Eurozone

Ernst & Young Eurozone Forecast

Summer edition June 2011

Austria Belgium Cyprus Estonia Finland France Germany Greece Ireland Italy Luxembourg Malta Netherlands Portugal Slovakia Slovenia Spain

Ernst & Young Eurozone Forecast Summer edition June 2011

Outlook for Greece

17 Eurozone countries

Finland

Estonia

Ireland Netherlands Belgium Germany Luxembourg Slovakia Austria France Italy Slovenia

Spain Portugal Greece

Malta Cyprus

Published in collaboration with

Highlights
The fiscal crisis has escalated, raising the likelihood of a default

The last few months have seen an escalation in the fiscal crisis facing Greece, with growing concerns about the possibility of a debt restructuring. Greek bond prices have dropped sharply, with short-maturity paper now yielding as much as 25%, signalling that investors place a high probability on a restructuring of Greek debt in the near future. While Greece has funds in place from the EU and International Monetary Fund (IMF) to cover its needs in 2011, it faces a financing gap in 2012 unless it can regain access to financial markets. At present, this appears unlikely at anything other than prohibitive costs. As a result, it seems almost certain that Greece will receive a new loan from the EU and IMF in exchange for the privatization of government assets. This will buy Greece some time but, unless the official sector absorbs all Greeces maturing debt in the years ahead, the country will still have to regain market confidence and access to private finance at some point. Another possibility that has been discussed is a soft restructuring or reprofiling in which the maturity of the government debt held by the private sector is extended. An extension of the maturity of Greeces debt would reduce its funding requirements after its

bailout loans expire, easing its liquidity problems. Such an approach might also shield foreign creditors against having to book large losses. However, unless such a deal were wholly voluntary, it could still legally be considered a default, which could have severe implications on the borrowing costs facing the Government. This is one main reason why the European Central Bank (ECB) is opposed to this proposal. A significant problem with these options is that they would leave the Government with a very high stock of debt likely to rise above 170% of GDP by 2013. These debt levels imply a massive ongoing burden of interest payments, which means that the Government will have to run large primary budget surpluses for many years if it is to bring debt down. The fiscal measures under way have already come at a large cost to the economy in terms of output and employment. For this reason, the austerity measures in Greece have grown increasingly unpopular, with numerous strikes against the austerity measures. The latest package of austerity measures faced strong opposition before being finally adopted in early June. The growing unpopularity and social costs of austerity may make it difficult for the Government to stick to the very tough conditions contained in the EU/IMF program.

The final option for the Government involves a write-down on the principal of Greek debt perhaps as much as 40%50% to bring Greeces debt to a manageable level. This would inevitably have damaging consequences for the economy, particularly if the restructuring were badly managed. The banking sector would be forced to make large write-downs on government debt. In addition, this would probably rule out the possibility of regaining capital market access for some time, implying the need either to get more official finance or rapidly close its budget deficit. No option provides an ideal and risk-free solution. However, we believe that if a restructuring were managed properly, with investors perhaps offered a menu of options in a market-oriented debt exchange, some of these effects could be mitigated. Whichever route is finally taken, the outlook for the real economy in the near term remains bleak.

Ernst & Young Eurozone Forecast Summer edition June 2011 | Greece

The fiscal crisis has escalated, raising the likelihood of a default

Investors have grown more nervous about Greek debt

The last few months have seen an escalation in the fiscal crisis facing Greece. On 18 April, the Greek newspaper Eleftherotypia reported that the Government had told the EU and the IMF that it wants to restructure its debt, although Greek and EU officials have vehemently denied this. This followed reports from German officials that a restructuring may be considered. With the possibility of losses on holdings of Greek sovereign debt greatly increased, markets have pushed bond prices down even further spreads on Greek 10-year government bonds over German Bunds have soared above 12%, higher than the pre-bailout level. Meanwhile, the yield on two-year government bonds has risen to 25%, signaling that investors place a high probability on a restructuring of debt in the near future. Currently, credit default swaps (CDS) spreads imply more than a 70% risk of default on Greek debt over the next five years.

as Greece faces a possible financing gap next year

Investors have grown increasingly concerned that Greece faces a possible large financing gap next year. It has already received about 50 billion of bailout loans, and further disbursements of these would cover the countrys financing needs for this year. However, planned disbursements for 2012 do not fully cover maturing debt and the projected budget deficit, leaving Greece needing to regain access to capital market financing. At present, this looks unlikely at anything other than a prohibitive cost. A variety of measures are being discussed to deal with this issue. Probably the least damaging short-term solution would be for Greece to receive a fresh bailout from the EU and IMF which now seems all but certain. At the time of writing, the exact amount of the new bailout was not known with sources pointing to sums between 50 billion and 170 billion. Any new bailout will be negotiated against a new program of privatizations.

However, this solution is not without its problems. Such a deal might buy some time, but unless the official lenders were willing essentially to absorb all maturing debt onto their own balance sheets in the years ahead, Greece would still need to restore capital market access at some point, so the refinancing risk would remain. Taking on all the debt held currently by the private sector, while financing Greeces budget deficit, could require additional official finance of as much as 200 billion over the coming years, for which the political appetite might not exist. Moreover, it could create huge problems of moral hazard, perhaps prompting other troubled Eurozone countries to seek the same deal at potentially huge additional cost. This is why a number of EU governments are pushing for a soft restructuring or reprofiling in which the maturity of government debt held by the private sector is extended. From 201315, the Central Government faces a refinancing hump of

Table 1

Greece (annual percentage changes unless specified)

2010 GDP Private consumption Fixed investment Stockbuilding (% of GDP) Government consumption Exports of goods and services Imports of goods and services Consumer prices Unemployment rate (level) Current account balance (% of GDP) Government budget (% of GDP) Government debt (% of GDP) ECB main refinancing rate (%) Euro effective exchange rate (1995 = 100) Exchange rate ($ per ) -4.4 -4.6 -16.5 0.5 -8.3 3.8 -4.8 4.7 12.6 -10.4 -10.5 142.8 1.0 120.7 1.33 2011 -4.8 -4.5 -12.9 -0.8 -15.4 -1.1 -16.5 2.8 15.4 -9.1 -8.0 159.2 1.3 122.4 1.42 2012 -1.2 -2.8 -4.4 0.2 -11.1 3.4 -5.8 0.7 15.9 -8.1 -7.1 168.3 2.3 121.8 1.38 2013 1.7 0.3 3.4 0.7 -2.5 5.8 1.9 1.0 15.9 -6.2 -5.1 168.6 3.1 119.5 1.33

Source: Oxford Economics 2014 1.9 0.9 6.0 0.7 -0.1 6.0 4.0 1.2 15.5 -5.1 -3.8 166.4 3.5 115.2 1.27 2015 1.9 1.4 5.3 0.7 0.5 5.5 5.3 1.7 14.9 -4.7 -3.6 164.0 3.9 113.3 1.24

Ernst & Young Eurozone Forecast Summer edition June 2011 | Greece

112 billion, roughly one-third of its total debt stock. An extension on the maturity of Greeces debt would reduce its funding requirements after its bailout loans expire, easing its liquidity problems. This option would also have the potential advantage that some investors who currently hold Greek debt at par (rather than marking to market) might, under international accounting rules, still be able to do so, reducing the risk of financial contagion. However, unless a deal to extend debt maturities were wholly voluntary, it could still be termed a distressed exchange by the rating agencies and would thus legally be a default. This would still risk financial and reputational damage to Greece as a sovereign.

The Government faces a growing debt burden

Another problem with both of these options is that they fail to reduce the Governments substantial debt stock. Greek public debt rose to 142.8% of GDP in 2010, considerably higher than any other Eurozone country (Italys debt-to-GDP ratio, the second highest, is 119%). Moreover, this ratio is set to worsen over the next few years, settling at around 170% in 2013. These debt levels imply a massive ongoing burden of interest payments, which means that the Government will have to run primary budget surpluses for many years if it is to bring debt down the IMF estimates that there will have to be an annual primary surplus of 6% of GDP through to 2020 just to bring the debt level back down to 130% of GDP. In addition, these projections require the economy to return to growth and regain capital market access on reasonable terms, leaving considerable scope for slippage.

Already, Greece has slipped on the targets set out under its austerity program. In 2010, its budget deficit was 10.5% of GDP, higher than its upwardly revised target of 9.4%. In addition, early budgetary data from 2011 suggests further fiscal slippages. From January to April, the Central Government deficit was 13.5% higher than its level a year earlier, largely the result of a 9.2% decline in revenues. This suggests that additional fiscal measures will be needed this year for the Government to hit its deficit target of 7.5% of GDP. On 8 June, the cabinet approved a four-year austerity package, after long negotiations, an essential condition to receiving a new bailout. New measures for 2011 include a further clampdown on tax evasion and cuts to public sector spending and wages. It also hopes that privatization measures will bring in an additional 50 billion in revenue by 2015 and will reduce annual interest expenditures by 3 billion. However, we think that this target will be difficult to meet, given the continued revenue shortfalls facing the government. But the recession has already come at a large cost to the economy in terms of output and employment. GDP in 2010 contracted by 4.4%, a larger decline than the 4% fall that had initially been projected. Meanwhile, the unemployment rate in December rose to 14.1% under the EU harmonized measure, some 3.9 percentage points (ppts) higher than a year earlier. Quarterly GDP growth in Q1 2011 was unexpectedly positive, although only slightly at 0.2%. Moreover, this follows a downward revision to growth in Q4, and we think this expansion in GDP is unlikely to be sustained. Both the Government and the IMF forecast that GDP will fall by 3% this year, although this assumes that GDP will start growing in the second half of the year, a hypothesis that we see as highly unlikely. Assuming that the Government sticks with its latest program of fiscal austerity, we see GDP falling by nearly 5% this year, with significant declines in all components of domestic demand.
Figure 2

Figure 1

Yield curve
% points 6 4 2 10-year yields minus 2-year yields

Ministry of Finance deficit projections

% of GDP 10

Primary budget balance

0 0 -2 -4 -6 -8 -10 Jan-08 -15 -5

-10 Overall budget balance

-20 Jul-08 Jan-09 Jul-09 Jan-10 Jul-10 Jan-11 2009 2010 2011 2012 2013 2014 2015

Source: Oxford Economics; Haver Analytics

Source: Greek Ministry of Finance

Ernst & Young Eurozone Forecast Summer edition June 2011 | Greece

The fiscal crisis has escalated, raising the likelihood of a default

With the economy deep in recession, the austerity measures have grown increasingly unpopular, which may make it difficult for the Government to implement new fiscal measures. In addition, the fall in output has made it difficult for it to increase its revenue intake. These factors may make it politically difficult for the Government to run primary surpluses for several years. However, we believe that if a default were managed properly, some of these effects could be mitigated. One possible approach would be for the Greek authorities to offer investors a menu of choices in a marketoriented debt exchange, with new bonds offered for old along the lines of the Brady Plan. Mark-to-market investors might accept new bonds with a discounted face value, given that Greek debt is already trading far below face value. Investors holding bonds at face value, and who have not yet booked any losses, could be offered a deal based on new bonds with the same face value but much longer maturities and possibly a slight reduction in coupons. This would still give significant debt relief but, by allowing this group of investors (who are believed to hold the bulk of Greek debt) to avoid posting heavy losses, it might avoid some of the worst of the contagion risks, especially if it were combined with continued financial support from the EU and IMF. There are recent precedents, such as Uruguays debt exchange of 2003, which have also allowed sovereigns to regain access to capital markets surprisingly rapidly. However, such a plan has its drawbacks. Although it provides a plausible solution for reducing Greeces debt burden, it does not guarantee that the Government will retain access to capital markets. Furthermore, investors that hold debt at face value may be unwilling to sell their holdings of Greek Government debt at a haircut, which would make such a plan ineffective, Still, in our view, this approach would soften the losses from a Greek debt restructuring, while not eliminating them entirely. A simulation of a managed debt exchange by Greece on the Oxford Global Model featuring contained international financial contagion still sees Greek GDP shrinking by 6% in 2012 and remaining 8% below our baseline forecast in 2015. However, the knock-on effects on the wider world are less severe, with the Eurozone and other major economies avoiding the recession that could come from a disorderly default.

which may require a cut in the a principal being repaid to bring back down

The final option for the Government involves a write-down on the principal of its debt perhaps as much as 40%50% to bring its debt stock to a manageable level. Inevitably, this will be extremely damaging to the economy. A poorly managed restructuring would be particularly disastrous. Of particular concern is the impact on the banking sector. In February, Greek banks had claims on 48 billion of government securities and had provided an additional 13 billion of loans to the Government, roughly equal to 12% of their total assets. A haircut on Greek debt of 40%50% would therefore knock off 5%6% of total assets, which would effectively wipe out equity in many banks, making them unable to lend in domestic markets. In addition, a large write-down on Greek debt would probably rule out the possibility of regaining capital market access for some time, implying the need either to get more official finance or rapidly close its budget deficit. In the latter case, this could lead to an even deeper near-term recession. There would also be adverse effects on consumer and business confidence, with knock-on impacts on the real economy. Simulations run on the Oxford Global Model, assuming a 60% haircut on Greek debt, suggest that GDP would fall sharply, by 7.5% in 2012, with the recession lasting for another three years. The level of GDP in 2015 would be more than 12% below that in our central forecast. A disorderly default would also risk major international financial contagion, causing sharp falls in the value of stocks and other financial assets and possibly triggering a chain of further defaults.
Figure 3

Figure 4

Contributions to GDP growth

% year 8 6 4 2 0 -2 -4 -6 -8 -10 1990 1993 1996 1999 2002 2005 2008 2011 2014 Net exports GDP Domestic demand Forecast

GDP
% year 8 6 4 2 0 -2 -4 -6 -8 -10 -12 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 Eurozone debt crisis Forecast Baseline Managed Greek default

Source: Oxford Economics

Source: Oxford Economics

Ernst & Young Eurozone Forecast Summer edition June 2011 | Greece

Follow the Eurozones progress online

Please visit www.ey.com/eurozone to:
View video footage of macroeconomists and Ernst & Young professionals discussing the future of the Eurozone and its impact on businesses Use our dynamic Eurochart to compare country data over a five-year period Download and print the Ernst & Young Eurozone Forecast and forecasts for the 17 member states

Or follow our ongoing commentary on Twitter at http://twitter.com/EYnews

Ernst & Young Eurozone Forecast Summer edition June 2011 | Greece

Ernst & Young Assurance | Tax | Transactions | Advisory

About Ernst & Young Ernst & Young is a global leader in assurance, tax, transaction and advisory services. Worldwide, our 141,000 people are united by our shared values and an unwavering commitment to quality. We make a difference by helping our people, our clients and our wider communities achieve their potential. Ernst & Young refers to the global organization of member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients. For more information about our organization, please visit www.ey.com About Oxford Economics Oxford Economics was founded in 1981 to provide independent forecasting and analysis tailored to the needs of economists and planners in government and business. It is now one of the worlds leading providers of economic analysis, advice and models, with over 300 clients including international organizations, government departments and central banks around the world, and a large number of multinational blue-chip companies across the whole industrial spectrum. Oxford Economics commands a high degree of professional and technical expertise, both in its own staff of over 70 professionals based in Oxford, London, Belfast, Paris, the UAE, Singapore, New York and Philadelphia, and through its close links with Oxford University and a range of partner institutions in Europe and the US. Oxford Economics services include forecasting for 190 countries, 85 sectors, and over 2,500 cities sub-regions in Europe and Asia; economic impact assessments; policy analysis; and work on the economics of energy and sustainability.
The forecasts presented in this report are based on information obtained from public sources that we consider to be reliable but we assume no liability for their completeness or accuracy. The analysis presented in this report is for information purposes only and Oxford Economics does not warrant that its forecasts, projections, advice and/or recommendations will be accurate or achievable. Oxford Economics will not be liable for the contents of any of the foregoing or for the reliance by readers on any of the foregoing.

2011 EYGM Limited. All Rights Reserved. EYG No. AU0875 In line with Ernst & Youngs commitment to minimize its impact on the environment, this document has been printed on paper with a high recycled content.
This publication contains information in summary form and is therefore intended for general guidance only. It is not intended to be a substitute for detailed research or the exercise of professional judgment. Neither EYGM Limited nor any other member of the global Ernst & Young organization can accept any responsibility for loss occasioned to any person acting or refraining from action as a result of any material in this publication. On any specific matter, reference should be made to the appropriate advisor. The views of third parties set out in this publication are not necessarily the views of the global Ernst & Young organization or its member firms. Moreover, they should be seen in the context of the time they were made.

EMEIA MAS 132.0611