Why the decline in securities matters

The recent rout of Greek stocks and bonds reflects the significant rise in political uncertainty ahead of the three rounds of the presidential election in Parliament and the likelihood of early general elections, but more importantly concerns about a collision with the country’s lenders. In this regard, we may see more volatility and a further deterioration in market sentiment in the days and weeks ahead which could take its toll on the fragile economy. It is ironic but the negative impact of political risk could vindicate the troika’s prediction about the disputed 2015 fiscal gap by undermining economic activity.

One of the main disagreements between the two-party coalition government and the troika has centered on the fiscal gap, that is, the difference between the estimated primary budget surplus and the 3 percent of GDP target for next year, according to pundits. The Greek side based its calculations on economic recovery with GDP growth picking up to 2.9 percent or more from a projected 0.6 to 0.8 percent this year.

However, recent political developments and the prospect of protracted political uncertainty have made a number of analysts and others raise their eyebrows, while some have even taken action. Therefore, the recent sell-off in Greek stocks and bonds is not surprising. Readers are reminded that the Athens general stock index lost more than 20 percent in just four consecutive sessions on increased trading volume. Moreover, the yield on the three-year bond rose above 11 percent on Friday, surpassing medium- and long-term yields. The resulting inversion of the Greek yield curve is generally assumed to point to the increased likelihood of a moratorium on interest payments.

Some in Greece say it does not matter that stocks and bonds are falling because it is the living standards of the people that matter. This contention would have been correct if the sharp drop of the stock exchange and bond prices did not affect economic activity, but it is not certain this is the case. True, Greek investors’ stock holdings on the Athens bourse have been in decline, so the sharp price drops will not inflict the same pain it would have caused in the past. Still, it dents market sentiment and adversely affects consumer and business confidence. This will become more evident if the Athens bourse remains under pressure in the next few weeks and months because it will likely make consumers and businesses less willing to spend, slowing down the economy.

Something similar is happening in the bond market: Greece is not borrowing from the capital markets so the sharp rise in the yields is not affecting its funding program. In addition, only about 35 billion euros of Greek bonds is estimated to be in private hands, mostly foreign investors. So the market-to-market losses on their bond portfolios are having a minor impact on local investors, such as banks.

However, Greece had been planning to raise 9 to 12 billion euros from the markets next year, and the recent sell-off, especially if it persists for the next few weeks or months, will make it more difficult to tap the markets. Of course this could change if the domestic situation improves drastically and the ECB provides a helping hand in 2015. Moreover, it makes it more difficult for Greek banks and companies to raise capital in financial markets.

This means banks will depend more on the ECB and the Bank of Greece for liquidity and make them less willing to provide loans. Also, private companies may not be able to refinance old expiring loans or finance new investment projects by selling their bonds. In this kind of environment, Greek exporters and importers will also find it tougher to secure cheaper funding or obtain easier credit terms. In other words, the business climate will be adversely affected and combined with the negative signs from the stock market lead to the postponement of investment plans.

It is obvious the rout of stocks and bonds, especially if it goes on for a while, will undermine any efforts to stimulate aggregate demand via higher investing spending and a small pickup in consumer spending next year. If this also leads to sizable cancellations in bookings for 2015 and the tourism industry is hurt, the overall negative impact on economic activity will logically be bigger. In turn, this means Greece may have to revise downward the official projection for a 2.9 percent growth rate next year. Some analysts even warn of a double dip in the economy if the Greek government fails to reach an agreement with the official lenders to ensure the economy is properly funded.

But slower growth, especially much lower than the projected 2.9 percent rate, will likely translate into a smaller primary budget surplus, leading to a bigger fiscal gap since the distance from the surplus target set in the program will widen. If this is the case, it is certain the troika will be vindicated and will demand new measures to fill the bigger fiscal gap, leading to more economic pain and increased social tensions. The Greek political system will have only itself to blame for this development if this is the case but we guess they care less in reality since power is the name of the game.