UPDATE: S&P Upgrades Greece to 'B-'; Outlook Stable (FXE)

(Updated - January 22, 2016 11:39 AM EST)

RATING ACTION

On Jan. 22, 2016, Standard & Poor's Ratings Services raised its long-term foreign and local currency sovereign credit ratings on the Hellenic Republic (Greece) to 'B-' from 'CCC+'. The outlook is stable. At the same time, we raised the short-term foreign and local currency sovereign credit ratings to 'B' from 'C'.

RATIONALE

The upgrade reflects our assessment that the Greek government is broadly complying with the terms of its €86 billion financial support program financed by eurozone member states via the European Stability Mechanism (ESM). In particular, by the end of March we expect a compromise to be reached on pension reform that will balance the government’s preference to raise social security contributions and consolidate the separate pension funds into a single system, with creditors’ and the IMF’s focus on spending cuts to narrow an unsustainably high pension deficit, currently estimated at 9% of GDP. An impending agreement on pension reform, leading to the successful conclusion of the first review of the program, would raise the possibility of additional relief on the official portion of Greece’s general government debt (which makes up 88% of all general government medium- and long- term liabilities, including Eurosystem holdings of Greek tradeable bonds).

In the face of two general elections, a referendum, the imposition of capital controls, and further tax increases, the Greek economy contracted only slightly last year (-0.3% is our 2015 GDP forecast), with investment declining by a much larger 12%. In particular, consumption was surprisingly resilient during 2015 with car sales up 13.5% year-on-year. This was partly because, in the run up to capital controls, households hedged themselves by front-loading purchases of consumer durables. Ministry of Labor data also indicates that there was net private sector job growth for 2015 as a hole, reinforcing expectations that unemployment has finally peaked in Greece, albeit at the highest level in the EU (24.5% in October 2015).

Our prognosis for the Greek economy is for one more year of essentially flat growth, followed by a more robust recovery. We see three key drags on GDP this year. First, despite last autumn’s successful recapitalization exercise, we anticipate that, throughout 2016, Greek financial institutions will remain focused on cleaning up their balance sheets rather than lending to the private sector; nonperforming loans (NPLs; European Banking Authority definition) at Greek banks are at an estimated 46% of total loans, implying high levels of financial distress among Greek corporates and households.

Second, under Greece’s current (and third) official loan program, the government is committed to increasing public savings this year, which will directly subtract from GDP. Further fiscal tightening will be challenging to implement, not least because of the precarious state of the health care and educational systems after seven consecutive years of spending cuts.

Third, the carry-over from last year’s GDP growth creates a notable negative statistical effect for this year. We also expect that some of last year's exceptional consumer behavior will reverse during 2016. At the same time, some positive effects could contribute to a stronger-than-anticipated recovery this year. Further declines in oil prices during 2016 will support consumption. Financing arrangements under the program include plans to pay down an estimated 3% of GDP of arrears to the private sector, which firms are likely to use to clear their own wage arrears to employees, who may spend it. On top of this, Greece’s tourism sector, which saw record arrivals in 2015, is well positioned to benefit during 2016 from a weak euro and rising security risks in key competitors.

Since August of last year, there has been progress on most of the program milestones. The Greek government has partly relaxed capital controls by liberalizing foreign exchange spot transactions and derivatives trading, and raising limits on transfers abroad. The introduction of capital controls last year seems to have had the unintended positive benefit of encouraging the use of debit-card and other non-cash forms of payment, apparently reducing the size of the informal economy. Also during 2015, the government passed important legislation facilitating NPL sales and workouts, including the controversial lifting of a moratorium on home repossessions. Lastly, the VAT regime has been simplified.

Last October, the ECB’s banking supervisor estimated a stress scenario capital shortfall in Greece’s four large systemic banks of €14.4 billion (8.2% of GDP). By the end of 2015, banks had raised 60% of this shortfall from private investors via a combination of new equity, and bail-ins of junior creditors--together totaling €9.0 billion (5.1% of GDP). As a consequence, the general government only had to assume €5.4 billion (3.1% of GDP) of the cost of supporting two of the four banks versus the program assumption of nearly five times that amount. Any estimates of the long-term financial cost to the state of this exercise, however, should also reflect the ensuing dilution of the government’s banking stakes given the low equity component (the 25%/75% common equity to contingent convertible bonds split) in the recapitalization contribution by the Hellenic Financial Stability Fund. There is also a possibility that the banking system, including smaller financial institutions, could eventually require capital support. Nevertheless, in our opinion, the recapitalization exercise has contributed to Greece’s financial stability while considerably lowering the risk that further financial sector contingent liabilities will crystallize on the government’s balance sheet.

To understand the 2015 accounting for public debt, it is important to recognize that last year’s return of €10.9 billion in recapitalization notes (issued under Greece’s second program) to the European Financial Stability Fund actually means that overall government support of the financial sector in 2015 made a net negative contribution to general government debt of an estimated €5.5 billion, equivalent to 3.1% of GDP. This, plus the consumption of most remaining general government cash reserves, led to a very small increase in gross general government debt last year of just under €2 billion, we estimate. Net general government debt increased more significantly, from 172.1% of GDP at end-2014, to an estimated 181.4% by end-2015. We project that net general government debt will increase significantly again this year to 187.4% of GDP, mainly because we project no nominal GDP growth this year, but also because the government plans to make just over 3% of GDP (€5.5 billion) in arrears payments, as well as to finance a deficit of just under 3% of GDP. From 2017, however, we project sizeable annual declines in net general government debt to GDP, on the assumption that the economy starts to grow and reinflate again, and that the primary fiscal position improves.

We are forecasting a primary surplus of 0.4% of GDP this year (versus the 0.5% target), increasing to close to 2% by 2019. This is, however, substantially below the program target of 3.5% by 2018. One risk to fiscal targets this year is last year’s Council of State decision declaring that pension cuts introduced in 2012 were unconstitutional.

Merchandise export performance has generally been positive since late 2010, but from a low base (merchandise exports account for just 15% of GDP). Reflecting lower volume imports, the fall in energy prices, and a 9% year-on-year increase in tourist arrivals, we estimate that last year’s current account shifted into surplus. This would be the first current account surplus (under BPM6 methodology) for Greece since the mid-seventies. We expect Greece’s current account will shift back into deficit as demand recovers over the next few years, though oil prices, should they remain at current levels, could improve the current account position this year by as much as 2% of GDP. We note that, over the last half decade, Greece’s capital account has averaged a surplus of 1.5%-2.0% of GDP, and that €35 billion (20% of GDP) is available to Greece between 2014-2020 through EU funds, on top of substantial remaining EU grants under the 2007-2013 envelope. For this reason, we anticipate the capital account to remain substantially in surplus over the forecast horizon.

Greece’s external debt levels are also far higher than European averages especially as a percentage of current account receipts (an indicator of capacity to service foreign debt).

Given the current Greek government’s busy reform agenda, and its narrow majority of three seats, the prospect of implementing long-term reforms such as to the judicial system and public administration seems low. Nevertheless, our baseline expectation remains that, regardless of what government is in power, Greece will largely comply with the terms of the Eurogroup support program. We take this view as we don't believe the alternative would be viable for Greece’s financial stability; the banking system continues to depend on Eurosystem support of €107.5 billion or 61% of GDP (€68.9 billion of which was Emergency Liquidity Assistance) as of end-December 2015.

We expect any re-profiling of Greece’s official debt to come in the form of interest rate deferrals, and maturity extensions. At 16.5 years, Greece already has the longest dated debt stock of all rated sovereigns; while, at anestimated 1.9%, the general government’s effective borrowing cost (measured on an accruals basis; on a cash basis it is even lower) is already considerably lower than most peers. In light of these low annual maturities and very low interest rates, Greek government debt levels are affordable, in our opinion, and we reflect that in our final credit rating on Greece. At the same time, in the absence of meaningful front-loaded reductions in Greece's net general government debt to GDP ratios, we think the possibility of Greece re-accessing commercial markets toward the end of the third program at similarly long maturities and low interest rates remains low. However, political constraints in creditor countries appear likely to rule out write-downs of Greece’s official liabilities that might make earlier re-entry into commercial markets at affordable terms viable. This means, more realistically, that whether or not Greece can bring down its net general government debt level of 187% of GDP(the government's projection for end-2016) quickly will ultimately depend on whether the economy recovers rapidly in both real and nominal terms. According to our projections at optimistic nominal GDP growth rates of 5%, with an annual primary surplus of 2% of GDP and at current borrowing costs, it will still be another 13 years before net general government debt falls below 100% of GDP, assuming privatization receipts over the period of €20 billion.

Should the first review be completed successfully, we anticipate that the small amount of Greek government bonds still in the market are likely to become eligible for QE purchases by the Bank of Greece. In addition, a potential decision by the ECB to reinstate its waiver on the eligibility of Greek sovereign and sovereign guaranteed bank collateral for ECB (rather than costlier Bank of Greece Emergency Liquidity Assistance) financing would benefit the profitability of Greece’s highly challenged banking system. We, however, anticipate an only gradual lifting of the capital controls still in place, including withdrawal limits on household deposits.

OUTLOOK

The stable outlook indicates our view that, over the next 12 months, risks to our 'B-' rating are balanced.

We could consider an upgrade if we saw stronger growth performance, and measureable progress in the reduction of the still-high NPL levels in Greece’s banking system, alongside the lifting of capital controls including deposit withdrawal limits, which would be a strong indication of a recovery of confidence in financial stability and hence growth. We could also consider raising the rating on the back of an unexpected write-down of Greece’s level of net general government debt, which, at a projected 187.4% of GDP by end-2016 (excluding guaranteed debt outside of the general government perimeter), is one of the highest public debt levels of all rated sovereigns.

On the other hand, we could lower the ratings on Greece if the new government cannot implement the reforms it has agreed to in the Memorandum of Understanding between itself and the ESM. Prolonged implementation problems with the ESM program could eventually lead to a general default on the government’s debt.

KEY STATISTICS

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RATINGS SCORE SNAPSHOT

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