Greek Prime Minister George Papandreou gets a warm welcome in the village square in Kritsa, on the island of Crete, July 30, 2010.

Greece has made a "strong start" in bringing order to its its public finances but what are the challenges ahead?

An EU-ECB-IMF review was carried out in the past two weeks, in advance of a second loan payment of €9.0bn due at the beginning of September, following an initial €20bn loan in May. A further €9.0bn payment is scheduled for December. The review has moved Greece from the 'basket case' and in an signal of the change since April, at the conclusion of the ECB press conference in Frankfurt yesterday, the ECB president, Jean-Claude Trichet, noted that that he had not received any question on Greece, even though a joint EU/ECB/IMF mission to Athens, to review progress on Greek reforms, reported Thursday. No news is often said to be good news! 

European economists, Daniele Antonucci and Elga Bartsch, at US investment bank, Morgan Stanley, say the upshot is that Greek sovereign risk appears more than adequately priced into both the bond and CDS (credit default swaps) markets, in their view. This is especially true for long-dated paper, which is still trading at a fairly heavy discount. Of course, uncertainty is still out there. But the risk/reward trade-off - - at least at this stage - looks quite attractive to them.

Is Greece Hitting its Fiscal Targets?: The economists say Greece's efforts to regain market confidence and restore the viability of its funding model have to do with shrinking the budget deficit and reducing the debt burden, as well as with far-reaching structural reforms aimed at enhancing potential growth and limiting ageing-related spending over time. Although these are still early days, Greece's progress on both fronts looks tangible.

The budget numbers - any improvement in sight?:Despite initial market scepticism on Greece's ability to deliver on its fiscal adjustment plan, "we can't help but notice that Greece's net borrowing needs declined considerably in H1 2010 relative to the corresponding period of the previous year, with the deficit shrinking by 41.8%Y. And the improvement was truly remarkable regardless of whether the calculation is performed on a cash or fiscal basis.

The central government's cash deficit fell to €11.45bn in January-June 2010, from €19.68bn in January-June 2009. The budget's primary deficit - - which excludes debt-servicing costs -  -also narrowed to €5.47bn from €12.42bn. This is clearly a positive development, and puts Greece on track to reach its deficit-reduction targets for this year, or even slightly ahead.

The scope for improvement was considerable - given the poor situation of Greece's public finances before the start of the fiscal consolidation process - so the hard part is still ahead of us. Whether this encouraging trend in the budget numbers will be sustainable remains to be seen. However, while we remain cautious, we find some comfort in these numbers," the economists say.

What measures have already been implemented?:The fiscal adjustment plan - - together with the accompanying structural reforms - - has already gone through several phases, starting with the initial set of measures outlined in the context of Greece's stability programme presented at the beginning of the year and ending (at least for now) with the recent extra tightening in the context of the conditionality attached to the EMU governments/IMF loan.

Phase #1: Greece's belt-tightening has started before its request for financial support to the other EMU governments and the IMF. The initial fiscal effort was not sufficient to achieve the deficit-reduction targets Greece had committed to in its latest stability programme (presented to the European Commission on January 15), but its subsequent implementation - - along with additional measures - - has been key, in our view, to cut the budget deficit by a significant amount in the first half of this year.

Phase #2: Following an emergency procedure, the Greek parliament approved a package of additional fiscal measures on March 5, amounting to about €4.8bn (approximately 2% of GDP). Among the most significant revenue-raising measures (worth around €2.4bn, or 1% of GDP), there was an increase in the VAT rate across the board (from 4.5%, 9% and 19% to 5%, 10% and 21% respectively), further rises in excise taxes (fuel, cigarettes and alcohol) and the introduction of new excise taxes (luxury goods and electricity).

Among the most significant expenditure measures (worth around €2.4bn, or 1% of GDP), there was a further reduction of public sector nominal wages and pensions. In particular, the extra payment that the Greeks generally receive in December as part of their salary was cut by 60%, various wage supplements were reduced by 2% (on top of the 10% already announced), salaries of workers in public sector enterprises were cut by 7%, and all private and public sector pensions were frozen (all the increases already budgeted were cancelled).

Phase #3: The Greek parliament passed the new tax bill on April 15. The law introduces reforms in five main areas of the Greek tax system:

• Taxation of personal income: 1. introduction of a unified progressive tax scale, which treats all sources of income uniformly; 2. abolition of autonomous taxation and most tax exemptions on personal income; 3. determination of imputed minimum taxable income, based on the services, assets and estates owned or used by the taxpayer; 4. incentives for issuing and collecting transaction receipts in purchases of goods and services; 5. accounting-based determination of incomes, with documented receipts and expenses and invoices for goods and services for all self-employed persons; and 6. obligatory electronic submission of tax declarations as of 2011.

• Taxation of capital and real estate: 1. taxes on real estate holdings, and transfers and contributions of real estate or shares of companies that hold or manage real estate assets; 2. taxes on donations of real estate and contributions in cash to non-profit legal persons governed by public law, legal persons governed by private law and other persons previously exempted; 3. higher taxes on real estate offshore companies, as well as abolition of all existing exemptions; 4. higher taxes on church real estate and introduction of taxes on church property income; and 5. repatriation of capital from abroad.

• Taxation of business income: 1. separation of taxable profits into non-distributed and distributed profits - the taxation of non-distributed profits will gradually decrease from 25% to 20% by 2014, while distributed profits (i.e., dividends) will be taxed as personal income; 2. extension of VAT obligation to include various economic activities previously exempted; 3. self-auditing standards to increase voluntary compliance of small business; and 4. tax certificates for businesses issued by certified auditors that verify the accuracy of the tax liabilities of businesses and companies.

• Tax administration measures: 1. execution of all payroll and business-to-business transactions via bank professional accounts (2011); 2. acceptance of invoices exceeding €3,000 among companies or between companies and the state only by electronic means (2011); cross-referencing data for income tax verification purposes; 3. obligation for every company, business or professional to issue receipts via certified cash registers; 4. creation of specialised tax professionals to audit high-income individuals, fight tax evasion and collect overdue tax liabilities; and 5. higher penalties for illicit trade.

• Tax incentives: 1. three-year tax-exempt period for the establishment and operation of new businesses by individuals up to 35 years old; 2. tax incentives for employment retention, particularly for businesses with reduced turnover due to the economic crisis; 3. tax incentives for energy conservation, upgrading of buildings and reduced energy footprint of businesses; 4. increased deductions in taxable profits for businesses investing in research and technological innovations; and 5. targeted tax incentives to promote entrepreneurship, safeguard employment and enhance investment in research.

Phase #4: The economists say the fiscal adjustment programme that Greece is pursuing within the context of the EMU governments/IMF loan includes cumulative fiscal consolidation measures (additional to those already adopted in March) amounting to 11% of GDP through 2013. From 2013, the debt/GDP ratio is projected to follow a downward trend. The programme revises the government's deficit target for 2010 to 8.1% of GDP, down from its 2009 level of 13.6%.

• Additional fiscal measures for 2010 of €5.8bn - approximately 2.5% of GDP - were adopted by the parliament on May 6. In particular, the new belt-tightening measures include:

• An additional €1.25bn increase in tax revenues (0.6% of GDP), with a significant carryover for 2011, through a further increase in VAT rates from 21% to 23%, and from 10% to 11% - the second hike over the past few months - and in taxes on fuel, cigarettes and alcohol on top of those previously announced.

• An additional €4.55bn in expenditure cuts (1.9% of GDP) by means of: nominal wage cuts of 7% through a reduction of bonuses and allowances (total from all 2010 measures = -14%); nominal pension reduction of 9%; intermediate consumption cut; and public investment reduction.

The structural reforms - progressively implemented:Daniele Antonucci and Bartsch say Greece's adjustment plan goes far beyond fiscal tightening. Fixing a number of fiscal deficiencies is another key goal. On this front, parliament passed the all-important pension reform bill at the beginning of July. Among the various structural reforms that will need to be implemented, this is one of the most relevant, in their view.

Indeed, the IMF estimates that, without reform, spending on pensions would exceed 24% of GDP in 2050 - a 12.5ppt increase from 2010. Such an increase would result from very generous benefits relative to wages - e.g., an average replacement rate of nearly 75% - which can often be received before age 60, and from a benefit structure offering little incentive for older workers to remain in the labour force.

The pension reform could curtail spending on pensions over the next few decades by introducing a contributory pension to top up a non-contributory, means-tested, minimum pension. In particular, the reform will raise the retirement age to 65 (including women in the public sector), curtail early retirement, increase the number of contribution years and index the retirement age to life expectancy.

According to the IMF, the reform is less successful in containing spending on pensions in the medium term. Indeed, after the initial drop in pension expenditure, due largely to the elimination of the Easter, summer and Christmas payments, spending is projected to increase by 3% of GDP between 2015 and 2035. Moreover, the effects of the reform can be greatly reduced if some of the key pillars are excluded, resulting in a bigger increase in spending on pensions.

The upshot is that the focus will now shift from passing the law in parliament (which has happened already), to executing it. The challenge of implementing the measures outlined is significant and room for slippages remains high. The burden of proof remains on Greece to convince markets that progress on this front is concrete and sustainable, but the economists find Greece's effort an appreciably good start.

On Track, Possibly Better Than Expected: Fine on the fiscal and structural reform fronts... Antonucci and Bartsch say the budget data suggest that Greece is on track to reach its deficit-reduction targets and start implementing the required structural reforms this year (or slightly ahead). Naturally, the scope for improvement was substantial - - given the poor state of the public finances before the start of the fiscal consolidation - - so the difficult tasks are still ahead of us, in their view. Of course, whether this favourable trend in Greece's public finances will continue remains to be seen. However, while they remain cautious, they find some comfort in these numbers.

Further, the economists expect revenue growth to accelerate somewhat in H2 2010, courtesy of the second round of VAT and other indirect tax hikes - - which kicked in only in July. If anything, this suggests that the budget deficit may continue to improve at a brisk pace, especially in the short term. The progress on the structural reform front - - especially on pensions - - is equally encouraging. Here too, these are still early days and the economists say they are well aware that there is a difference between passing a law in parliament and implement it in full. Nonetheless, it seems to us that - over this very short time span - - Greece is delivering satisfactorily on its overall adjustment plan.

...but what about the banks? Liquidity conditions are still tight. Banks face difficulties, as market confidence has not yet been restored and spreads have not yet resumed their downward trend - at least not for a considerable period of time. The recently published bank stress tests indicate that banks' solvency buffers remain adequate, with some erosion. However, the quality of banks' loan portfolios declined throughout the economic downturn.

According to the IMF's latest report on Greece (IMF Country Report No. 10/217), published in July, non-performing loans (NPLs) have increased from 7.7% of the total in December 2009 to 8.2% in March 2010. What's more, the system-wide capital adequacy ratio has declined from 13.2% to 12.9% over the same period (still well above the 8% regulatory minimum).

Partial data available for April and May 2010 indicate further slippage, with some differentiation among banks. Although banks' pre-provision operating income has remained stable at elevated levels, the need for larger provisions against NPLs has driven the banking system as a whole into a loss - - after including provisioning and taxes.

Against this background, the Greek parliament has now passed the legislation for the Financial Stability Fund (FSF). This should ensure that this facility becomes operational fairly soon. The FSF will be endowed with €10bn to be disbursed in equal installments in September and December. The board will be composed of seven members, five of which will be nominated by the governor of the Bank of Greece and then appointed by the latter and the finance minister. The remaining two members will be the deputy governor of the Bank of Greece and the secretary general of the Ministry of Finance.

The FSF will be independent and autonomous. Internal auditing functions will be established to ensure good governance. The FSF will provide monthly balance sheets and annual audited financial statements to the Greek parliament, Ministry of Finance, Bank of Greece, as well as the teams of the European Commission, ECB and IMF working on Greece.

The modalities of capital injection will vary depending on various circumstances. Broadly speaking, one of the main mechanisms for capital injection is through preference shares, which would be converted into common shares if targets identified under the restructuring plan are breached or if the capital ratios are not complied with.

The upshot is that, on this front too, Greece seems to have a plan in place to deal with banks' liquidity pressures and some solvency erosion. In the unlikely case that earlier financing were needed, this could be bridged by using T-bill placements or by drawing down cash balances. An IMF stress test update is planned for September to incorporate the latest developments on potential capital injection needs.

So Far, so Good - What Are the Risks? Is the political will there?

Although it appears that Greece is delivering on its adjustment plan, many continue to doubt that Greece could muster the political will over time, Antonucci and Bartsch. While the Greek government and parliament have not given much reason to doubt their resolve, one main concern seems to be that strikes, street protests and social unrest more broadly will ultimately result in a ‘fiscal reform fatigue', which could lead to a delay - - or even a rethinking - - of the belt-tightening plan.

This is a key risk. Greece has to deal with a significant credibility gap, which goes over and beyond its current public finance difficulties. Indeed, despite strong domestic growth and favourable funding conditions, Greece's fiscal position has deteriorated considerably since its entry into the Eurozone. That's why markets still appear reluctant to view the recent positive developments - - at an admittedly early stage - - in a more positive light. But developments on the political front are so far as encouraging as those on the economic front:

• Parliamentary majority appears solid: The government is supported by a robust majority in parliament. For example, the pension reform bill in early July passed with 159 votes in favour out of 300, i.e., it got the full vote of the socialist party (157 MPs) and two extra votes. Moreover, Greece has a unicameral parliamentary system, i.e., there is no upper house that could eventually slow down the approval of the various policy measures. And the president cannot decide to hold a referendum on a particular bill, as was the case in Iceland.

• Social unrest seems fairly contained: The government is coping well with protests - - especially given the severity of the fiscal tightening. For example, a 20-day confrontation with the Greek farmers back in January did not result in any concession. And the six or seven general strikes that took place this year did not see the participation of huge crowds in several cases. This is not to say that accidents cannot happen. There is still a latent risk of social unrest - - as the May episodes remind us. However, the overall situation appears fairly benign to date.

• Prime Minister Papandreou remains popular: Despite the tough fiscal consolidation plan - - and the deepening of the recession - - various opinion polls suggest that the prime minister (who seems to understand that this is a historic opportunity to modernise the country and mentioned publicly that he is not necessarily seeking re-election in 2013, if this means a softer fiscal stance or less ambitious structural reforms) still enjoys broad support. And there seems to be a decent support for the austerity programme - though not for all the individual measures.

• Tax-collection mechanism looks improved: Anecdotal evidence indicates that the fiscal administration - - which needs to continue to improve, and by a substantial margin, by the government's own admission - - is becoming more effective. There is no guarantee that this will continue, or that the situation will progress at the brisk pace observed over the past couple of months. However, while the economists remain cautious and acknowledge that room for slippages remains high, they think that the focus on tax evasion, for example, will continue to bear fruits.

The upshot is that, up to now, not only has Greece met the demands of the Eurozone governments and the IMF; it has also done so in the context of no major social or political accident. And socialist - - such as Greece's - - or centre-left governments often find it easier than their conservative or centre-right counterparts to engineer a significant fiscal turnaround by negotiating with the trade unions.

Fiscal Sustainability - A Few Scenarios: So Greece appears to be delivering on its adjustment plan. But what about the medium term? The economists sat that while investors don't seem very concerned about the short term - - as shown by their take-up in the recent T-bill auctions - - their main worry relates to Greece's debt burden, which many deem to be unsustainable. After all, the purpose of the adjustment is to stabilise the debt/GDP ratio at less than 150% of GDP in 2012-13. Where to from there? Several factors could potentially have a significant impact on the Greek debt trajectory: lower growth, greater deflation, higher interest rates and contingent liabilities from state-owned enterprises and the banking system. The main conclusion of IMF sensitivity analysis is that adverse shocks of reasonable magnitude would still be consistent with a turnaround in the debt dynamics (though the timing might differ from the base case). However, the combined impact of the various adverse shocks would render the dynamics clearly unsustainable.

These simulation exercises, while helpful to contextualise the main risks surrounding the base case, have a rather mechanistic nature and disregard the key role of expectations. There is an aspect of ‘self-fulfilling prophecy' in these scenario analyses. For example, assuming higher financing costs would require additional fiscal austerity to meet the fiscal targets. In turn, this could cast doubts on Greece's ability or willingness to deliver on its adjustment plan, thus justifying the assumption of wider bond yield spreads.

However, this argument is somewhat circular, in the view of the economists. For example, assuming that markets feel progressively encouraged by Greece's fiscal progress, the resulting confidence boost might well lead to lower financing costs. In turn, this might translate into a more favourable debt trajectory over time, thus justifying the assumption of narrower bond yield spreads. So, while it makes sense to assume a conservative base case, the long-term debt trajectory depends on factors that cannot necessarily be modelled in these projections.

This is not to say that the next phase of fiscal consolidation will be easy. The economists cite the economic contraction in Ireland - - where real GDP has so far declined by around 10% from the peak - - could be a reasonable template for Greece (where GDP has so far declined by about 4%).

A couple of years of tough domestic adjustment to restore some of the lost ground in terms of competitiveness are inevitable. But further down the line, if Greece continues to deliver on its fiscal targets, it is possible to imagine a not too far-fetched scenario where the structural reforms and the resulting crowding in of the private sector start paying off.

These higher growth dividends, along with a potential upward revision - - admittedly difficult to quantify - - in the level of GDP (courtesy of the uncovering of the underground economy) might help reduce the debt burden. Should this happen within a reasonable timeframe, sentiment might improve and risk premia subside - - as was the case for other high-debt Eurozone countries with a sounder fiscal policy (e.g., Italy and Belgium).

Is the Unthinkable so Unthinkable? : The economists say the scenario above is just one of the many possible futures. Of course, should Greece fail to deliver on its adjustment plan because, say, a protracted recession weighs more than expected on tax revenues or political instability leads to a U-turn in fiscal policy, then a debt restructuring might well happen. The evidence, however, seems fairly encouraging on this front - - at least so far.

Antonucci and Bartsch say it is maybe more interesting to consider another scenario, which is increasingly becoming the consensus view. In this version of the story, Greece takes the deliberate decision to restructure all or a part of its debt when it manages to bring its primary budget balance (i.e., the overall budget balance excluding interest expenses) back in surplus. This will happen - - at best - - in 2012, they think. This scenario rests on the key consideration that, as long as the primary budget balance is in deficit, the incentive to restructure is not really there. In these circumstances, cutting the debt will not really solve the problem because, with the government now unable to fund the primary budget deficit, the savings required to balance the books will be substantial anyway.

However, when the primary budget is back in surplus (or when the savings to make ends meet are lower than the interest rate expenses), Greece might be tempted to restructure - - according to this line of reasoning -  - especially if it becomes too evident that the future pace of expansion of the economy is too low to sustain the debt-servicing costs (not the MS central scenario).

What's more, a country would choose to default on its domestic debt, instead of enduring a painful domestic adjustment, if the cost of the latter exceeds the cost of the former. The cost of a sizeable fiscal retrenchment might be deflation, which affects the whole population. Conversely, the cost of defaulting on government debt affects the existing debt holders (and the future borrowing costs). But if a large share of government debt is held by foreigners (about two-thirds in the case of Greece), a default might seem more palatable, as the cost on the domestic population would be smaller.

Both arguments are too simplistic, the economists say. However, they are not saying that the outlook cannot play out along these lines. Rather, they think that the incentives to avoid a restructuring are quite compelling too. In essence, this hypothetical scenario seems more realistic for an emerging market - - where, at times, there really is the physical impossibility to get the foreign currency to make a payment, for example.

But most of the debt is in domestic currency in Greece. True, ‘printing money' is not an option for an individual Eurozone member. However, the restructuring option - - should it happen at all - - would be weighed against four hurdles:

• EMU countries most exposed: Antonucci and Bartsch estimate that (non-Greek) Eurozone banks account for about three-quarters of the outstanding foreign bank holdings of Greek government bonds. More broadly, Eurozone banks account for about one-third of foreign claims on EMU peripheral assets. In a sense, this suggests that there is a strong incentive for the Eurozone as a whole to avoid a restructuring or a default. Ultimately, it all comes down to a fine balance between transfers from the fiscally sound EMU members to those requiring a belt-tightening under strict conditionality. This is not to say that the EMU framework, in its present form, does not have room for improvement. Rather, it is an observation that defaulting on Greece's lenders of last resort (including the ECB) does have considerable political costs. Put differently, refusing to comply with the demands of much bigger neighbours does not come very easy. True, there is a probability attached to any scenario and a unilateral restructuring could still happen, but such an institutional set-up does strengthen Greece's resolve to comply, the economists think.

• The domestic costs of debt restructuring: Greek bank holdings of Greek government bonds amount to no less than €60bn. And, including the domestic sector as a whole (e.g., households, other credit institutions, insurance companies, mutual and pension funds), the overall figure could easily exceed €100bn. Is there an incentive to default on the domestic holders of government bonds? Not really, in the MS view. "Let's assume, for example, a 50% haircut on the debt held by residents. The annual savings, in terms of reduced debt-servicing costs on this portion of the debt outstanding, could be less than 2ppt of GDP. Are these benefits big enough to justify a restructuring versus the costs (e.g., possible significant recapitalisation of the domestic banks, restricted access to the international bond market for several years, etc.)? On balance, we think that the former do not sufficiently outweigh the latter," the economists say.

• Sentiment playing a key role: There is no recent historical precedence for a default of an advanced country. However, the evidence suggests that, when the IMF loans were effective in helping to restore fiscal sustainability, it wasn't because of the size of the financial support package. Of course, the bigger the package the better - - all else being equal. But in many cases the key factor was that private sector investors felt encouraged by the backstop, along with clear progress of the country undertaking the adjustment on the fiscal and structural reform fronts. In those episodes, the country complying with the IMF programme had considerably more respite and was able to continue to access financing, through the financial market, even after the end of the loan. This has not yet happened in Greece as, understandably, investors want to see progress over and above the initial encouraging results. From this perspective, a restructuring would not really boost sentiment. Conversely, it would undo the confidence-building that might eventually emerge. "We believe that the Greek authorities will do their best to prevent such scenario from materialising," Antonucci and Bartsch say.

• Exiting the EU: One argument that is often mentioned on the ‘benefit' of a default is that, by reintroducing its own currency, Greece would be able to boost its exports by devaluing its exchange rate. In this case too, however, the benefits seem rather small. The fact is that Greece is a rather closed economy, with extra-EMU exports accounting for just 10% of GDP. What's more, leaving the Eurozone is not something that can happen overnight or behind the scenes, because the infrastructure to ‘print money' will have to be rebuilt, i.e., the ‘printing press' needs time to start working at capacity, new staff might need to be hired and trained, etc. Financial market participants and economic agents more broadly (from non-financial corporations to households) would know about this. The chances are that the reaction will be quite disordered. Given that there are no restrictions in the Eurozone, capital outflows might well happen - - on the back of the uncertainty on the fate of the domestic banking system. To stop these outflows, Greece will have to reinstate capital controls, i.e., it will have to exit the Common Market and leave the EU - - not just the Eurozone - - thus reinventing its institutional architecture of the past 25 years. This is possible, but the economists deem the associated costs to be very high.

Conclusions: There is no guarantee that Greece will not default. This could even happen within the three-year period of the loan that the EMU countries and the IMF have agreed upon. There may be a fiscal slippage along the way or a refusal to tighten further, both resulting in no further disbursements. Or there might still be some kind of voluntary restructuring further down the line, or even some form of debt rescheduling within the arrangements of the EMU governments/IMF loan. Other risks are less talked about, such as the impact of a less favourable tax regime on companies and high-income or skilled individuals, which might drive financial and human capital away. Yet Greece appears to be delivering on its adjustment plan. "These are still early days and we remain cautious, but the recent evidence is encouraging, in our view. Investors will need to see progress over a longer time span. But we don't see any compelling reason for an imminent reversal of the recent trend. Meanwhile, the disincentives to default are stronger than the incentives, we think. Uncertainty is still out there, but the sovereign risk/reward trade-off looks attractive, in our view," Daniele Antonucci and Elga Bartsch conclude.