Overvalued bonds affair could turn out a blessing in disguise

The scandal of the overvalued government bonds bought by pension funds, which has dominated Greek politics the last few weeks, may turn out to be a blessing in disguise for a very simple reason. It has made everybody aware of the shortcomings of the present system and no responsible person can pretend he or she does not know what is going on and argue in favor of preserving the status quo with minor changes. As the main opposition PASOK party tries to keep the affair in the limelight to score more points politically and the government tries to wrap it up to stop the hemorrhage, the average citizen is learning what a number of bankers and stockbrokers have known for years. These pension funds were important clients who could buy a great deal of bonds, helping to bring in tens of millions of euros in revenues to banks and brokerages. However, to be successful in this business required some kind of close relationship with members on the boards of pension funds and especially their heads. Bankers and stockbrokers who have sold or tried to sell bonds to pension funds in the past, including the previous decade, say in private that it was not unusual for one or more board members to request some favors. In the majority of cases, the favors were material. Some of the salesmen were pretty successful, while others gave up because they either did not want to condone such practices or were prohibited by the rules and ethics of their own organizations. At this juncture, Greece now has the opportunity to overhaul the way pension funds manage their reserves. One of its priorities should be to change the stringent allocation rules which require that 23 percent of the money is allocated to domestic equities and real estate and the rest (77 percent) to Greek government bonds. Moreover, up to 60 percent of the 23 percent quota can be put into stocks with the remaining 40 percent in real estate. The stocks should be listed on the Athens Exchange and comprise mainly blue chips, while investments in derivatives are allowed only for hedging the stock portfolio risk. The relevant authorities, namely the Labor Ministry and the Bank of Greece, will have to give their consent before social security funds can go ahead and sell their bank shares. This should change and Greece can look into the examples of other state pension funds in other European Union countries for enlightenment. The case of Norway is very recent. The government pension fund of Norway, one of the biggest in the world, which has holdings worth more than 200 billion euros, announced late last week that it will raise its allocation quota to equities to 60 percent from 40 percent. Norway, a country with a population of some 4.6 million people, continues to invest a small portion of its revenues from the exports of oil to the fund annually. Interestingly, the Norwegian pension fund has produced an annual return of about 8 percent on average in the last five years. This is well above the average annual return the typical Greek pension fund has earned over the same period. So one of the major changes that has to be instituted in Greece has to do with aligning the Greek pension funds’ asset allocation rules with international standards. The bond scandal helps to that effect because it has made many people, including politicians, understand that investing in bonds is not a risk-free exercise. The value of straight fixed-rate government bonds can rise or fall as money interest rates go down or up respectively. In addition, it is more difficult to find prices for more complicated products, such as structured bonds, especially if you do not know, because they are usually traded on electronic trading platforms or organized exchanges. Of course, if one asks Greek politicians of all stripes, one will get the same answer when it comes to keeping the 23-77 percent quota intact: Stocks are more risky than government bonds on average and it would be imprudent to put social security contributions in a harm’s way. It is not clearly spelled out that one of the reasons behind government officials’ insistence on maintaining the current allocation rules has also to do with the country’s public debt-to-GDP ratio. If social security funds liquidate a significant portion of their Greek government bond holdings and place the proceeds in other forms of investment, the country’s debt-to-GDP ratio will rise. This is because the stock of government bonds held by state pension funds is subtracted from the outstanding stock of bonds issued by the country. Assuming pension funds liquidated some bonds worth 10 billion euros of the 15 to 20 billion euros thought to be in fixed-income government securities, Greece’s public debt would jump to about 106 percent of GDP. Luckily, Greece can overcome this hurdle in the next six months or so when Eurostat, the EU’s statistical service, gives the expected green light for revising the Greek GDP by some 25 percent from an estimated 196 billion euros at the end of 2006. This revision will drive the public debt-to-GDP ratio well below 90 percent, providing plenty of room to maneuver. So, government officials have no reason to fear a more rational allocation scheme in which investments in Greek and foreign equities and real estate constitute a much bigger portion of social security funds’ total portfolio holdings than the current 23 percent. The same holds true for the composition of bonds where government bonds from other EU countries as well as corporate bonds should be allowed alongside Greek government securities. The government and the political parties in general should understand that making the asset allocation rules more flexible would help pension funds reap the benefits of portfolio diversification in the medium to long term. So, following the example of Norway and other EU countries in allowing more money to be channeled into Greek and foreign equities and real estate and other EU country bonds is a good way to start overhauling the present system.

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