Greece is facing an unprecedented economic crisis, which could well evolve into a major political and social crisis if the economy does not stabilize and start recovering in the next few quarters.
The history of Japan and other countries shows this cannot be done without a healthy, well-capitalized banking sector capable of luring in private capital. About a month and a half ago, we highlighted rising political risk as the biggest threat to Greece’s eurozone membership next year. We argued that public discontent over the austerity will boost support for left-wing SYRIZA, initially putting it ahead of the conservative New Democracy party in the polls and then widening its lead in the first quarter of 2013.
Whether this trend in the polls will result in the form of inertia plaguing the Greek civil service in the runup to general elections remains to be seen. Recent polls confirm this scenario is playing out so far with the ultra-right-wing Golden Dawn party registering gains as well. This should come as no surprise since it is very hard for any democratic society to endure such an overdose of austerity for many years, resulting in record unemployment numbers among the younger generations and private sector employees. It is therefore imperative that the economy stabilizes as soon as possible to avoid the worst.
Spending a billion euros more than the funds allocated to next year’s public investment budget, as we argued a few weeks ago, is a step in the right direction since it is very difficult for local and foreign private capital to invest sizable amounts in Greece under the current circumstances. However, the government cannot count on bailout loans and will have to find the money from other sources. Even more important for making the recessionary turn into a deflationary spiral is for the local banking sector to become sound and healthy and once again assume its intermediary role in the economy. This is the lesson from other countries which found themselves in economic distress in the past.
The example of Japan is well known although the context is different. The large stock market and land price declines that started in the late 1980s and early 90s impaired collateral values but the response of the political and regulatory authorities was to deny the existence of the problem and delay the reforms. Banks continued to extend credit to insolvent companies, betting they would recover or be bailed out by the government. As a matter of fact, the government even encouraged banks to boost loans to small companies to ease the credit crunch in the late 1990s.
The result was the creation of so-called zombie banks that became part of the problem, delaying the recovery of the Japanese economy. Greece’s international lenders have identified the significance of the problem as indicated by the allocation of some 48.5 billion euros in the second economic adjustment program plus 1.5 billion from the first.
However, the process has been delayed considerably given the severity of the economic situation. Readers are reminded that 25 billion euros in EFSF bonds destined for bank recapitalization had to be disbursed last spring and an additional 23.5 billion made available in June 2012. At the time, many analysts and others thought the amount of 50 billion euros more than sufficed for bank resolution and recapitalization. Some even suggested part of the sum could be put to other uses, such as reducing the burgeoning public debt.
A few months later, a minority of analysts and bankers are suggesting 50 billion euros may not be enough after all because the economy has deteriorated more than projected and there are signs this trend will not abate any time soon. Moreover, they are expressing concern about the use of various accounting techniques to reduce the overall capital needs of the banking system and particularly the four large, systemic credit institutions.
They cite, as an example, the deferred tax related to the seemingly successful debt buyback, where local banks appear to have offered 12 to 15 billion euros’ worth of bonds as of Saturday, December 8, largely thanks to moral suasion. According to this view, which we also share, Greek banks will not just have to be well-capitalized to play their role in contributing to the stabilization and recovery of the local economy; they will have to be hugely overcapitalized to convince sophisticated market participants, some of whom have suffered large losses from holding Greek bonds and stocks, to take a look at them and finance them.
This runs contrary to the prevailing conventional logic of using accounting methods to reduce the banks’ capital needs. Of course one cannot rule out the possibility things turning out unexpectedly well for the Greek economy, in which case the conventional logic will triumph. However, this is not the market consensus at this point. All in all, the Greek economy will have to break out of the recessionary-deflationary spiral as soon as possible to avoid unpleasant political and socioeconomic developments.
The experience of other countries shows this cannot be done without a financially sound banking sector. Given the current projections about the country’s poor economic performance in coming years, the banks will have to have “clean” balance sheets and be overcapitalized to attract genuine market interest. The use of accounting methods to reduce their capital needs is not a solution, barring an unexpected positive surprise by the Greek economy in the years ahead.
*Dimitris Kontogiannis holds a PhD and MBA in international finance and MPhil in macroeconomics, has taught graduate and undergraduate courses at US universities and worked at an established Wall Street firm.