ANALYSIS

Economy needs reforms, investment

economy-needs-reforms-investment

The ECB is expected to decide midweek on the recapitalization of Greek banks, setting in motion the process which policymakers hope will be completed before the end of the year. Even if everything goes well, one shouldn’t be under any illusions. Resolving credit supply constraints is not enough to avoid Japanization.

It is generally accepted that the economies of countries with large foreign direct investment (FDI), such as Ireland, and/or private sector companies with strong liquidity positions can grow at a satisfactory rate with little or no credit growth. In contrast, countries which cannot count much on FDI flows and/or have companies with relatively weak liquidity positions need positive credit growth to advance.

Greece belongs to the second category and needs credit growth to sustain strong real gross domestic product rates in the medium term and repay its public debt. In this respect, credit availability matters and the prospective bank recap is important. However, the authorities will have to avoid past mistakes and ensure Greek banks will be overcapitalized this time to be able to deal effectively with the large stock of bad loans and absorb other shocks in the future as we have argued repeatedly.

Although Japan is another animal, as we say, one can draw some useful lessons from its banking sector. To start with, let’s remember that the trigger for the problems encountered by the Japanese banking sector in the last few decades was the large land and stock price declines that began in the early 1990s.

Within three years of their peak in 1989, Japanese stocks had lost about 60 percent of their value. In addition, after the 1992 peak of commercial land prices, they fell by roughly 50 percent over the next 10 years. The large drops in these prices impaired collateral values to such an extent that any banking system would have found it hard to adjust. This is because the situation warranted very high provisions for nonperforming loans and significant write-offs.

However, the political and regulatory response of the Japanese authorities was to essentially deny the existence of the problem and delay the restructuring of the banks and any serious reforms. Banks had to comply with minimum capital adequacy ratios while some of them were nationalized.

In this environment, Japanese banks continued to extend credit to insolvent corporations, betting they would recover or the government would bail them out. Banks also felt they would have to roll over even problematic loans because they would have faced criticism from the public that they contributed to the deepening of the recession by denying credit to needy companies.

In addition, Japanese banks came under pressure from the government to provide more loans to small and medium-sized companies to ease the credit crunch. The end result was to create zombie banks and many nonproductive companies on life support from the banking system, contributing to the economic stagnation.

One can discern some similarities between the Greek and Japanese banking sector experience during the years of economic crisis, although the roots of their problems are different. At this point, Greece has the opportunity to cope with the credit supply constraint via the recapitalization of its banks. Having said that, one should also bear in mind that cleaning up loan portfolios requires time and usually has a negative impact on the banks’ willingness to lend.

Cleaning up bank balance sheets and boosting their capital adequacy ratios is definitely necessary for credit institutions to play their intermediary role, but liquidity is also important for extending more loans and the Greek banks are short of cash. Attracting deposits withdrawn over the last few years could be a solution but it will be much more difficult after the capital controls and the policies pursued by the tax authorities, as the feeling of distrust among depositors appears to be widespread.

Even if one assumes the removal of the credit supply constraint for credit growth, there is no reason to believe the credit demand constraint will not be binding and the latter may be more important. After all, the economic outlook is not promising, business sentiment is downbeat again, a number of companies are trying to deleverage as they still face high debt levels and doubts about the implementation of the third economic policy program persist. Some individuals and businesses even question whether the newly elected government will be able to survive the implementation of the new program.

The above picture does not bode well for credit growth and this should be a cause for concern because Greece lacks significant FDI flows and does not have a private sector with a strong liquidity position. This is more so since the local economy seems to be sliding back into recession after an interlude of economic growth. Even if we assume the good scenario of recovery in the second half of 2016, it may take a few more quarters before credit growth turns positive.

All in all, it will take more than bank recapitalization and the removal of the credit availability constraint to restore credit growth. Boosting aggregate demand via more EU-funded and other investments and implementing more structural reforms may do the job by speeding up the return to credit growth and economic expansion.

[Kathimerini English Edition]