The second European Union support package may have improved the sustainability of the Greek public debt but it did not put the issue to rest, as the behavior of Greek credit default swaps (CDS) and bonds show.
Under these circumstances, putting the Greek economy on a sustainable growth trajectory is of paramount importance, but this cannot be done as long as the private sector continues to face a credit crunch. In this respect, Greek banks will have to make some tough choices.
We do think that the decisions taken at the last Brussels summit constitute a step forward for the eurozone by giving greater powers to the European Financial Stability Mechanism (EFSF) to contain contagion which is the most important decision they reached in our view.
In addition, they gave Greece some breathing space to adjust its public finances via a maturity extension of its debt and a reduction in the interest rates on new loans provided by the EFSF.
By assuming a 90 percent participation by the private sector in the second support package and a buyback of Greek bonds on the secondary market by about 20 billion euros, this can cut the public debt by some 12 percentage points, or some 26 billion euros.
This reduction may look relatively small for a country facing a debt-to-GDP ratio of more than 160 percent at this point and it indeed is but it is not negligible. Still, the markets are not convinced this is the end game as evidenced by the cost of insuring against a halt of payments on Greek bonds.
The spread on five-year Greek CDS may have receded to 1,700-1,800 basis points from 2,000 points prior to the eurozone summit but they are still extremely high, indicating some investors are willing to pay 17 or 18 percent annually to buy CDS to insure their Greek bond holdings against default. Equivalently, there are market participants out there who are willing to bet on a Greek default by paying CDS at a very high price.
This can be interpreted in two ways. First, the market either thinks the private sector involvement (PSI) will not finally be a success, producing a financing gap, or the country will be forced to restructure its debt once again down the road.
Whatever the case, Greek banks are directly affected by holding government bonds of nominal value exceeding 45 billion euros. They have already paid very dearly for this by seeing the value of their stocks on the Athens bourse plummet, hurting their shareholders.
However, the banks themselves have not shown the losses from their bond holdings because they have parked in the hold-to-maturity and loan receivables portfolios.
By participating in the PSI of the second Greek package, they may have to recognize these losses, proving the stock market right. Assuming a 21 percent haircut, it is generally estimated Greek banks may need a recapitalization of a few billion euros.
This may be a negative development for their shareholders who may not be able to participate and some banks will have to resort to the EFSF and the Financial Stability Fund set up under the first support package, although it is generally good for the Greek economy.
The latter cannot get out of its slump if the private sector is not funded properly and this cannot be done as long as the banks do not recognize all possible losses from their bond portfolios and their nonperforming loans and recapitalize.
Of course, the Greek economy will still have to embark on a far-reaching program of structural reforms and privatizations and downsizing the problematic public sector to boost its international competitiveness in the medium term and raise its potential output growth rate.
Nevertheless, it needs a well-capitalized banking sector to grow. Needless to say, the recapitalization of Greek banks will have to be accompanied by painful cost cuts since the new operating environment at home will be characterized by slower credit growth than in the past.
Moreover, local banks will have to adjust to a different business model from retail banking where they made money easily by providing loans to consumers and small and medium-sized businesses.
The new business model will require that they place more emphasis on asset management, private banking and other sources of income largely disregarded during the boom years of retail banking in the past.
Whether the large local banks can produce these revenue and cost synergies by merging with other local banks to avoid being nationalized remains to be seen. However, they have no choice but to face reality and make some tough decisions.
The Greek economy cannot rely solely on structural reforms and the so-called European ?Marshall Plan? to grow out of its misery and make the public debt sustainable.
It needs a well-capitalized banking sector with a rational cost structure and a different business model. This is more so since the US Marshall Plan provided aid and stimulated investment while its European version seems to offer more loans and austerity.