented three economic adjustment programmes, which eliminated the twin deficits (fiscal and external) and at the same time significantly improved the competitiveness and extroversion of the Greek economy. Despite the progress made so far, the Greek economy still faces major challenges that will need to be addressed in the medium term, such as high public debt, the large stock of non-performing loans, high unemployment, low structural competitiveness and the collapse of investment. Addressing these challenges will determine future growth prospects. To this end, economic policy must focus on the following:
• A more growth-friendly fiscal policy mix. The excessive reliance of fiscal adjustment on high tax rates acts as a disincentive to both work and invest, while also encouraging informal economic activity and tax evasion.
• Improvement of structural competitiveness. This requires opening up the goods and services markets, closed professions and energy transfer networks. The “knowledge triangle” (education, research, innovation) must also be enhanced, through policies and reforms that promote research, facilitate the diffusion of technology and encourage entrepreneurship. Meanwhile, it is crucial to improve the quality and strengthen the independence of institutions, in order to boost investor confidence and support long-term growth.
• Drastic reduction of the high stock of non-performing loans (NPLs), by overachieving the present targets for NPE reduction. The State, the banks and the supervisory authorities will need to carefully assess the blueprint provided by the European Commission on how to set up national Asset Management Companies (ASCs) and how these can contribute to a drastic NPE reduction.
• An aggressive policy for attracting strategic foreign direct investment. If the country is to attract foreign direct investment, priority must be given to eliminating major disincentives, such as red tape, an unclear and shifting legislative and regulatory framework, an unpredictable tax system, weaknesses in property rights protection, contract enforcement and dispute resolution, and capital controls.
• Addressing the social and economic impact of high unemployment. Support must be provided to the long-term unemployed, through employment and training programmes and targeted social transfers.
After several years of recession and stagnation, the Greek economy returned to positive growth in 2017. Progress with the implementation of the adjustment programme improved the credibility of economic policy and bolstered confidence, led to a gradual return of deposits, a relaxation of capital controls, a decrease in banks’ reliance on emergency liquidity assistance from the central bank and a decline in Greek government bond yields. The resilience of banks was confirmed by the results of the recent stress test exercise. The economy continued to grow in the first quarter of 2018, driven mainly by increasing exports. For 2018 as a whole, a pick-up in economic growth as well as the achievement of fiscal targets can be expected.
Based on the above developments, it is reasonable to anticipate that economic growth will accelerate in the period ahead. For this to happen, the following conditions must be in place:
1st Assurance, after the end of the programme, that economic policy will remain committed to reform and avoid any backslide to past practices that brought on the crisis. This calls for steadfast political will and a marked improvement in the operation of the public institutions in charge of carrying out the implementation of reforms.
2nd A return of the Greek State to financial markets on sustainable terms. Decisive steps in this direction are the Eurogroup decisions of 21 June 2018 on the restructuring of Greek debt and the build-up of a sizeable cash buffer, as well as the commitment to further debt relief measures in the case of an unexpectedly more adverse scenario.
3rd Given that the Eurogroup decisions are linked to enhanced surveillance and conditionality (as would be the case with a precautionary credit line) and, moreover, ensure public debt sustainability, they would enable the ECB to use its discretion to consider keeping the waiver on Greek bonds in place, so that the latter remain eligible as collateral in Eurosystem monetary policy operations. At the same time, they would enable the ECB to use its discretion to allow the inclusion of Greek government bonds in its asset purchase programme (both in its regular duration and during the reinvestment period).
The waiver, if kept in place, maintaining the eligibility of Greek government bonds as collateral for Eurosystem monetary policy operations, would lower the cost at which Greek banks receive financing from the ECB, but also through market-based financing (repos). At the same time, the participation of Greek government bonds in the ECB’s quantitative easing programme would lower borrowing costs for the Greek government. Lower borrowing costs for the government and banks would have a multiplier effect on the economy, as they would be passed on to businesses and households. This in turn could reasonably be expected to lead to a recovery of bank credit to the private non-financial sector and speed up economic growth.
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