KWR Special Report

The Next Round in the Greek Tragedy
By Scott B. MacDonald

For a small country with an economy based on shipping, tourism and agriculture, Greece caught the world's attention in April and May 2010, when it edged close to a sovereign debt default and threatened to rend the fabric of the European Union (EU). Supported by a €110 billion credit facility by the EU/IMF, the government implemented a tough economic reform program. Despite the efforts of the Papandreou administration to right the fiscal ship and recreate the Greek economy, considerable doubt remains over the ability of the government to persevere in the face of public discontent, which could become more manifest in the upcoming November local elections. The elections are increasingly going to be a point of focus for Greece and investors as to the government's ability to stick with the austerity program and stave off pressure to either default or restructure its debt.

Greece, according to the Bank for International Settlements (BIS), has $297.2 billion of government debt, which makes its debt/GDP ratio over 100% and rising. The burden is more than likely unsustainable. This view dominates the market (hence 5-year Greek Sovereign CDS spreads close to 1,000) and has its cadre of economists forecasting a default or restructuring of the country's debt. One of the more recent gloom-and-doomer's is Hans-Werner Sinn, head of Germany's IFO, a prestigious economic think tank, who believes that Greece's austerity measures cannot prevent default and will lead to a breakdown of the political order if continued for long. As the good economist proclaimed: "This tragedy does not have a solution." He also points out that societies under such stress usually end up with political fatigue in the second year.

The stress Greece faces - a brutal economic landscape and political fatigue - are creeping into the picture. The Socialist (PASOK) government of Prime Minister George Papandreou, backed by a €110 billion joint EU/IMF credit facility, has implemented a tough, many would say harsh, structural adjustment program, seeking to create a more efficient economy and eventually put the financial house in order. By staying with the euro, Greece is being forced to adopt an internal devaluation by reducing wages, cutting public spending, and looking to privatize parts of the state-owned sectors. To this backdrop the economy is expected to contract by 4.5% this year and another 2.5% next year, giving the Balkan country of 11 million people the prospect of three consecutive years of a shrinking economy. Unemployment continues to rise (at 12% in May) and benefits once doled out by the state are rapidly evaporating.

Papandreou and PASOK were elected in October 2009, inheriting a fiscal mess from the outgoing conservative New Democracy (ND) party, lead by Kostas Karamanlis. The departing ND administration was not well known for its transparency and disclosure and the size of the fiscal deficit was concealed. By the early days of the PASOK government the fiscal deficit to GDP ratio had ballooned out past 10%, ultimately to settle a little short of 14% for 2009. This, in turn, shocked much of the international financial community and investors, who had assumed Greece's risk to be EU risk - or very close to it.

Papandreou was forced to take drastic measures to avert a default. While this helped reassure (to a point) international investors and paved the way to the EU/IMF facility, Athens and some of the other major Greek cities were caught up in a whirlwind of riots and demonstrations. An overblown lifestyle paid for by other European taxpayers was coming to a painful end, leaving many Greeks angry and disillusioned with their political class (which got them into this mess) and the rest of Europe (which proved to be very critical of Greek mismanagement and showed little sympathy over the looming loss of substantial social benefits).

Greece had an uneasy summer, as austerity measures including higher taxes on almost everything bit into household spending. Falling wages have forced many families to fall back on savings. According to Greek government sources, bank deposits held by businesses and households fell in July to €212.3 billion from €216.5 billion in June, the seventh straight monthly drop.

Although the Greek government is meeting most of its targets and had little trouble in receiving the €9 billion tranche from the EU/IMF facility in September, good news on that front is difficult to translate into good cheer for a financially hard-pressed public. Recent opinion polls reflect a growing pessimism about the future, something that PASOK needs to consider with local, mainly municipal, elections to be held on November 7th, 2010. In those opinion polls, 76% of respondents said the nation's economy was not going to improve; 69% indicated that the government's policies are not setting the stage for growth.

With an eye to the November elections, Prime Minister Papandreou reshuffled his cabinet in early September. Two elements were at play. He kept Finance Minister George Papaconstantinou at his post and strengthened the position of technocrats at a number of ministries hoping to buttress to economic growth, privatization and attracting foreign investment. The government reiterated its intention to cut the deficit to 8.1% of GDP this year and 7.6% in 2011. Papaconstantinou also indicated that the major portion of the austerity measures will be felt in the third quarter, when structural changes to the pension, labor and transaction systems start.

Papandreou also brought into his administration two more traditional socialists who publicly criticized the reforms as too harsh. Room was also made for 12 additional deputy ministers. All in all, the reshuffle was meant to underscore ongoing commitment to restructuring the economy and austerity, moving people into place that could help speed up a shift to economic growth, and provide a kinder and gentler PASOK to the voters.

A short-term test of market confidence for Greece will be the effort by the country's largest bank, the National Bank of Greece (NBG), to raise €2.8 billion ($3.5 billion) in new capital to bolster capital. If the deal goes through - which will depend heavily on pricing - NBG's capital adequacy ratio would exceed 14%. This is an important step for the country, considering Greece has seen an eight-month liquidity squeeze on its banks which have been excluded from the wholesale banking market. Part of the funds raised would go to repay an earlier €358 million capital injection from the government.

PASOK has not had an electoral litmus test since it won the October 2009 elections. Considering that an upswing in the economy is not expected, unemployment is likely to continue to rise, and strikes are continuing - a new one for transport workers as this is being written, the government faces considerable pressure. A major defeat could put PASOK under pressure to ease off austerity measures or force a split between the party's moderate and left wings, possibly precipitating a political crisis and new elections. Greece could find itself involved in the often messy business of coalition politics.

A new round of Greek troubles clearly has implications for the rest of Europe. According to the BIS report, French banks are the largest holder of Greek foreign debt, with $111.6 billion as of March 31st, 2010. German banks hold $51 billion and U.S. banks $41.2 billion. The possibility of a debt default or restructuring would give many bankers heartburn and would ripple into the ranks of Europe's institutional investors.

We believe that Greece will make it through the year without a default or a restructuring of its debt. Beyond that horizon the landscape becomes more difficult to read as politics are likely to increasingly impinge on economic policymaking and the government's fortitude could be eroded by a bad day at the polls in November. One saving grace for PASOK and Papandreou is that most Greek voters remember that it was the opposition ND that presided over the slide into the crisis. Moreover, the ND is doing little to provide new ideas to extract Greece from the mess it contributed to. All things considered, Greece is going to remain as a point of concern for international markets for the remainder of 2010 and probably into 2011. Banks and investors gradually have to accept and prepare for the likelihood that at the end of the day they will also have to share in the cost of deleveraging. We do not rule out the possibility that the Greeks adhere to their austerity program and maintain international support in a muddle through scenario. Indeed, we hope that is the case. However, there is no denying that the political factor is going to increasingly dominate the situation, injecting greater uncertainty to an already uncertain situation.

While the information and opinions contained within have been compiled from sources believed to be reliable, KWR does not represent that it is accurate or complete and it should be relied on as such. Accordingly, nothing in this article shall be construed as offering a guarantee of the accuracy or completeness of the information contained herein, or as an offer or solicitation with respect to the purchase or sale of any security. All opinions and estimates are subject to change without notice. KWR staff, consultants and contributors to the KWR International Advisor may at any time have a long or short position in any security or option mentioned.

KWR International Advisor

Editor: Dr. Scott B. MacDonald, Sr. Consultant

Deputy Editors: Dr. Jonathan Lemco, Director and Sr. Consultant and Robert Windorf, Senior Consultant

Publisher: Keith W. Rabin, President

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