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Greece’s sternest test yet to come

01 Dec 2000

On January 1, 2001, the Hellenic Republic will, after a long and hard struggle, join the Emu. Everyone associated with the Greek capital markets is hopeful that membership will banish memories of the political, social and economic troubles of the past decade. In the debt capital markets, at least, this optimism appears well founded. However, as investors begin to compare Greek debt and equity capital markets participants with those in the eurozone, rather than with its previous emerging market peers and issuers are coming under increasing scrutiny. In this special EuroWeek report, Philip Moore examines whether Emu membership will prove a blessing or a bane for Greece as it enters a new era.

It's official. Equity investors, at least, will have a difficult time justifying calling Greece an emerging market any more. On July 31, Morgan Stanley Capital International (MSCI) announced that it was reclassifying the MSCI Greece Index as a developed market benchmark. Announcing the change, MSCI pointed out that Greece now exceeds the GNP per capita threshold used by the World Bank to characterise high income countries.

There was no great surprise about the MSCI announcement, which many equity investors had in any case been discounting, and which will not officially take effect until the end of May 2001. But, all in all, the confirmation of Greece's new status rounded off a good week - and a good year - for the Pasok government of Costas Simitis, which had won April's general election by the slimmest of margins: 43.7% of the vote compared to the 42.7% of the New Democratic Party.

Four days before the MSCI announcement, Fitch had become the latest rating agency to upgrade the Hellenic Republic, from BBB+ to A-. "The rating action anticipates Greece entering Emu on 1 January 2001, which is virtually certain," noted Fitch at the time, "and also reflects positive developments in the economy.

"In order to participate in the euro area, the macroeconomic environment has been greatly improved through tight fiscal and monetary policies. There has been a steep decline in inflation to levels of 2% from 20% in the early 1990s. This has been aided through a decline in unit labour costs and wage moderation. The general government budget deficit was reduced to well below the Maastricht limit of 3.0% to 1.6% of GDP in 1999, with the government aiming at a small surplus by 2002."

Although Greece's overall debt level of 104.4% of GDP in 1999 continues to worry Fitch - the ratio being the third highest in the EU and therefore still described by the agency as a "constraint on the rating" - other commentators are more relaxed about the debt level. For example, when Thomson Financial BankWatch upgraded Greece in February, also from BBB+ to A-, it pointed out that "the Emu has not shown a great deal of concern regarding the public debt to GDP ratio in the past, and this is not likely to be a handicap for Greece. As a matter of fact, although the ratio should not theoretically exceed 60%, only five EU countries are in line with it, and both Belgium and Italy were integrated while their ratio was higher than the current Greek one."

Of more concern, perhaps, is Greece's inflation rate. According to ING Barings' September Emerging Europe Research monthly review - which should, technically, no longer have included Greece - Greek inflation rose in the previous two months faster than any other EU country bar Portugal. "Nonetheless," noted the update, "the rate remains comfortably close to the eurozone average for now." The same update sees inflation rising gently upwards from 2.5% in 1999 to 3% this year and 3.3% in 2001.

Be that as it may, any increase in Greek inflation makes the process of bringing interest rates closer to the euro rate more difficult. The September cut in the 14 day deposit rate by 75bp to 7.5%, for example, left Greek rates still well above the ECB's 4.5% refinancing rate. As Schroder Salomon Smith Barney noted in a September update, the upward inflation trend in August "is encouraging the Bank of Greece to delay monetary loosening".

Nevertheless, Salomon also expects interest rate convergence to gather momentum over the last quarter of 2000. As a result, it noted that "Greek bonds still offer good value, as forward yield spreads over Bunds to January 2001 range from 50bp to 70bp, whereas we expect that post-Emu spreads will range between 35bp and 55bp. It is noteworthy that the 10 year spread is at the same level as last April, when the drachma's remaining depreciation to the Emu lock-in rate was 1.5% compared to just 0.5% currently."

Against this background, it is small wonder that Miranda Xafa, analyst at Citibank Salomon Smith Barney in Athens, says that she would certainly be a buyer of Greek bonds at those spreads. It is also of little surprise that she reports strong foreign interest in recent auctions of new 10 year bonds by the Greek Treasury. "The potential for a 20bp gain in three months with very little foreign exchange risk is not at all bad," she says.

But why should a fully paid up member of Emu be stopping at a spread narrowing of just 20bp, still leaving Greek bonds trading some 50bp to 60bp over German Bunds? Xafa says there are two reasons why Greece is likely to continue to trade at a significant premium to the core eurozone for the foreseeable future, and therefore two elements that could, in theory, lead to further spread narrowing. "The first potential source for spread narrowing would be if Greece were upgraded again," she says. "Remember that at A- we are still three notches below Italy and Portugal."

While Xafa says that an upgrade to single-A might be worth 15bp off the Greek-German differential, she also suggests that for the time being investors hoping for action of this kind would probably be well advised not to hold their breath. "I don't think an upgrade is imminent," she says, "because both major credit ratings agencies have said that they would expect to see more progress on structural reforms in terms of privatisation and debt reduction before another upgrade is possible."

A second factor that could lead to some spread narrowing, even in the absence of a little help from Standard & Poor's (S&P) or Moody's, says Xafa, would be a change in the asset allocation of state owned Greek pension funds. "For historical reasons, the pension funds have always invested mainly in treasury bills and FRNs," she says. "But they currently have about Dra2tr in cash, so if they were to shift their investment policy towards 10 year bonds that would create large additional demand and probably help spreads to narrow."

Xafa says she expects eventually to see increased allocation by these funds into government maturities beyond the very short dated paper on which they have depended in the past. But for the time being, she and other local bankers point out that Greek pension fund managers - most of whom are civil servant government appointees - simply do not have the experience or the confidence to step in any meaningful way down the maturity curve.

While analysts and rating agencies might worry about such niceties as Greece's debt or inflation ratios, international fixed income investors seem to care much less about the figures, if their response to new issues coming out of the country this year are anything to go by. The landmark transaction of the year came in February: a Eu2.5bn May 2010 offering from the Hellenic Republic led by Credit Suisse First Boston (CSFB), Deutsche Bank, Morgan Stanley Dean Witter and the National Bank of Greece (NBG).

The transaction was priced at 53bp over Bunds, a gratifying level for the borrower given that original price talk had suggested a level in the high 50s over. The pricing also meant that, at the equivalent of Euribor plus 10bp, the level was 5bp inside Greece's outstanding 2008 deal. But at 20bp over the Hellenic Republic's closest European peer, Portugal, the issue was viewed as offering outstanding value.

The benchmark was followed up at the start of July by a Eu500m 10 year fungible deal sole-led by Merrill Lynch. The add-on was priced at a spread to Bunds of 57.5bp, or close to Euribor flat - an indication of rapidly improving investor sentiment towards the Hellenic Republic.

International acclaim

The international response to this year's borrowing programme has been very satisfying for Christopher Sardelis, who had recently moved from Bank of America in Athens, where he was chief economist, to the Bank of Greece, where he is responsible for the country's external borrowing. "When we decided to launch the benchmark deal, one of our main targets was to position the Hellenic Republic as an Emu sovereign even before the decision to join Emu was officially taken," he says, "and I think that was achieved successfully."

One of the most striking elements of the February transaction, say Sardelis and the bankers that led the deal, was the broad spread of investors it attracted. "It was probably the first time that you had a real diversity of investors coming into a Greek issue," says John Zafiriou, head of European coverage at CSFB in London. "It was two and half times oversubscribed and we saw a lot of new money coming in from investors that had previously never bought Greece. For example, we saw a lot of buying from some of the very large Dutch institutional investors, as well as from Scandinavian and German accounts that were first time buyers of Greek paper."

Sardelis believes 53bp over Bunds was a fair price for Greece to pay for its benchmark deal, given Greece's rating and its relatively high debt to GDP ratio. But, looking to the future, he echoes a number of other European borrowers when he says that over the longer term Greece will be priced and trade less in reflection of its macroeconomic fundamentals, and more in line with its strategy and positioning as a borrower.

"It is still too early to say what our definite borrowing plans will be next year because we are still working on several different scenarios," he says. "We are still working on next year's budget and before that is ready it will be difficult to comment on our exact funding plans. But gross funding in 2001 will be something between Eu22bn and Eu24bn."

What is much more certain, says Sardelis, is that the republic's principal focus in 2001 will be on bolstering the liquidity of Greece as a credit. "In a couple of maturities next year we will not be issuing new bonds but reopening old ones in order to improve liquidity," he says. "The target I have is to have at least seven bonds trading on EuroMTS by the end of the year." Individual sovereigns are allowed to have up to 11 bonds traded on the new electronic trading platform for government issuers, distributed across four different maturity brackets. "As we enter into the euro at the start of 2001," says Sardelis, "we will already have two 10 year benchmarks that qualify for inclusion in EuroMTS, so my target is to add another five during the course of next year."

Bolstering the liquidity of Greek sovereign issues will be one way, Sardelis believes, of broadening investor demand for Greek bonds - which is a key priority for the Central Bank. "The domestic institutional investor is important and is going to remain so," says Sardelis. "But one of our targets for the coming year is to achieve much broader distribution of government bonds. One of the projects we are working on now is the expansion of the group of primary dealers so that between 60% and 70% of these will be foreign banks."

Another longer term objective for Sardelis is to build a more complete yield curve for the Hellenic Republic by issuing at the longer end. "We are considering taking a further step forward by issuing a 30 year bond for the first time," he says. "It will not happen at the start of next year, but it is something we are considering for later in 2001. If the market has an appetite for duration and volatility, a 30 year bond will be the final step for us in terms of developing a complete yield curve."

Bankers are confident that there will be plenty of demand for Greek risk over the coming 12 months, especially given that the Hellenic Republic is now included in a number of key international government bond indices. "Because the Republic has not been a prolific borrower in international markets, there is definitely a scarcity of Greek paper," says Zafiriou at CSFB.

Corporate or sovereign risk?

This is not to say that the only exposure international bond investors have had to Greece has been via issues from the Hellenic Republic, although the other issues to have emerged over the last 12 months have broadly been seen as lacking much in the way of genuine diversification.

For example, when OTE launched its highly successful Eu800m deal in January, which was later increased to Eu1.1bn, it was rated A2 by Moody's and A by S&P - on a par with the republic itself. The OTE seven year offering, led by Merrill Lynch, Morgan Stanley Dean Witter and National Bank of Greece, was priced at 50bp over Euribor, compared to original price talk of between 55bp and 60bp over. Extensively roadshowed, the OTE deal was about five times oversubscribed, with demand coming from many institutions that were still very underweight in Greece.

OTE was naturally delighted by its January transaction, the proceeds of which were earmarked, among other things, to fund the joint acquisition with Royal KPN of the Netherlands of a 51% stake in Bulgarian Telecom, as well as other new investments in the Balkan region. The issue also propelled OTE into the brave new world of the e-capital markets, the company proudly announcing that the deal was "the first euro corporate deal ever to be open for subscription over the internet through MSDW's online system."

Another relatively frequent Greek borrower in the international capital markets has been the state owned electricity utility, Public Power Corporation (PPC), which has responsibility for all generation, transmission, distribution and supply of electricity in Greece. PPC's borrowing in the international capital markets is driven by its relatively high capital expenditure programme. According to credit research published earlier this year by Dresdner Kleinwort Benson: "PPC's plan from 1998-2002 sees a Dra1.4tr (Eu4.3bn) expenditure programme. This is 'on plan' according to the company and includes the building of circa 800MW of extra capacity."

On the basis of pure fundamentals, PPC would look like a weak credit. But in a European corporate market that is pitted with minefields of event risk in almost every sector - and utilities are far from an exception to this rule - bankers point out that PPC's bonds have, paradoxically, been more or less insulated from the sort of risk that has accompanied those from stronger corporates. This is because although PPC's bonds do not carry an explicit government guarantee, they do benefit from the next best thing: a near watertight set of covenants dictating that if the Greek government's ownership of PPC fell to below 50%, a put option at par would be triggered. Offering even more security to investors is an additional option to put the PPC bonds at par if the company's share of the domestic electricity market falls to below 90%. As one banker puts it: "these covenants add up to the closest you can possibly get to an explicit government guarantee."

PPC's role as the dominant local provider of electricity does not seem to be under much threat. Upgrading PPC to BBB+ in November 1999, S&P noted that the rating reflects the company's "monopolistic industry position, a competitive cost position in generation, a reasonably supportive regulatory environment, and an improving financial profile. Risks inherent in the ratings include the need for considerable investments and the lack of a transparent tariff-setting mechanism."

Before launching a series of transactions in the single European currency, PPC had issued modest amounts in US dollars ($150m maturing last month, November) and yen (¥30bn due in July 2003). But the company's debut euro denominated benchmark, and its first to include the protective put options for investors, was an Eu500m 10 year deal launched in February 1999. As Paribas noted in an analysis of this curtain raiser: "This deal appealed to funds looking for semi-sovereign paper from emerging or converging paper." At 25bp over where sovereign Greek deals were trading, added the Paribas note, "as investors try to diversify away from euro and highly rated borrowers, this is just the kind of higher yielding paper they are looking for".

More recently, this February, PPC launched another Eu300m seven year deal via ABN Amro, BNP Paribas and Dresdner Kleinwort Benson priced at 45bp over Euribor, which once again incorporated the all important put options. This, twinned with investors' underweight position in Greece, prompted another heavy level of oversubscription, which led to the lead managers contemplating increasing the size of the deal in response to demand. However, PPC decided against this option as it had no need for additional funding at the time. Instead, it made a return to the market in October with a deal for a further Eu400m, led by BNP Paribas, CSFB and Schroder Salomon Smith Barney.

Another recent international offering from Greece also offered investors exposure to quasi-sovereign risk. This was a Eu560m 10 year deal for Hellenic Railways led in September by Deutsche Bank and Banca IMI. The issue was guaranteed by the republic, but with pricing set at 69bp over Bunds, the deal offered a pick-up over Greek sovereign paper of between 8bp and 9bp. In other words, like the PPC offerings, this deal effectively paid a premium over the Hellenic Republic for what was essentially government risk.

Clearly, issuers like PPC and Hellenic Railways have been helped by the success of the republic's issues, which, says Sardelis, were at least partially aimed at repricing the entire Greek yield curve and establishing a benchmark for other borrowers tapping the international capital market. "It is clear that the republic's issues have helped to change the entire profile of the Greek debt market," he says. However, what is less clear, for the time being, is whether or not this will help other borrowers - especially those that are entirely free from government ownership - reach out to the broader international market.

Sardelis is confident that this will happen over the longer term, but he is also keen to emphasise that Greece is still a relative newcomer to the international fixed income market. "Remember that on the bond side at least, the history of the Greek capital market is still very short," he says. "In the space of just three years, we have developed a broad capital market and I think the structure of the market will continue to change quite rapidly."

Equity challenges

So much for the good news arising from Greece's entry into Emu. What of the less positive news, which, think some bankers, may paradoxically turn out to be Greece's upgrade to developed equity market status by MSCI?

At UBS Warburg in London, managing director Christos Sclavounis says that if the Portuguese precedent is anything to go by, following the upgrade in Greece's status, portfolio flows in the Greek equity market will follow three readily identifiable stages. Firstly, dedicated emerging market money will flow out of Greece. Secondly, mainstream European equity fund money will flow in. And thirdly, Greek equity investors will start to move out of the domestic market in search of relative value overseas. Sclavounis says the jury is still out on what the net impact of these dynamics will be, but some analysts are concerned that for the Greek equity market, the result will be damaging, at least in the short term.

"The problem is that all of a sudden Greek companies are no longer going to be compared with Turkish and Hungarian ones," says one analyst. "They are going to be compared with those in developed EU economies, and, quite frankly, they don't stand up to the comparison very well in terms of shareholder value."

At Morgan Stanley Dean Witter in London, European equity strategist Teun Draasima says he is very encouraged by the long term prospects for the Greek economy, and therefore for its equity market. But, he says over the short term the market may be held back by a combination of relatively high valuations and structural deficiencies. "Greece has the lowest free float in Europe and the lowest gearing level," he says. "In order to attract developed market investors, Greece will have to offer lower valuations than today in addition to its longer term growth prospects. Having said that, the largest portion of its underperformance must be behind us."

For the time being, Morgan Stanley thinks that the relative overvaluation of the Greek equity market will outweigh the immediate benefits of the market's upgrade by MSCI. "We estimate that, based on today's market cap, Greece would have a 0.9% weighting in MSCI Europe," MSDW noted in the summer. "This would lead to new demand for MSCI Greece worth $6.7bn, based on our best guess of $750bn benchmarked to MSCI Europe, passive or active.

"However, Greece leaving MSCI emerging status would lead to outflows too. Our best guess of these outflows is $5.8bn, based on $100bn benchmarked to MSCI Emerging Markets Free (EMF) and Greece's current 5.8% weighting. Net net, this would result in inflows of $0.9bn, or only 1.5% of market cap. Moreover, if the amount benchmarked to MSCI EMF is $115bn, rather than our estimated $100bn, then the hypothetical upgrade would result in zero inflows or actual outflows from Greece."

Others are also downbeat about the impact of the MSCI upgrade. "We actually see it as a very negative development," says Edward Fryer, analyst at ING Barings in London. "It means that Greece is going to go from being the largest fish in a small pond of emerging European markets to being very much on the periphery. Of all the investors we talk to, we know of none who are thinking of picking Greece up as a western European developed market country."

An early test of the new supply/demand dynamics in the Greek equity market came with the sale at the beginning of October by OTE and the Norwegian telecoms company, Telenor, of a 17% stake in Greece's second largest mobile operator, CosmOte. The deal was led by Merrill Lynch, Schroder Salomon Smith Barney, DLJ and HSBC Investment Banking. When details of the plans to sell off the CosmOte stake were originally announced in August, it was forecast that this would generate revenues of about $5.5bn. This ambitious target was set before a range of external factors conspired to make this valuation far too optimistic. These included a general weakening of Greek, as well as international equity prices, twinned with mounting concerns about an oversupply of telecoms new issuance in the fourth quarter of 2000. The postponement of the privatisation of Turk Telecom hardly helped the CosmOte case.

The net result of all these influences was that the price range for the CosmOte sale was substantially lowered from its original target, even though it still remained comfortably the largest Greek IPO of the year. The Dra156tr ($400m) offering was priced at Dra3,200, compared with an originally planned range of Dra3,070-Dra3,750. This was subsequently revised to Dra3,120-Dra3,494, with some 60% of the shares eventually placed with domestic investors, compared with an original target for the domestic tranche of 40%.

Although its pricing and distribution may have been disappointing, at a fundamental level there does not seem to be much wrong with the CosmOte story. An ING Barings analysis of the company published at the end of July noted that CosmOte announced an "explosive growth in 2Q00 subscriber numbers, increasing by 150% year-on-year and accounting for a huge 53% of net additions, way ahead of both Stet Hellas with 24% and Panafon with 23%". ING Barings sees total revenue at CosmOte climbing from an estimated Dra264.4bn in 2000 to Dra432bn by 2005, with net profit during the same period expanding from Dra32.9bn to Dra93.6bn.

Banking consolidation

It is not just the telecoms sector - which most analysts still appear to be very bullish about over the longer term - that is perhaps now being compared more critically with its European peers. The banking sector, which is the other heavyweight component of the Athens Stock Exchange (ASE) General Index, is another that analysts say will find itself increasingly playing in a different league when the convergence game with developed European markets is played out.

As ING Barings commented in a recent report on the leading Greek banks: "Earnings at the banks in 1999 benefited from falling interest rates, resulting in strong trading profits, from both bond and equity trading. However, the outlook for earnings in the medium term is not encouraging, due to the combination of pressure on net interest margins and falling trading profits, as interest rates stabilise at eurozone levels."

The leading Greek banks dispute this, insisting that they remain very compelling growth stocks. "We are really talking about a great growth story," said Marinos Yannapoulos, executive general manager of Alpha Bank at a presentation to investors organised in London by UBS Warburg at the end of September. Apostolos Tamvakakis, deputy governor of the National Bank of Greece (NBG), agreed. At the same presentation, he pointed out that the Greek banking sector, by virtually any yardstick, still lags its southern European competitors, let alone those in more developed EU economies, by a factor of three or four.

Research published by UBS Warburg underscores this point, noting: "The low level of financial services penetration reflects the fact that a number of promising segments are underdeveloped compared to Europe. The penetration of consumer credit in Greece - a highly profitable segment - is significantly below other European countries." At the end of 1998, according to the UBS Warburg data, this amounted to 2.8% of GDP, compared to 11.1% in Germany, 11.6% in Portugal and 12.4% in the UK.

Aside from the growth potential in areas like personal loans, credit cards and mortgages, Greek bank share prices may be underpinned by increasing speculative appeal, in part arising from the steady withdrawal by the government from ownership in the banking sector. Between 1997 and 2000, according to Alpha's Yannapoulos, the market share of state controlled banks fell from 60% to 45%, and this is expected to fall further if and when the government sells down its residual holdings in, for example, NBG, in which it still holds a 33% stake. As the role of the state in the banking sector diminishes further, the issue of whether or not a country with a population of about 11 million people needs five banks is likely to be raised more and more often.

It was raised, for example, at the UBS Warburg presentation in London, when NBG's Tamvakasis was asked when he thought consolidation would gather pace in the Greek banking sector. "At the start of this year, I was optimistic for consolidation," he replied, "and I thought that the sale of the CBG stake would trigger a second phase of consolidation. So far, that has proved not to be the case." This was a reference to the sale by the government of a 6.7% stake in Commercial Bank of Greece to Crédit Agricole earlier this year, which many analysts believe is a precursor to more privatisation and, potentially, to more speculative appeal in the stock. "The bank that we would see as being most vulnerable is CBG," says Fryer at ING Barings in London. "It is slowly sorting itself out, but it has a history of pretty poor profitability compared to the other ones."

The banking sector is by no means the only Greek industry in which the general consensus is that privatisation urgently needs to be accelerated. Ostensibly, the government is committed to pressing ahead with selling its holdings, either partially or entirely, in companies such as Olympic Airways, the Agricultural Bank of Greece, several ports and utilities, and exhibition organiser DETH.

Privatisation questions

The National Bank of Greece noted in its July update on the economy that "the Ministry of National Economy is determined to proceed with privatising 18 public companies by the end of summer 2001. It is estimated that privatisation revenues in 2000 will reach Dra1tr. However, no particular time limits have been set for privatising each public utility in order to avoid pressures from special interest groups."

Caveats like this will sound depressingly familiar to those who have been analysing the Greek economy for the last decade or so, and who have grown wearily accustomed to the power of the local unions. Their action has, in recent years, resulted in sporadic and crippling industrial action, especially in companies such as national airline Olympic Airways, at which days lost to strikes is among the highest of European airlines.

The power of the unions has also manifested itself in periodic violent upheaval in the centre of Athens. One of the most infamous examples of this took place at a shareholders' meeting of the Commercial Bank of Greece in an Athens hotel in June 1998, when the chairman of the bank's former subsidiary, Ionian Bank, was physically attacked by protestors incensed by its proposed sale.

Bankers say that this sort of shameful outburst has now been consigned to the history books and that public opinion is increasingly supportive of privatisation and restructuring. At UBS Warburg in London, Sclavounis does not think that there is much potential for industrial action to upset the Greek economy. "I think strikes associated with privatisation initiatives are yesterday's news in Greece and are nowadays largely symbolic," he says.

Nevertheless, resolving the problem of labour relations, say many analysts, is pivotal to the economic outlook for Greece, and hence to its credit ratings and future borrowing costs in the international capital market. "The major risk going forward," says Xafa at Citibank Salomon Smith Barney, "is that Greece joins the eurozone with rising inflation and eroding competitiveness, the result of which could be a slowdown in growth and possibly a rise in unemployment. That is what makes it so urgent that Greece achieves some clear efficiency gains and better productivity through structural reforms. The Government is aware of this and is making some progress, but at a very slow pace and with a lot of compromises still being made to the labour unions."

Others agree that a critical factor in the reduction of state involvement in the economy in general, and privatisation in particular, will be labour reform. "To ensure the economy remains competitive over the medium term, the recently elected left wing Pasok government must push through structural reforms," warns ING Barings in its forth quarter 2000 Global Economics report. "These include allowing companies to fire more than 2% of the workforce in one year and selling state owned companies such as the telecoms fixed line monopoly. Greece remains far behind most of western and eastern Europe in terms of such reforms. The government has ambitious plans but these could be watered down significantly in the face of parliamentary and union opposition."

This is why external analysts welcome the recent initiative by the government to set in motion a so-called "social dialogue" aimed, among other things, at persuading the unions to accept increased wage moderation and reduced constraints to dismissals and part time work. "We expect only slow progress in the negotiations," noted Morgan Stanley Dean Witter in an update published in August. "Given Greece's high degree of unionisation, even a slight decrease in labour market rigidity would be a step forward, in our view."

Perhaps the clearest example of the formidable challenges facing Greece in pressing ahead with labour reform and privatisation is the proposed sale, originally slated for the fourth quarter of this year, but now put back to the first quarter of 2001, of a minority stake in electricity utility Public Power Corporation. Although Greece was given a two year extension to the EU directive on opening its electricity supply business up to competition, theoretically, it will need to start deregulating its utility sector in 2001, and if PPC is to remain competitive in this environment, it urgently needs to overhaul its entire structure and improve its efficiency.

Partial privatisation is viewed as a means of starting this process, but in its present form the company appears ill-equipped for life in the private sector. As Chase pointed out in a review of the European electricity sector published last year: "PPC is managed as a part of national infrastructure and therefore does not operate solely with the objective of making a profit. Privatisation is not widely supported and in any event, PPC does not have the financial profile that would support privatisation."

Bankers in Athens hardly seem thrilled by the prospect of PPC's upcoming partial privatisation. "The risk is that the government will interpret the EU directive in a minimalist way," says Xafa at Citibank Salomon Smith Barney, "and do no more than go through the motions to show Europe that it has opened up the market to competition. Under the government's present plans for PPC, any efficiency gains are likely to be elusive largely because the company's pension fund has huge unfunded liabilities. Instead of clearing up these liabilities, the government plans to separate the pension fund from the rest of the company and fund it with revenues from privatisation and earmarked taxes. That would defeat the entire purpose of liberalisation, which ought to be to engineer efficiency gains through cost cutting in order to benefit customers."

Even leaving aside the problem of the pension liabilities, PPC's profitability in recent years has been very modest. In 1998, according to the Dresdner Kleinwort Benson analysis, PPC made profits before tax of Dra14.3bn on sales of Dra839.2bn, which compares to total outstanding debt of Dra1,449bn.

"The reason PPC is making such a low profit," says Xafa, "is firstly that it has excess personnel, some of whom will be moved across to the company that will manage PPC's pension contributions. Secondly, the government has either frozen electricity prices altogether in recent years or permitted no more than very small increases to help make sure that the general inflation rate complies with the Emu criteria. So the price of electricity has been kept artificially low to make the inflation numbers look good while the company's costs have continued to rise, eroding its profitability."

For prospective equity investors in PPC, the attraction of the company ought to be its cost-cutting potential, especially on the personnel side, twinned with the outlook for economic growth and electricity consumption. "The Greek market is far from mature and Greece is seeing tremendous economic growth," notes the Dresdner Kleinwort Benson analysis. "Growth in the Greek electricity market is approximately three times the European average. The growth is led by the tourist destinations, where demand for air conditioning is high. There is also demand from agriculture."

Fair enough. But if all this potential growth is to be diluted or eaten away by wasteful personnel costs and other cash drains, this is not a story that is going to set the heart beats of investors in established Emu markets racing.

Aside from flotations, an important component of privatisation will also be the sale of chunks of Greek industry to strategic investors. Aside from the disposal of the 6.7% stake in Commercial Bank of Greece to Crédit Agricole, the landmark deal in this respect will be the sale of a 15%-20% stake in OTE to a strategic partner. Credit Suisse First Boston (CSFB) and UBS Warburg are advising the government on this transaction, which would at last bring its stake in the telecoms company below 51% and should be concluded by the end January 2001.

In mid-November, six telecoms companies were still expressing an interest in OTE - France Télécom, Deutsche Telekom, Telecom Italia, Telefónica, Southern Bell and NTT - with another five that had earlier been involved declining to participate in the sale.

While strategic investors are therefore expected to play an important role in the privatisation programme in the future, equity investors hope that more flotations on the ASE will help to broaden the depth and liquidity of a market that remains dominated by a handful of companies. At the start of September 2000, four companies in two sectors - OTE and Panafon in telecoms, National Bank of Greece and Alpha Bank in banking - accounted for almost 24% of total market capitalisation and for a high proportion of daily trading volumes.

It is unlikely that new issues from the private sector will do much over the coming 12-18 months to dilute this large share. At HSBC Pantelakis Securities in Athens, head of research Joanna Tellioudi says there is a pipeline of about 220 small and aspirant companies officially waiting to list their shares on the Athens Bourse, but how many of these are serious candidates for a market quotation is anybody's guess.

This is in part because the stellar performance of Greek equities in 1999 led a number of opportunistic companies, many of which were not suitable for a public quotation, to leap aboard the IPO bandwagon. "Last year we saw a number of companies using the strength of the market to launch new issues at ridiculously high valuations," says Tellioudi, "but with the market weakening a little this year, I do not know how many of those 220 companies will eventually list."

Investor support

While more listings of quality companies would be a longer term shot in the arm for the Greek capital market, so too would an increased level of sophistication among local institutional investors. This is because the equity market continues to be driven chiefly by retail liquidity, although some analysts detect a recent change in the dynamics of the market. For example, ING Barings commented in its September round-up that "local funds and retail investors do not 'control' the market any more, as most blue chips are now owned by foreign funds".

But that seems to be the antithesis of what most observers of the Greek market believe. Morgan Stanley Dean Witter has noted that according to the estimates of local brokers, about 60% of total trading volume in the Greek market originates from domestic retail investors, who own about 40% of the market, with foreigners accounting for the remaining 20% of trading volume.

Much of this retail participation in the equity market has resulted from an explosion of the assets under management of Greek equity mutual funds over the last 12-18 months. According to research published by UBS Warburg, as of the end of August, equity funds accounted for 29% of total funds under management in the Greek mutual fund sector, which amounted to some Dra11.9tr at the end of 1999. This compares with just 4% two years ago and, encouragingly, Greek investors seem prepared to ride out spells of intense volatility in the equity market.

As UBS Warburg notes in its recent update: "Despite the equity market's poor performance in August, equity units under management have remained flat and, surprisingly, no material redemptions have taken place. The main reason behind this trend seems to be the reluctance of investors to realise losses by selling their holdings. Moreover, until recently, the consensus believed that the downside potential of the market was limited, hence there was no reason to redeem in that context."

Fair enough. But a more solid institutional base is desperately needed in Greece as a means of injecting longer term stability into the local capital market. And more importantly, as far as the economy is concerned, Greece is now facing what UBS Warburg describes as "a pension time bomb".

In its Economic Survey of Greece published in 1997, the OECD put the present value of future Greek pension liabilities net of contributions at about 200% of GDP, which is far higher than other OECD countries. A silver lining to this potential disaster, suggests UBS Warburg, is that the situation might force the government into championing an increase in private long term savings schemes, which in turn would underpin valuations in the stock as well as the bond market. "We believe a greater emphasis on equity funding, requiring the government to encourage the equity culture via tax incentives for investors and companies alike, is inevitable," notes UBS Warburg.

Another important challenge for the longer term health of the Greek equity market, say analysts, is the efficiency with which it is regulated and policed.

Again, the concern here among many market observers is that the government continues to have too much influence on the market, not just through its ownership of substantial stakes in listed companies, but also through its occasional manipulation of the market via the state owned pension funds. The clearest example of this came in the run-up to April's closely fought election, when the government intervened in the equity market, propping up valuations via the state owned pension funds.

At the UBS Warburg presentation in London in September, Alexis Panagiotis, chairman of the Athens Stock Exchange, reassured his audience that the ASE is determined to introduce levels of "safety, credibility and transparency" that will ensure the exchange provides an "environment comparable with international standards".

And international commentators appear to believe that important progress has been made towards achieving this objective. When MSCI announced the reclassification of Greece as a developed market, it noted that in addition to a significant growth in size and liquidity, "there has been a marked improvement in the operational efficiency of Greece's equity market.

For example, the change in the clearing and settlement process (dematerialisation) of Greek shares, completed in November 1999 has proven successful in handling increased trading volumes, while simultaneously reducing the number of failed trades."

Specifically, the Athens Exchange has recently drafted a series of changes to the regulatory framework aimed at, among other things, expediting the listing procedure for new companies. The exchange's draft notes that this will provide "a more sufficient and accurate supply of information" to investors, as well as "a more efficient review of [the prospectus's] content by the competent departments of the ASE". It also notes that in the case of prospectuses for would-be entrants to the market "new quantitative and qualitative information must be added, which [is] expected to eliminate any possibility of deliberate or unlawful withholding of significant information, as well as of any vague presentation of data leading to misinterpretations".

International bankers welcome these initiatives. "The authorities are clearly moving in the right direction, although there is still more that could be done," says Sclavounis at UBS Warburg in London.

But for the broader Greek capital market, it remains to be seen whether or not the government will be prepared to put its full weight behind the long term structural changes that are urgently needed if both the bond and the equity markets are to flourish over the medium term. As ING Barings remarks equivocally in its most recent Global Economics update: "The next few months will show whether Greece has truly entered a new era or just a new exchange rate."

01 Dec 2000