Greece’s ability to overcome the strains created by the ongoing financial and economic crisis will partially depend on the strength of its banking system. If the country’s large banks hold their ground this year and the government behaves in a responsible way, the Greek economy may be able to avoid an outright recession that would lead to a protracted and painful adjustment and opt for the next best alternative, namely weak but positive gross domestic product (GDP) growth. The country will face another tough test this week when it taps the international capital markets with a 5-year syndicated bond issue in the aftermath of its recent downgrade by Standard & Poor’s. The international credit agency downgraded Greece’s sovereign ratings to A-/A-2 from A/A-1 last week, citing a host of factors, including weak public finances leaving little room for measures to cushion the impact of the ongoing downturn. Although Moody’s has signaled it does not intend to follow the same route for the time being, Fitch Ratings, the third largest credit ratings agency, essentially warned of a downgrade if the government does not take steps to address the budget deficit. Analysts believe the European Commission will forecast a Greek budget deficit in excess of 3 percent of GDP this year on a sharply lower economic growth rate when it releases its latest projections today. This is not the best combination of events for a country seeking billions of euros from global capital markets to refinance expiring government securities amounting to some 7 billion euros this month, plus funding for new emerging fiscal needs. Of course, the fact that last week Greece borrowed some 3.15 billion euros by issuing 3, 6 and 12-month T-bills takes some pressure off, but this is short-term paper which has to be rolled over again in a few months’ time. Still, despite all the hoopla about paying large spreads over German government debt, Greece may end up paying an average interest rate which may be no higher than 50 basis points over the average rate paid in its 2008 borrowing program. This is due to two factors. First, a good chunk of the widening Greek spreads over Germany is offset by much lower German bond yields and sliding euro money market rates such as Euribor. Second, the country intends to cover almost a quarter of its annual borrowing needs via T-bills, where it can bank on interest rates of less than 3 percent. The consensus at this point wants Greece to raise the necessary funds even at an elevated average interest rate. However, market views differ on how big the economic downturn will be, though they all agree on one thing: The ability of the Greek economy to weather the international economic crisis will rely to some extent on the health and strength of its banking system. Top bankers admit that profits are not their top priority this year. This is easy to understand, since bank stock prices have fallen some 70 percent from their highs in October 2007, so it does not make much sense to focus on profits. After all, they know the spreads they earn on loans and deposits will be compressed further this year and total lending is bound to slow considerably from around 18-19 percent in 2008. Their main concern is the financial health of their banks, namely whether they are well capitalized, have taken adequate provisions for bad loans – that are expected to pick up as the ongoing economic slowdown intensifies – and whether there is plenty of liquidity to finance their assets. The Greek rescue plan worth about 28 billion euros is aimed at addressing precisely these problems and concerns. However, the much weaker-than-expected economic environment in Greece – combined with sharply slower growth rates in neighboring countries, depreciating national currencies and falling real estate values – create a dangerous cocktail. At this point, its is highly questionable whether the target for 10 percent lending growth set by the Greek authorities to support economic growth will be achieved. This is so because Greek households appear more reluctant to take out new mortgages and/or consumer loans when there is so much uncertainty and banks appear to be more cautious about lending to businesses with lower credit credentials. At this point, total annual lending growth of the order of 4 to 5 percent appears to be more feasible but this signals very weak GDP growth in 2009. If this is indeed the case, the question is whether the sharp economic slowdown will produce more bad loans than Greek banks can handle without putting their franchises at risk. If we were to hazard a guess given the available information, the answer would be affirmative, but one or two large banks would also have to think harder about their future the day after.