The Executive Board of the IMF completed on January 16 the first and second review of Greece’s economic performance enabling the disbursement of the €3.24 tranche. Following Executive Board’s discussion, IMF Managing Director Christine Lagarde issued a brief statement with IMF views on recent developments and outlook noting that:

“The program is moving in the right direction, with strong fiscal adjustment and notable labor-cost competitiveness gains. While the program has been adjusted to take account of the deeper recession and implementation capacity, the strategy remains focused on restoring growth, competitiveness, and debt sustainability. Forceful structural reforms and broad-based domestic support will be needed to meet challenges, alongside long-term support from Greece’s European partners”.

On structural reforms, Ms Lagarde stressed “Greece has made progress with structural reforms, reflected in recent actions to reduce non-wage labor costs and reform the product market. However, much more remains to be done to achieve the critical mass of reforms needed to boost productivity and lower prices. Ambitious reductions in barriers to competition are crucial. It will also be important for the government to deliver its privatization plans and to take appropriate steps to strengthen the governance of the process, if necessary”.

On Greek banks, IMF Managing Director said “Efforts must continue to restructure and strengthen the banking system. With the finalization of the bank recapitalization framework, it is vital that the new monitoring and supervisory framework be made effective to protect the public interest and prevent state interference in management. Additional financing from euro area member states to allow Greece to redeem treasury bills from banks could support liquidity and credit creation”.

As a conclusion, Ms Lagarde stated “Greece’s fiscal effort has been impressive by any measure. The frontloaded adjustment will help bring spending back towards pre-euro levels, and has been designed to protect the most vulnerable. Looking ahead, Greece needs to radically overhaul its tax administration to bolster tax collections, fight tax evasion, and shrink the public sector, in particular through targeted redundancies”.

Two days later on January 18, IMF released the long-awaited report on the first and second review of Greece’s economic adjustment program. Overall, the program is moving in the right direction, but the challenges ahead remain enormous. The program continues to be the best opportunity for Greece to successfully complete its adjustment within the euro area. In this regard, even with generous debt relief, Greece will not successfully restore robust growth while remaining in the euro area without deep structural reforms.

We summarize below the key conclusions:

• The Greek program continues to present a mixed picture with stark contrasts. The fiscal adjustment has been extraordinary by any measure and labor market reforms have produced significant wage adjustment. There should be no doubt on part of Greece’s European partners that it is enduring exceptionally painful adjustment in order to stay within the euro area. However, the manner of the adjustment leaves much to be desired. The fiscal adjustment has relied far too much on cuts in discretionary spending and increased taxation of wage earners, while the rich and self-employed have continued to evade taxes on an astonishing scale and bloated and unproductive state sectors have seen only limited cuts. Moreover, labor has shouldered too much of the burden as lower wages have not resulted in lower prices, because of failure to liberalize closed professions and dismantle barriers to competition. While the economy is now re-balancing apace, this is happening mainly through recessionary channels, rather than through productivity boosting reforms. Meanwhile, the mounting sense of social unfairness is undermining support for the program.

• The new government acknowledges that the program will fail unless it overcomes these entrenched vested interests. In all key policy areas, its main objectives and plans are generally aligned with those advocated by IMF. But while it has already delivered important upfront changes in some areas, it still needs to demonstrate political resolve in some of the most difficult ones.

• Fiscal efforts remain very impressive. The scale of the frontloaded adjustment is evidence of the government’s strong determination to bring the program back on track. The refocusing on cuts in wages and social transfers has no doubt been socially and politically painful, but this was overdue as the surge in wages and, in particular, pensions was the main reason for the rise in the fiscal deficit following euro adoption. In order for the government to deliver on its promise to avoid further wage and pension cuts, it is critical that it soon achieve efficiency savings via significant mandatory redundancies, and that it move to radically overhaul the corrupt and ineffective tax administration. The government’s achievements in these two areas have so far not been commensurate with its ambitious goals. Going forward, tackling tax evasion will be a litmus test for the support of the program, both within Greece and among Greece’s European partners.

• Privatization rhetoric needs to be matched with results. Greece needs to move decisively away from its previous state-led growth model, and privatization is key to this. Results to date have been extremely disappointing. IMF welcomes the government’s stated intention to accelerate privatization, and while there is no significant evidence of this so far it accepts that it will take time to restart the stalled process and that market conditions are unfavorable. Still, IMF remains concerned about the robustness of the privatization process to political interference – the agreement to require the privatization agency to consult with parliament have heightened such concerns – and about its ability to resist giving preference to insiders. Should the planned mid-year review of the privatization process show that the problems persist, the government should consider radical governance changes, including the replacement of current managers by foreign experts.

• Good progress is being made in stabilizing the financial sector. IMF welcomes the finalization of the recapitalization framework. Looking ahead, the almost complete removal of direct sovereign exposure from banks’ balance sheets has significantly reduced risks. However, with the state set to take a major stake in all key banks, it is critical that the Government refrains from interfering in day-to-day management, while the HFSF takes steps to protect public interests. In this regard, IMF welcomes the establishment of an enhanced monitoring and supervisory framework. With so much in public resources on the line, it will be important for the EC and ECB to use the powers made available to them to exert effective oversight, alongside Greek supervision agencies.

• Greece’s European partners are taking politically difficult steps to ease its debt burden. The agreed upfront measures are an important first step, but IMF projections suggest that they will be insufficient to keep debt close to the targeted trajectory. IMF, therefore, welcomes the assurances to take additional measures in 2014 and 2015—provided that Greece adheres to its primary deficit targets—to reduce debt to 124% of GDP by 2020 and substantially below 110% by 2022. Upfront measures to achieve a reduction to the original target of 120% by 2020 would have been preferable, as would a specification of the exact modalities for future relief. Still, IMF recognizes that the assurances concerning future conditional relief given in the context of the present review reflects an explicit acknowledgement, for the first time since the onset of the crisis, that Greece’s debt burden is unsustainable without long-term transfers. From this perspective, Greece and its European partners have turned an important corner.

• The extension of repayment periods on GLF and EFSF loans has significant long-term benefits. In combination with the buyback of much of the privately held bonds, the extension has sharply reduced what would otherwise have been a surge in refinancing needs starting in 2022. This has an important impact on debt-to-GDP over the very long run, as Greece will carry low-interest-rate debt to its European partners for much longer than previously assumed. This positive long-term impact on refinancing needs and debt, which should facilitate Greece’s return to markets, is further evidence of European partners putting in place a credible framework for a lasting solution to Greece’s debt problem.

• Financing constraints remain a concern. The program is fully financed on a 12-month forward-looking basis, and the proposal to roll-over maturing bonds held by Eurosystem Central Banks could provide sufficient financing assurances through end-2013. Greece’s European partners would have to commit to new funding at this point by the latest. On a related matter, financing constraints mean that the government is no longer planning to reduce its T-bill exposure by €9bn in 2013, contrary to what was assumed in the program. With no accommodation by the ECB, this suggests that liquidity conditions will be notably tighter. If this is judged to pose a significant risk to the macro framework, IMF would expect euro area member states to provide additional financing in 2013 to allow Greece to reduce its T-bills exposures as originally programmed, or for the ECB to raise its limit on repo-eligible T-bills.

• The gradual and contingent approach to debt relief will need to be revisited if the high debt burden continues to weigh on investments. The assumption that GDP will start to recover in 2014—when fiscal consolidation is still exerting a notable drag—is based on the expectation that a gradual recovery in confidence and in investments will begin to take hold by then. Important in this regard, IMF believes that recent evidence that the authorities are determined to persevere with the program, despite a difficult political situation, and that European partners are continuing to provide unprecedented support, will gradually convince investors that the risk of euro exit is dissipating, despite the high debt levels entailed by the gradual approach to debt relief. Should it become evident, however, that investors’ confidence remains subdued because of concerns about the debt burden – despite strong program implementation by the authorities – a more frontloaded approach to debt relief would need to be considered. The macro and debt outlook will therefore need to be assessed carefully at each future review.

On debt sustainability in particular, IMF reports notes Greece and its European partners agreed to a package of upfront debt relief measures and a maturity extension on existing loans. The measures adopted include an interest rate reduction on existing GLF loans, and fiscal transfers by member states (of ECB profits related to Greek bond holdings). The Greek authorities also completed, on December 18, 2012, a voluntary buyback of bonds from the private sector. Greece’s European partners also agreed to a 15-year extension of the maturities on official loans. Together, the latter two measures dramatically reduce rollover requirements post-2020. All told, these measures are projected to deliver some 16pp of GDP in debt reduction by 2020.

Since this was not enough to restore debt sustainability, IMF stresses that Greece’s European partners gave supplementary assurances of additional conditional debt relief. Through the Eurogroup statements on November 29 and December 13, and via separate interactions with the Managing Director, they have made clear that they will: (i) provide 1.4pp of GDP in debt relief in early 2014 (provided the primary balance target for 2013 is met); and (ii) take measures in 2015 to ensure that debt drops to 124% of GDP by 2020 and substantially below 110% of GDP by 2022 (provided Greece’s primary balance swings to a surplus as programmed in 2014). It is noteworthy that IMF points out that time will tell what the full commitment will require, but IMF’s assessment at this point is that some combination of haircuts on outstanding GLF loans, close to zero interest rates on GLF loans and lower rates on EFSF loans, or long-term transfers will be necessary.

IMF reports also notes that taking into full account the maturity extension on loans, Greece’s debt in fact now appears to be considerably more manageable. Interest payments in 2013–20 have been reduced by almost 3pp of GDP per year in cash terms (falling below the euro area average), and principal repayments on debt falling due from 2020 to 2030 are reduced by an average of about 4.5pp of GDP per year. The sharp decline in the debt service burden means that Greece’s headline debt – peaking at about 180% of GDP in 2013 – overstates the debt burden. To lend some perspective to this, the NPV of end-2012 debt evaluated at Greece’s long-run projected nominal growth rate (around 4%) would be significantly lower, at 148% of GDP. This is also lower than the debt NPV at the time of EFF program approval (when it stood about 3pp higher). Using a higher discount rate – in line with the range of borrowing rates within the euro area – would produce even lower debt NPVs.

On Greece’s financing needs, IMF report notes that the additional balance of payments over the period 2012–16 were estimated to be €32bn. The debt buyback added about €9.8bn to needs during 2012–16 (with €10.8bn upfront) while other debt-related measures reduced financing needs by about €10bn over the same period. As outlined below, a total of roughly €26bn in new financing was agreed, leaving a gap of €5.5–9.5bn (depending on how transitory movements in deposits are accounted for), falling entirely in 2015–16:

• Greece’s European partners agreed to a deferral and capitalization of EFSF interest payments falling due for one decade (providing an estimated €11.5bn in financing through 2016).

• The ECB agreed, on a preliminary basis, to a rollover of maturing Greek bonds held by the national central banks (generating about €5.6bn in further financing through 2016). To the degree this rollover is not confirmed by March, the euro member states agreed to provide equivalent relief via other means.

• At the request of its euro area partners, Greece agreed to delay the programmed €9bn net redemption of T-Bills now held by banks. With only a small share of the stock of T-Bills expected to be eligible for use as collateral for BoG funding beyond Q1’13, Greek banks will need to make room for this through other adjustments in their balance sheets (likely involving higher ELA and higher access to ECB instruments which should be facilitated by the ECB’s decision in mid-December 2012 to expand the list of eligible collateral).

IMF report also underlines that the strategy for fiscal adjustment in 2015–16 has not yet been fully identified. To close the estimated gap of up to €4bn, the authorities intend to focus on retaining expiring measures, base broadening, and gaining efficiency savings from long-term structural reforms. The largest gains would come from extending expiring revenue measures (i.e., the solidarity surcharge on PIT). IMF also sees potential in continuing the reforms of the social benefits system, which remains complicated and inefficient. The fifth review, coinciding with the preparation of the 2014 budget and MTFS update, will aim to define specific measures.

On public sector staff reductions, IMF notes that the authorities have not yet finalized plans. They committed to transfer 27,000 staff to a new mobility scheme, a successor to the seldom-used labor reserve. They have initiated this scheme by transferring 2,000 staff as a prior action (still well short of the 15,000 they should have transferred to the labor reserve by end-2012). Targets for dismissals are now needed (the framework would be expected to follow the model laid out for the labor reserve, where the reduced pay received for a one-year period prior to dismissal would count against severance). Targeted dismissals are essential to help the authorities realize their operational savings goals, and will help to ensure the right mix of skills in the future public sector labor force (reliance on attrition alone provides no guarantees). The authorities agreed to set targets at the time of the next review, once staffing plans are known.

Regarding Greek banks, IMF points out that the revised macroeconomic framework for the program implies a higher peak for non-performing loans and lower asset valuations. These factors would tend to raise capital needs for recap and resolution. Additional needs have also been identified in cooperative banks. However, a revision of core Tier I targets from 10% to 9% (to align them with EBA recommendations on capital buffers), and capital injections by the owners of some banks have helped offset this impact. Overall, IMF concludes that the envelope of c€50bn was found adequate with sufficient buffers to deal with stress scenarios and to address potential needs in banks’ foreign subsidiaries. Furthermore, IMF notes that BoG analysis indicates that banks could sustain a peak NPL level of 40%, assuming a coverage ratio of 50%. In addition, the core banks hold tax credits for about €3.2bn associated with PSI losses that have not yet been incorporated into program capital estimates. While buffers appear sufficient for now under the present macro framework, an additional top-down verification of capital needs will be conducted by end-December 2013. This stress test will assess whether the banking sector will remain well capitalized through 2014, under updated macro assumptions and given performance through June 2013.