Investing in Greece: Notes from the 2015 Capital Link Conference

Although the recovery in the Eurozone is underway, Greece has so far been left behind.  Europe is growing now at an overall rate of 2% per year.  Even the other peripheral countries that had been experiencing difficulties– Ireland, Italy, Portugal and Spain – are now showing positive growth.  Greece, meanwhile, will likely report that its economy contracted again in 2015, but probably only slightly.  It is expected to return to growth in the second half of 2016.

Prior to the election earlier this year of the SYRIZA-led government of Prime Minister Alexis Tsipras, Greece had returned to growth, largely with the help of a boom in tourism. But those tentative signs of recovery were quashed when the new government assumed an adversarial posture with EU creditors on Greece’s austerity-driven bailout program.  This brought the country to the precipice of default and raised fears that it would leave the euro.  By the start of summer, Greece had to implement capital controls to limit the flight of deposits from its banking system.  All of this brought business activity to a near standstill.

Greece’s banking system is recovering once again.  The banks have recently completed another round of capital raising, which has substantially wiped out existing investors for a second time.  A well-functioning financial system is key to Greece’s economic recovery.  In late 2014 and early 2015, before the negotiations with the EU turned rancorous, there were also early signs of recovery in the banking system, including a pick-up in loan demand.  As the negotiating deadline on the bailout program neared with no deal in sight, depositors began to camp outside the doors of their local bank branches and banks were forced to tightened credit standards and raise rates on loans.

Since the government and the EU have declared a truce, the banking system has been returning to normalcy.  Deposits have stabilized.  Interest rates have come down.  But Greek government bond yields remain much higher than other EU countries.  Greece’s 10-year notes currently yield 8%, 740 basis points above Germany and 630 basis points higher than Italy and Spain.

Getting the sovereign yield down is a key policy objective because it will reduce borrowing costs across the entire economy.  Policymakers hope that Greece will be able to return to the markets to issue new notes before the end of 2016 and that the 10-year rate will fall by 300 basis points or more during the year.  With further improvement in the economy, lending to small- and medium-sized enterprises, the backbone of Greece’s economy, should begin to thaw.

Despite last summer’s emotional roller-coaster ride, it is not clear whether the stand-off with the EU has had as much of a negative impact on Greece’s economy and financial system as originally feared.  Certainly, the flight of deposits and the changes in credit standards and interest rates served to slow the economy’s momentum; but GDP growth estimates going into 2015 were modest – up less than 1% – and current expectations anticipate a decline in GDP of less than 1% for 2015, better than previous assessments of a 2% decline.

While investors in Greece’s banks have taken it on the chin, the second round of recapitalizing the banks was also driven by the need to provide extra capital support for a permanent resolution to the banks’ excessively high level of non-performing business and consumer loans (especially mortgages).  The size and scope of the NPLs has undoubtedly been a major factor delaying Greece’s economic recovery.  Until outstanding loan defaults are resolved, most businesses and households will not or cannot make major investment decisions.  This second round of capital raising should bring the capital position of the Greek banks to a high enough level (average Tier 1 capital of 17% of risk-weighted assets) so that a third round of capital raising should not be necessary.

The same thinking might be applied to the additional €86 billion estimated cost of the “new” bailout program that was agreed in July and signed in August.  Back then, I assumed that this was the additional amount required to fix the damage done to the Greek economy and banking system as a result of the contentious negotiations that took place in the first half of the year.  But this €86 billion is the total estimated cost of a three-year program, only a part of which is intended to plug funding shortfalls from 2015.

Consequently, it is not clear to me how much of the estimated €86 billion cost was already anticipated in the old bail-out program.  Since the summer, the EU has released, by my calculations, about €19 billion to Greece (net of a €7 billion loan repayment from Greece to the EU).  Any incremental amount required as a result of the negotiating standoff should have shown up mostly in this year’s disbursements, perhaps with a smaller add-on for future years because of changes to the economy’s performance trajectory.  If I am correct, the hole caused by the negotiating standoff was far less than €86 billion.

Since asking for a new bailout program in July, the government appears to have met all deadlines and requirements so far.  Yet, the financial markets remain skeptical about the government’s ability and willingness to follow through on the program and whether the Greek economy can achieve liftoff.  The return to normalcy has helped push short-term Greek government bond yields sharply lower, from around 30%-35% to about 7%.  The 3.375% Notes due July 2017 have rallied from 58 on June 30 and to around 94 currently.  Long-term bond yields, however, have not moved much.  Greece’s 10-year note yield is still around 8%.

Greece must pass a third set of reforms in January.  (This one focusing on Greece’s pension system.)  The government wants to preserve the remaining benefits because it believes that pensioners cannot withstand another cut.  Mr. Tsipras has said that the government can meet its pension spending target in other ways, including raising business taxes, if necessary.

If the third round of reforms passes in January, Greece will face a formal review by the EU of its progress-to-date on the new bailout program in late January.  Passing the review would open the door to additional releases of bailout funds in 2016.

Although Greece has benefited from the boom in tourism, it is uncertain whether it can achieve sufficient progress in other sectors to put the economy on a sustainable growth path and bring unemployment to a reasonable level.  Every effort is being made to exploit the country’s competitive advantages in shipping, logistics, energy distribution, agriculture, aquaculture and others, but the benefits to income and employment will take time.  Greece hopes that stepped up efforts to find and develop oil & gas reserves in its territorial waters will add to the economy’s recovery.

Resolving the backlog of non-performing loans is critical to giving the economy a fighting chance at recovery.  Yet, Greece adopted a workable bankruptcy resolution process only recently and the banks do not currently have the organizational capacity to process the mountains of bad loans.  The new bankruptcy regime will allow banks to sell off portions of their NPL portfolios to workout specialists; but it is essentially that this work be done quickly.  At the recent Capital Link conference, several bankers discussed some of the intricacies of case-by-case loan workouts, but Greece cannot take another five years to work out its NPL backlog.  Getting the job done quickly would undoubtedly cause many businesses and individuals to be treated more harshly than most would like.   The challenge will be to implement a process that is both speedy and fair.

The NPL backlog is so high that resolution will undoubtedly have a significant structural impact on many industries.  If it has not done so already, the government should consider hiring strategy consultants from firms like McKinsey to guide it through this industry reshaping process.  Without such guidance, bankers may find it challenging to create realistic financial projections for individual enterprises upon which their bankruptcy restructuring plans will be based.  Until this workout process is complete, Greece may not achieve the level of investment spending necessary for its economy to achieve lift-off.

In the meantime, Mr. Tsipras has asked for the support and trust of the investment community to complete the work of the bailout program and put Greece on a sustainable growth path.  Europeans have already given Mr. Tsipras a significant vote of confidence, as evidenced by the success of the recently completed €14.4 billion bank recapitalization program.

There will still be contentious issues going forward that will put investors on edge, but the government will most likely follow through with the important parts of the reform program, as long as the EU and global economies hold up.  If there is a major economic downturn, the government will probably have little choice but to leave the euro.  It is unlikely that Greece will continue to suffer through a sustained economic downturn for very much longer without reclaiming its ability to control its destiny.

Since National Bank of Greece has delisted its NYSE-traded shares, there are no Greek securities that trade on U.S. stock exchanges, except for the Global X FTSE Greece ETF (GREK).  Although I believe that GREK has significant near- to medium-term upside potential, it is highly speculative.  Investing in Greece is probably best left now to Greeks, Europeans and those who can invest directly in the country.  Accordingly, while I will continue to follow developments in Greece with great interest, I will probably not continue to publish research reports and commentary on Greece going forward.

Stephen P. Percoco
Lark Research, Inc.
P.O. Box 1543
Linden, New Jersey  07036
(908) 448-2246

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