Greek Marathon Isn't Over Yet

The eurozone is one big step closer to resolving its longest-running and most damaging crisis. But before anyone gets too excited, there is still a long way to go.

Greece this week finally agreed with its creditors on a package of reforms needed to unlock its next installment of bailout cash. With the economy stalling and major bond redemptions falling due in July, Athens badly needs the money.

But as things stand, it won't receive a cent until the International Monetary Fund is satisfied that there is a credible plan in place to put Greece's debt on a sustainable footing. Without this, the IMF won't lend anything to Greece -- and without the IMF on board, the German government has said it won't give Greece any more money either.

The stage is therefore set for another difficult negotiation, this time pitting the IMF against Greece's eurozone creditors led by Berlin. It could be a bruising fight.

The first argument will be over how much debt relief Greece is likely to need. That will hinge in part on what budget surpluses Greece's creditors expect it to achieve in the medium term. The bailout program currently envisages Athens delivering a primary surplus in 2018 of 3.5%, before interest costs, and maintaining this for 10 years. But no one thinks this is realistic.

The IMF would prefer a target of 1.5%: It thinks any fiscal space created as a result of the pension and tax reforms that Greece agreed to on Tuesday should be used to cut taxes, invest in training and boost capital spending, rather than repay debt.

This risks stirring up a political hornet's nest. Not only would it put Greece in breach of the eurozone's fiscal rules, which require countries to bring government debt below 60% of gross domestic product over 20 years, but it would give Greece easier surplus targets than several other euro area countries, potentially triggering other demands for debt relief or exemptions from the rules.

A second issue is what form the debt relief should take. Under the IMF's gloomy assumptions -- it believes that without further overhauls of product and labor markets, growth is unlikely to rise above 2.7% -- Greece will need far more debt relief than can be delivered by simply tinkering with grace periods and maturity extensions.

All of the alternatives are politically toxic. Eurozone governments have firmly ruled out simply writing off debt. The IMF's preferred solution is that the European Stability Mechanism -- the eurozone's bailout fund -- should fix the interest rates on its loans to Greece to lock in today's ultralow borrowing costs.

But this would saddle the ESM with heavy losses once interest rates rise. Based on market expectations of future rates, the cost of fixing the interest rate on the ESM's stock of loans to Greece at their current level of 1% would be around EUR100 billion (around $109 billion at current rates), according to a eurozone official. This would have to be borne by member states either in the form of a recapitalization of the ESM or a commitment to make up the losses via transfers of billions of euros a year from national budgets. Either would be politically explosive.

Over the next few weeks, the European creditors are sure to deploy a range of arguments to try to persuade the IMF to soften its stance.

They will try to convince the IMF to raise its growth forecasts. They will point out that Greece's borrowing costs are among the lowest in the eurozone and very little debt will fall due for decades, so there is no need to rush a decision on debt relief. They will argue that the IMF's framework for considering debt sustainability based on a time horizon of 10 years may be appropriate for developing countries but makes no sense in the context of a member of a common currency which has stable, low-cost 30-year funding and the full support of its partners.

Above all, creditors will appeal to the IMF to be pragmatic. They will point out that the ESM has already signaled its willingness to buy out all the IMF's existing loans to Greece, as part of a package of measures to lower Greece's borrowing costs. All that the eurozone is asking is that the IMF help it out of a political hole by providing a token loan to Greece of a few billion euros for the duration of the current ESM program, which expires in little more than a year's time. After that, say EU officials, the IMF need never participate in a eurozone bailout again.

Yet the IMF may prove as stubborn over debt relief as it was over Greece's reforms. It knows that its credibility has been badly damaged by its participation in two failed Greek programs. Relaxing its debt sustainability criteria also risks further damaging its credibility in the markets, particularly among investors who typically see an IMF program as a source of reassurance.

Unless the IMF and the European creditors can find a way to fudge their differences, the eurozone may soon be forced to make an unpalatable choice. Nobody wants another Greek crisis. But to avoid one, German leaders may yet have to agree to the IMF's demands on debt relief, or renege on their promise to lawmakers and proceed with the Greek bailout without the IMF after all. That isn't a situation Berlin wanted to find itself in just months before an election.

Write to Simon Nixon at simon.nixon@wsj.com

(END) Dow Jones Newswires

May 03, 2017 15:56 ET (19:56 GMT)