Market still expects debt restructuring

Whether Europe’s stress tests will end up reducing market uncertainty and appeasing investor concerns about the strength of continental banks remains to be seen. The stress tests made it clear, however, that the subject of Greek debt restructuring is well entrenched in the minds of many market participants. In this regard, it looks increasingly likely that Greek authorities may have to prepare for a longer-than-initially-thought battle to change this perception. Worldwide investors and governments looked upon European bank stress tests as a way to see how many financial institutions will make the grade under some stringent assumptions as regards any unexpected drop in economic output or sharp fall in the value of European government bonds compared to end-2009 levels. Criticism The fact that only seven out of 91 banks flunked the tests, including Greece’s ATEbank, should have pleased investors. However, a number of them had criticized the assumption of a drop in the price of certain European government bonds, especially those of Greece, as being relatively low when compared to current levels. The Greek 5-year bond has lost about 18 percent of its value to the year to date and therefore the assumption as part of the stress test for 23 percent drop comes close to equating current bond market conditions with the worst-case scenario. Criticism was also directed at the assumption that the drop in the value of bonds has an effect on the trading portfolio of the banks and not on the bond portfolio held to maturity, where a number of financial institutions, especially Greek banks, have placed the bulk of their sovereign bonds. A haircut, that is, a drop, in the value of the bonds held to maturity would have been equivalent to a sovereign default. European authorities are obviously unwilling to adopt such a scenario after putting such huge aid mechanisms in place and with so much at stake for the euro. No change in perception It is clear that this criticism of the European stress tests would not have been made if a number of investors did not doubt Greece’s ability to avoid the restructuring of its debt over the next two to three years. This shows that an easing in the former constant flow of negative news from the country in the last couple of months and positive news on the budget deficit front may have helped to stabilize Greek bonds in the thin secondary market. However, it has not done much to change the market perception that the country will eventually be forced to seek a restructuring of its debt. Under normal circumstances, the sharp cut in the budget deficit, which Greece is likely to deliver this year, should have eased investors’ concerns and paved the way for a change in attitude toward its debt. Even more so had the country continued to show resilience in meeting its deficit reduction target in the first half of 2011. Unfortunately, this somewhat encouraging news has been partly neutralized by the state’s takeover of debts belonging to essentially bankrupt state-owned corporations, such the Hellenic Railways Organization, and others to come. This is because this cleansing exercise will add more percentage points to the public debt ratio, further reinforcing the idea of a Greek restructuring. The fact that many international investors want to dispose of their Greek bond holdings following the country’s downgrade to junk status by the major credit rating agencies or under instructions by their credit risk units does not help either. Still it is reasonable to assume that they would have been able to get rid of a good deal of the overhang by the end of 2011 or the first quarter of 2012. Nevertheless, the interplay of the budget deficit reduction along with the rise in the public debt-to-gross domestic product (GDP) ratio and the positions of many foreign funds and banks in Greek bonds make a number of market participants continue to doubt a good scenario for Greece. This was clearly demonstrated in the criticism directed at the assumptions in stress-testing Greek sovereign bonds. It is difficult but not impossible to make skeptical investors change their minds. It requires consistency and perseverance on the fiscal front, an economy leaving recession next year and a stabilization of the public debt-to-GDP ratio to below 130 percent despite the takeover of debts from entities of the central government. The latter cannot be attained without asset sales, such as privatizations and the disposal of real estate holdings, in a relatively short period of a year and a half to two years. This is the indirect message sent to Greece by the investors who were critical of the European bank stress tests.