IMF Sees Longer Greek Downturn

By JENNY PARIS And IAN TALLEY

The Wall Street Journal

LONDON—Greece must press ahead with its fiscal reform and privatization agenda in a timely and determined manner in order to bring its debt back to sustainable levels, the International Monetary Fund said Wednesday.

"There's no room for slippages," said Poul Thomsen, deputy director of the IMF's European Department and mission chief to Greece, in a conference call with journalists.

In its staff report reviewing Greece's performance under the current joint European Union/IMF loan program, the fund warned that any deviation from policy conditions Greece has promised to implement would likely mean failure.

Officials and markets alike worry that Greece's debt problem is threatening to spark a sovereign-debt fire sale throughout the rest of Europe at a time when there are serious questions about the ability of European banks to handle such costs.

One area of particular IMF concern over Greece's role in the program is what staff called "shallow" political support for the measures. After days of numerous riots, strikes and protests in Athens, the fund said, "It is imperative for the government to develop broader support for these key reforms."

If the privatization program doesn't yield near the expected €50 billion ($70.8 billion) assumed by the IMF, debt would become unsustainable. Many economists question the viability and asset values assigned to the privatization strategy.

The IMF also noted a temporary Greek default may be unavoidable if private bondholders voluntarily participate in a new financing program for the beleaguered country.

Rating agencies have warned that any involvement by private bondholders in the Greece restructuring, even voluntary, would prompt them to declare a selective default on Greek debt. That could lead to a domino effect, since Greece uses the sovereign debt as collateral to borrow from the European Central Bank. And so a selective default could cause a credit squeeze.

Despite this, the IMF assumes, in its analysis of Greece's debt, that the private sector will contribute €33 billion in a Greece debt restructuring program for all bondholders through 2014. Such an approach is "appropriate," the IMF said in a review of Greece's economy.

"There will be some form of PSI," said Mr. Thomsen, referring to private sector involvement by bondholders in a new financing package for Athens.

The IMF said in Greek public debt could peak at 172% of the gross domestic product in 2012 and decline to 130% of GDP by 2020 if the government carries out its ambitious fiscal program, as promised under Greece's €110 billion bailout.

"However, stress testing shows that full and timely program implementation is absolutely critical: incomplete fiscal adjustment, privatization shortfalls or delays in structural reform implementation would see debt remain at very high and likely unsustainable levels through 2020."

The IMF acknowledged that recession in the Greek economy will be deeper and longer than previously anticipated, with the country's GDP now expected to shrink by 3.8% in 2011 instead of the 3% contraction expected earlier. A return to positive quarter-on-quarter growth is now projected for the first half of 2012, the IMF said.

On a positive note, the IMF expects competitiveness to gradually improve, with the inflation gap with the euro zone gradually closing and turning in Greece's favor in 2012, despite higher oil prices. Unit labor costs are expected to continue to decline at a pace similar to 2010.

However, the IMF pointed to risks linked to implementation of Greece's austerity program as well as the banking sector, which could come under pressure by continued poor market sentiment and persistently high spreads.

"A deeper private sector retrenchment, on top of the sharp fiscal contraction now underway, would lead to a much sharper recession than now projected in the program," the IMF said.

The fund praised Greece's medium-term fiscal strategy plan calling for additional deficit reduction measures and structural reforms, including privatizations, that was endorsed in June. But it expressed concern that the plan relies heavily on unpopular revenue measures that have led to widespread public outcry in Greece and could frustrate efforts to improve existing tax collection.

"It was therefore agreed that tax reform would be on the agenda for the fall, with a view to broaden the base and reduce rates," the IMF said.

The IMF said there was also agreement that banks would likely face significant additional capital needs and that a process is in place to clarify these needs.

Banks have been under severe stress amid deposit outflows and limited access to wholesale markets. Plans to also involve private creditors in further aid for the country may require banks to recognize losses, while the European Banking Authority's stress tests, due Friday, are expected to assume some loss of value on government bonds.

The IMF said that buffers will have to be rebuilt in case the government, and therefore the Greek banks, are delayed in returning to the market.

"Capital buffers must be large enough to reassure markets that banks can manage a further deterioration in their loan books and/or crystallization of potential losses on Greek government bond holdings," the IMF said.

Write to Jenny Paris at jenny.paris@dowjones.com