Restoration of credit flows appears vital for economy to recover

The Greek economy will not be able to get back onto a steady growth path unless normal credit flows to the private sector are restored.

Some pundits believe this may require the nationalization of one or more major banks and their subsequent sale to some large international banks.

The debate over whether Greece will restructure its public debt, what form this may take and when, appears to have stolen the limelight from another important issue: the struggle of a good part of the private sector.

Although part of the private sector has been able to flourish due to its association with the largely inefficient public sector and is therefore now paying the consequences, the local economy has relied heavily on the rest of the private sector to keep on going.

Faced with a steep drop in consumer demand along with heavy taxation and growing difficulties in securing the necessary funding from the local banking system, a part of the healthy private sector is showing signs of severe strain.

Since domestic consumption is projected to remain subdued for quite some time and foreign demand is not sufficient to pick up the slack, the least these companies need is less credit from their traditional funding source, that is, the local banks.

This is, of course, the result of the state?s inability to convince the international markets that the public debt is sustainable under the current economic policy program, as demonstrated by the record-high levels of Greek bond yield spreads over Germany and the large amounts paid by investors to insure their Greek bond holdings against a moratorium of payments by the country.

This has put the country into a quarantine by international markets and local firms, and banks are not excluded.

Banks have tried to replace deposit withdrawals with cheap short-term ECB (European Central Bank) funding with the help of state guarantees.

However, this is obviously not enough to fund the healthy private sector and the economy in general.

Moreover, it creates an asset-liability maturity mismatch for the banks since they have to fund mostly longer term loans to households and companies with loans up to three-months from the ECB.

In addition, local banks are fully aware that they will have to gradually reduce their dependency on ECB funding down the road and will have to deleverage, meaning that the amount of new lending will need to be less than maturing loans.

It is, therefore, very important that credit flows to the private sector and especially to its healthy component, are restored if the Greek economy hopes to recover, and, by extension enabling the state to repay its public debt.

Some think that the restructuring of the public debt may accomplish this by making the debt sustainable and opening up the markets to the country and its banks. However, this is not as easy as it may first sound.

Any voluntary form of debt restructuring such as an extension of repayments on existing bonds by five or 10 years with or without a coupon rate cap to, let?s say, 3.5 percent compared to an estimated 4.9-5.0 percent at present will not do it.

As we have argued before, only if the new bonds to be exchanged for old bonds are collateralized or credit enhanced by a AAA-rated entity such as EFSF, could there be some chance of opening up the interbank repo market for local banks.

However, it is not sure whether Greece?s EU partners will accept something like this since it is likely to burden their national debt, making it politically very difficult.

A mandatory form of haircut of 40 to 50 percent would have indeed reduced the debt-to-GDP ratio to lower levels that may be deemed sustainable by the markets. However, on the one hand, Greece?s EU partners are not willing to accept such a solution and, on the other, it would have likely shut the country out of the markets for many years.

Therefore, any form of debt restructuring except the credit enhanced solution of ?Brady bonds? will not help local banks access the markets for fresh funding. Even the ?Brady bond? solution of credit enhanced bonds may be of limited use for long-term issuance by banks.

But the Greek economy cannot wait forever so that normal credit flows are restored. From this point of view, some advocate that weaker banks become the sacrificial lambs in the sense that their shareholders lose most of their money by essentially nationalizing and then selling cheap to large international banks.

This can be done if banks are in need of fresh capital and existing shareholders are not able to participate in a share capital increase. The bank or banks, according to this rationale, will end up at the Financial Stability Facility funded with 10 billion euros from the 110-billion-euro loan.

Is is this the right solution for getting the economy jump-started?

It is obviously wrong to ?sacrifice? private companies in order to preserve a large and inefficient public sector.

Even if they have made wrong choices in the past such as giving loans to customers with poor credit for the mere purpose of enhancing their profits or/and buying an excessive amount of government bonds, banks and their shareholders do not deserve this fate.

However, since the political system seems unable to provide the right solution of drastically cutting back the public sector, one may argue that there seems no other solution left to improve the credit conditions in the broader economy and help avoid a prolonged recession.