Greece debt relief. Gap too large to be filled? Where we are. Economics 17 May Fabio Balboni

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1 Gap too large to be filled? Next week the Eurogroup will meet again to try and reach a deal on the first programme review. The Greek parliament is set to pass the remaining reforms this week, which could be sufficient to unlock between EUR9 and EUR12bn of funds. The main uncertainty seems to be related to whether the IMF will be able to re-join the Greek bailout programme. The stumbling block remains debt relief. The last Eurogroup on 9 May put on the table three-staged debt relief which does not seem to satisfy the IMF's requests (and which, in our view, will also do very little to help restore investor confidence). The eurozone might therefore have to go ahead without the active participation of the IMF to the programme, at least for now. Timeline of key Greek events until July Date Event 22 May Greek parliament to pass second batch of reforms 23 May Euro Working Group meeting (to discuss further debt relief measures) 24 May Eurogroup meeting 7 June Repayment of EUR0.3bn to the IMF 16 June Eurogroup meeting 14 July Repayment of EUR0.5bn to the IMF 20 July EUR2.3bn bond redemption and EUR0.7bn interest payment (owned by the ECB) Source: HSBC, European Commission, Bloomberg, IMF, Ekathimerini Where we are The Eurogroup on 9 May moved one step closer to a deal on the first review of the Greek programme. This was the deal that was agreed last summer and was supposed to have been completed last Autumn. As we highlighted in our previous update (Greece: close to a deal, but not there yet, 22 April 2016) the main stumbling blocks were the requests by the IMF that Greece agreed EUR3.6bn (2% of GDP) of contingent fiscal measures in case it missed its fiscal targets (a primary surplus of 3.5% of GDP by 2018), and the eurozone to agree debt relief upfront (even if it could then be implemented over time). Fabio Balboni European Economist HSBC Bank plc fabio.balboni@hsbc.com View HSBC Global Research at: Issuer of report HSBC Bank plc Disclosures & Disclaimer This report must be read with the disclosures and the analyst certifications in the Disclosure appendix, and with the Disclaimer, which forms part of it In this document HSBC may comment on the potential economic impact dependent on the outcome of the UK Referendum. HSBC is not taking a political position and this document and the information contained herein are not intended to promote or procure, or otherwise be in connection with promoting or procuring, a particular outcome in relation to the question asked in the UK Referendum. 4 The Eurogroup accepted the request by the Greek government that the 2% of GDP contingent measures should not be specified in detail upfront (as the IMF wanted) but that they will still be triggered automatically if there are fiscal slippages, and such mechanism should also be passed through parliament in the coming days. 4 On debt relief, the Eurogroup put forward a proposal (to be further specified by the Euro Working Group in the coming days) for a three-staged approach: (i) a short-term element which is essentially about liability management (issue more short-term to reduce funding costs, etc.), (ii) a medium-term element that will come into play by the end of the programme and provided Greece has complied with all the programme requirements (this could include longer maturities and grace periods to smoothen the repayment profile, early repayments to the IMF, redistribution of profits from the ECB's Greek bond holdings, etc.) and finally (iii) a long-term element of possible additional measures that might also be considered, if needed, at the end of the programme.

2 The Eurogroup is meeting again next week, on 24 May. Ahead of the meeting, On Sunday 22 May the Greek parliament is set to pass the additional EUR1.8bn (1% of GDP) of fiscal measures to complement the EUR3.6bn approved on 8 May, and the automatic spending cuts. The Greek press reports that some of the details of the mechanism still have to be agreed with the IMF, but overall it seems that Greece should have met all the requirements ahead of the next Eurogroup. This should be enough for the Eurogroup to unlock a disbursement by the ESM of between EUR9 and EUR12bn, of which EUR5.7bn for debt servicing (Ekathimerini, 16 May 2016). Enough debt relief for the IMF? The head of the Eurogroup Jeroen Dijsselbloem said after the 9th May meeting that having the IMF on board was a necessity not only for Germany, but for several other eurozone countries. But it remains to be seen whether the debt relief proposal put forward by the Eurogroup last week will be enough for the IMF to be back on board with the Greek programme (the IMF hasn't made a disbursement to Greece since September 2014, and the second IMF programme officially expired in March this year so a new programme would have to be agreed). In the Eurogroup on 22 April, the IMF backed down slightly in terms of debt relief requests, but the Eurogroup might have gone one step too far, effectively not putting forward any debt relief before 2018, or early 2019 (and it might even be later, as debt and interest repayments are manageable until 2022). Indeed, according to the Greek press, a European official said that differences between the European Commission and the IMF on debt relief are "huge" (Ekathimerini, 15 May 2016). Ekathimerini also reported that the IMF s European director, Poul Thomsen "insisted that the measures should apply immediately and over the course of the Greek program, which runs until 2018" rather than at the end of the programme as the Eurogroup suggested on 9 May. The International Monetary Fund is pressing the eurozone to let Greece skip paying interest or principal on bailout loans until 2040, say officials familiar with the talks. According to the Wall Street Journal, the IMF "is pressing the eurozone to let Greece skip paying interest or principal on bailout loans until 2040, and the loans to Greece to fall due gradually in the following decades, and as late as 2080" (17 May). At the moment Greece is due to start repaying eurozone creditors in 2022 Source: IMF, ECB, Bloomberg 2

3 So what might happen on 24 May? The European Commission Vice President Valdis Dombrovskis said that "medium- and long-term debt relief measures would not be finalised by May 24 but that a roadmap of steps to reduce Greece s repayments would be ready, with the aim of convincing the IMF to retain its role in the Greek program" (Ekathimerini, 16 May). However, if the IMF sticks to its guidelines and the eurozone does not want to provide any debt relief during the programme, the eurozone might have to go ahead without the IMF, at least for now. There could be a statement by the IMF, stressing the possibility of joining the programme later on, once there is more clarity on the headline fiscal measures (at the moment mounting public sector arrears to Greek corporations among others - EUR6.7bn in March - are blurring the picture). The German Finance Minister Wolfgang Schäuble said on 9 May that a positive statement by the IMF could be enough for Germany to give the green light to the review completion. If everything goes well on the 24 th As we argued in the past, the completion of the first review could lead to a turnaround in terms of the country's economic performance. In a nutshell: 4 It would mean fresh cash in the economy, of EUR3-6bn, allowing the government to reduce its arrears (the headline fiscal deficit is likely to deteriorate initially as a result due to higher spending, but it might also mean higher revenue; 4 Greek bonds could become eligible again as collateral in the ECB monetary policy operations. This would reduce the banks' reliance on more expensive Emergency Liquidity Assistance (ELA). Greek banks own EUR13.5bn of Greek bonds that could be used as collateral, and if some of the almost- EUR20bn extra cash in the economy also returned to the banks the reliance on ELA (some EUR65bn at the moment) could fall by even more. According to ECB sources, the ECB could discuss reintroducing the waiver allowing it to accept Greek bonds already at the June meeting (Reuters, 10 May); 4 Greek bonds could also be eligible for ECB QE. The ECB would also have to do its own DSA analysis before it started buying, but with the ESM effectively signing off the programme we think it will be unlikely the ECB would argue debt is not sustainable. According to our calculations, the ECB could buy EUR4.4bn of Greek bonds, having fallen below the 33% issuer limit last year, and EUR5.8bn after the 20 July redemption. This could also mean that, after a few months (and particularly if some banks' deposits increase), it might also be possible to remove capital controls. If all this were to take place, we remain of the view that it should be possible to see positive GDP growth from the second half of the year (GDP growth fell 0.4% on the quarter in Q1). The economy might look in better shape but we still hold little hope for Greece returning to the markets. By the end of the programme, of around EUR300bn of debt, about 80% would be in the hands of the eurozone official sector, and another EUR12bn of the IMF (assuming they do not put more cash in the programme). In those circumstances, any private bond holder of Greece's debt would know that it has more than 80% of higher credit-worthy debt holders ahead in the queue, which will not help restore Greece's market access. 3

4 By the end of the programme over 80% of the Greek debt will be in the hands of the official sector Domestic deposits have not returned to Greek banks yet Source: HSBC calculations based on Bloomberg, IMF Source: Greek Central Banks, HSBC 4

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