By Simon Nixon, Wall Street Journal
Last week Christine Lagarde made an apology to the U.K. What a shame the International Monetary Fund boss didn’t extend a similar courtesy to Greece this week. No damage was done by the IMF’s crass warning last year that the U.K. government was “playing with fire” by pushing ahead with its deficit-reduction strategy since it turns out the U.K. had already embarked on what has turned out to be a remarkable recovery. But the IMF’s mis-steps in Greece last year had real consequences.
The IMF’s refusal to believe that Greece would achieve a budget surplus before interest costs in 2013 led to a seven-month delay in the disbursement of crucial bailout funds, which in turn delayed the country’s return to the bond markets that has since fueled a revival in confidence and funding. Indeed, had Athens capitulated to IMF demands for further fiscal measures to meet the imaginary deficit, Greece would almost certainly be facing a seventh consecutive year of recession. As things stand, Greece delivered a 0.8% primary surplus last year and new data this week shows it is well ahead of budget for a 1.5% surplus this year.
But even if the IMF couldn’t bring itself to say the S-word, its latest review of Greece’s bailout program published this week shows plenty of signs of contrition. It talks of “significant progress towards rebalancing the economy” and acknowledges that turning the weakest cyclically adjusted fiscal position in the euro area into the strongest in just four years is “an extraordinary achievement by any international comparison”. It says that “structural reforms are progressing, although unevenly,” growth risks could be “tilting to the upside in 2014” and expresses “cautious optimism” for the future.
This acknowlegment of Greece’s progress is justified. There’s little doubt that Prime Minister Antonis Samaras is sincere in his determination to transform Greece into a modern market economy. Much progress has already been made toward dismantling the elaborate web of privileges, protections, subsidies and immunities that underpinned the old clientelist political system—despite intense opposition from vested interests. The results can be seen in tumbling prices for everything from energy to cab rides to baby milk formula. The full impact of some reforms will become more apparent as the economy recovers, behaviors gradually change and new entrants take advantage of the new opportunities.
What’s more, Greece has survived the biggest immediate threat to the recovery. The failure of the radical opposition party Syriza to score a breakthrough in last month’s European elections has strengthened the coalition government, increasing the likelihood that it survives at least until parliament votes on a new president in 2015 and possibly beyond. That in turn buys time for the government to accelerate its ambitious structural reform and privatization programs. Mr. Samaras’s decision to appoint a respected technocrat as finance minister in this week’s cabinet reshuffle sends a reassuring signal that the government knows that tough decisions must continue to be taken without political interference.
Even so, the IMF is right to stress that Greece’s long-term prospects continue to hinge on the health of its banking sector. The IMF is skeptical that the €5.8 billion capital shortfall at the four biggest banks identified by the Bank of Greece in this year’s stress tests is large enough to allow the banking system to absorb all likely losses, given non-performing loans equivalent 35% of total loans and a third of GDP. Indeed, the IMF produced its own analysis, which estimated a capital shortfall that was €6 billion higher. Yet the IMF’s skepticism is not shared by global investors who have poured €8.5 billion of equity into Greek banks this year and allowed them to issue unsecured bonds.
Who is right depends on whether banks now quickly work through this mountain of bad loans, restructuring the debts of viable companies so that they can invest and grow again and liquidating non-viable firms so that resources can be redeployed more productively. Until now, banks have been reluctant to do this. One reason was that they didn’t have enough capital to absorb losses so it made more sense to “amend and pretend.” Banks also suspected many of these defaults were “strategic”: at the height of the Grexit scare, many households and businesses stopped servicing loans and hoarded cash. At the same time, the government banned banks from foreclosing on mortgages, while pursuing corporate debts through the courts could take years. Banks gambled that by waiting they would achieve higher recovery rates.
This is the same gamble that investors are making today. The four systemically important banks have each established internal but independently run “bad bank” divisions charged with recovering as much value as quickly as possible from these assets. Following their recapitalizations, they each have sufficient provisions to write off at least 52% of their stock of bad debts without eating into their capital ratios, which are now among the strongest in Europe. The banks insist this is more than enough to now absorb likely losses given expected healthy bank profits as a result of falling funding costs, branch closures and less competition. Whether they are right depends on three big assumptions.
The first is that the government sticks to its promise to lift the mortgage foreclosure ban at the end of the year and to introduce a much tougher corporate insolvency regime in October. This will give the banks much more power to push creditors into bankruptcy and seize collateral. That in turn should give borrowers an incentive to seek deals with the banks.
The second assumption is that the banks can clean up their mortgage books without triggering further damaging falls in house prices. The banks are confident this can be done, based on their understanding of Greek borrower behavior when faced with the possible loss of their home; the fact that loan-to-value ratios remain relatively low even with prices down 30% from their peak giving borrowers an incentive to avoid foreclosure; and lack of a pre-crisis bubble, which suggests Spanish and Irish-style price falls are unlikely. This conclusion is shared by BlackRock Investment Solutions, a respected consultancy that advised the Bank of Greece on the asset-quality review. But the IMF remains skeptical.
The third assumption is that much of the cash that disappeared offshore and under mattresses during the crisis is available to pay down debts. Some €90 billion, roughly a third of the deposit base, was withdrawn between 2010 and 2012. But will borrowers be discouraged from bringing cash back onshore for fear of triggering tax investigations that might lead to stiff penalties? Some bankers fear that little cash will be repatriated without an amnesty—yet the Troika continues to rule this out, at least until Greece’s tax-collection system is sufficiently robust to maximize revenues and minimize moral hazard.
Over the next few months, it will start to become clear who is right. If the IMF is right and the banks are being over-optimistic about what they can recover from bad debts, then the credit squeeze will continue, hurting the recovery. But if the banks— and investors—are right then asset quality will rapidly improve as confidence returns. Bad debts will be swiftly restructured, bank lending will resume, growth will pick up—and the case for an IMF apology will become irresistible.
