Will the IMF Apologize to Greece?

Fund's Failure to Recognize Athens' Fiscal Success Has Had Negative Consequences

The Wall Street Journal

By SIMON NIXON

June 15, 2014 4:21 p.m. ET

The International Monetary Fund has apologized to the U.K. but what about Greece? Managing Director Christine Lagarde has acknowledged that the IMF'S warning last year that Britain was "playing with fire" by pushing ahead with its deficit-reduction strategy—just at the moment that a robust recovery kicked in—was a mistake.

But this mistake was responsible for nothing worse than a few red faces—unlike the IMF's slowness to recognize Greece's remarkable success in delivering a 2013 budget surplus before interest costs. This had real consequences.

It led to a delay in the disbursement of crucial bailout funds that postponed Greece's return to the bond markets and the resulting revival in confidence and funding. Had Athens capitulated to IMF demands for further fiscal measures to meet the imaginary deficit, Greece would be facing a seventh year of recession rather than a likely return to modest growth this year.

New data show Greece on track to exceed this year's target of a primary surplus of 1.5% of gross domestic product.

The IMF's latest review of Greece's bailout programshows some contrition.

It talks of "significant progress toward rebalancing the economy" and acknowledges that turning the euro area's weakest fiscal position into the strongest in just four years is "an extraordinary achievement by any international comparison." It says "structural reforms are progressing, although unevenly," growth risks could be "tilting to the upside in 2014" and expresses "cautious optimism" for the future.

Greece's position looks more promising than it did only weeks ago. It has warded off the biggest immediate threat to the recovery with the failure of opposition party Syriza to score a breakthrough in last month's European elections.

This has strengthened the coalition government, increasing the likelihood that it will survive at least until Parliament votes on a new president in 2015.

That, in turn, buys time for the government to accelerate its structural reforms and push ahead with an ambitious privatization program.

The fact that Prime Minister Antonis Samaras resisted the temptation to appoint a political ally as finance minister, choosing instead another technocrat, suggests Athens knows it must keep taking tough decisions and resisting vested interests.

Even so, the IMF is right to stress that Greece's long-term prospects hinge on the health of its banking sector. Greek banks have raised €8.5 billion ($11.5 billion) of equity this year, which they insist will be enough to absorb all the likely losses on their balance sheets, given nonperforming loans now equivalent to a third of GDP. This followed a Bank of Greece asset-quality review and stress test that identified a €5.8 billion capital shortfall at the four largest banks. But the IMF is skeptical that the Bank of Greece's test was tough enough or the recent recapitalizations sufficient. It has now produced its own analysis that estimated the capital shortfall was €6 billion higher.

Has the IMF been too pessimistic again? Much depends on whether banks now quickly tackle this mountain of bad debts, restructuring the loans of viable companies so that they can invest and grow again and liquidating nonviable firms so that resources can be redeployed. Until now this hasn't been happening. One reason was that the banks didn't have enough capital to absorb the losses so chose to "amend and pretend."

Banks also suspected many defaults were "strategic": during the crisis many households and businesses stopped servicing loans—encouraged by a government ban on mortgage foreclosures and a dysfunctional judicial system that protected corporate debtors—and hoarded cash offshore and under the mattress.

Banks gambled that if they waited they would achieve higher recovery rates—the same gamble that investors who have recapitalized the banks are making today. The four major banks now have sufficient provisions to write off just over 50% of existing bad debts without eating into their capital ratios, which are currently among the strongest in Europe. They have also established internal but independently run "bad bank" divisions charged with recovering as much value as quickly as possible from these assets. But a quick cleanup depends on three big assumptions.

The first is that the government needs to stick to its promise to lift the mortgage foreclosure ban at the end of this year and—crucially—to introduce a much tougher corporate insolvency regime in October. This will give banks more power to push defaulters into bankruptcy and seize collateral. Banks say that some customers are already seeking deals in anticipation of these legal changes.

The second is that a tougher approach to mortgage defaulters won't trigger further steep falls in house prices, which are already 30% below their peak. The Bank of Greece and its adviser BlackRock Investment Solutions think this is plausible given past customer behavior and the fact that loan to-value ratios even now remain relatively low. But the IMF remains skeptical.

The third is that much of the cash that disappeared during the crisis is repatriated to pay down debts. Some €90 billion, nearly a third of the deposit base, was withdrawn between 2010 and 2012. Not everyone is convinced this money will return. Some bankers acknowledge that customers may be wary of triggering tax investigations that might lead to stiff penalties. Substantial inflows may be unlikely without an amnesty—something Greece's official lenders are unlikely to sanction, certainly until the tax collection system is effective enough to maximize revenues and minimize moral hazard

It will soon become clear who is right. If the IMF is correct that banks still don't have enough capital to write down their bad debts then they will continue to starve the economy of credit, choking the recovery. But if the banks—and their investors—are right, then asset quality will improve, lending will resume, growth will pick up, and the IMF will have a further reason to apologize.

Write to Simon Nixon at simon.nixon@wsj.com