Greece is likely to need far more financial aid than seems to be on offer

IN FEBRUARY European Union leaders vowed to take “determined and co-ordinated action” to protect Greece against a sovereign-debt default and to stop its troubles infecting the rest of the euro area. Weeks later the same politicians are still discussing how precisely to meet that pledge (see article).

The need for clarity is now more urgent. Greece has to refinance some €20 billion ($27 billion) of debts that mature in April and May. The yields on ten-year Greek government bonds rose to 6.3% this week, a spread of some three percentage points over German Bunds. The euro fell to its lowest level against the dollar for ten months after Portugal, another troubled euro-zone country, suffered a downgrade.

A standby fund for Greece of €25 billion is rumoured, and euro-zone ministers now seem less frosty at the thought of help from the IMF. That may be enough to calm markets and enable Greece to roll over its debts. But it will be only a temporary fix. It will take years to repair Greece's public finances, which means a much larger rescue fund will be needed if it is to avoid default.

The Greek government has somehow to keep its economy on an even keel while pushing through a huge fiscal tightening. Countries that seek IMF help generally have to endure brutal cuts in public spending, which deepen recessions. To counter that effect, the IMF typically counsels a weaker currency. Sadly, this is not an option for Greece. Stuck in the euro, its exchange rate with its main trading partners is fixed. Greece cannot devalue, so it needs more time to adjust than the three years it has agreed with its EU partners—and a bigger safety net while it does.

Just how big? Analysis by The Economist suggests a figure of €75 billion rather than €25 billion. Greece is likely to need five years to get its deficit down below 3% of GDP (see table). On our projections interest payments will rise from 5% of GDP to 8.4% in that time, to reflect the higher cost of issuing new debts and of refinancing old ones. Other budgetary cuts will be needed to offset this. By our reckoning the Greek government will have to increase the “primary” budget balance (ie, excluding interest payments) by 13.5 percentage points of GDP to cap its debt burden. That is bound to have an effect on growth. Our projections assume that nominal GDP will be 5% lower by 2014.

This is necessarily a stylised analysis, which requires some brave assumptions (some of which may even be too kind). The estimate of how big a bail-out Greece may need hinges on a particularly heroic one: that private investors have had their fill of Greek bonds but would still roll over existing debts if a bail-out fund covered the country's new borrowing. Our projections imply that Greece will run-up an extra €75 billion of debt by 2014, by which time its debt will stabilise at 153% of GDP. This figure is a rough guide to how much financial aid Greece may require.

That may be too much even for the newly flush IMF. For its share of Latvia's rescue, says Laurence Boone of Barclays Capital, the fund stretched to 12 times the country's “quota”, the amount a member country contributes to the fund's coffers. A €75 billion package would require the IMF to provide around 40 times Greece's quota if the costs were split with the EU.

Optimists say that demand for Greek bonds will revive as its budget deficit falls and confidence returns. There is no theory that says investors will tolerate debts of 113% of GDP (Greece's ratio in 2009) but balk at anything higher. Japan's gross public debt is almost 200% of its GDP with as yet few signs of revulsion. But Japan is the only sovereign issuer of yen bonds, while Greece is the least creditworthy of the many countries offering euro bonds. Japan is a creditor nation that can rely on domestic savers. Greece is a deficit country that depends on “footloose” investors, says Thomas Mayer of Deutsche Bank.

Greek bonds are attractive because of their generous yields. If the interest-rate spread stays close to 3%, a buyer of a ten-year German bond who holds it until it matures would make only three-quarters of the return he could make on a similar Greek bond. For bold investors, such a gap is ample insurance against the risk that Greece may not able to pay back all it has promised. Others think the reward may not be worth the gamble. A debt restructuring, where bondholders are forced to swallow losses, is a “substantial risk” if recession in Greece drags on, says Marco Annunziata of UniCredit. Its would-be rescuers may conclude that throwing money at a weak, if profligate, country is still the cheapest way to stop trouble spreading. But the likely bill for Greece's bail-out looks larger than many are assuming.





A fuller version of the table in the article is available here.