Greece Able to Call Its Own Tune

TheWSJ: Things Are Starting to Look Better for Greece, One of Europe's Most Troubled Economies

The euro crisis started in Greece, and it won't be over until doubts over Greece's prospects are erased.

That this is still some way off was clear from Greece's latest bailout review, the longest and most attritional yet. After seven months of haggling, the troika of official lenders—the European Commission, the European Central Bank and the International Monetary Fund—reached a deal last week that should be formalized by European Union finance ministers next month. It paves the way for the release of €8 billion ($11 billion) needed to repay maturing bonds.

But the striking feature of this agreement was the extent to which Athens got its way on vital issues relating to the budget, bank recapitalization and structural reform. That is a mark of how far a recovering economy, buoyant markets and increasing confidence in Prime Minister Antonis Samaras have changed the terms of engagement.

The improving economic outlook certainly gave Mr. Samaras the upper hand in negotiations over the budget. At the start of the bailout review, the IMF insisted Greece faced a substantial deficit in 2013 and demanded further fiscal tightening. Athens stuck by its more optimistic forecasts, refusing to take actions that would prolong the depression. That decision was vindicated when Greek government figures showed that the country achieved a 1.1% surplus before interest costs in 2013.

This year the economy is likely to grow by 1.1%, reckons Alpha Bank.The PMI manufacturing index is in expansionary territory and consumer confidence has turned positive. Car sales are growing, building permits are up more than 70% year-on-year and the tourism industry looks to be heading for another record year. Money is starting to flow back into Greece, lured by the global search for yield: The Athens stock market rose 35% in 2013 and is one of the best performers in the world this year; Greek 10-year bond yields are down to just 6.84%. Piraeus, the market-leading domestic bank, last week even issued €500 million of three-year senior unsecured bonds at a yield of 4.5%.

Meanwhile, an estimated €4 billion funding gap in 2014—which has arisen because of the euro zone's failure to hand over profits from the ECB's holdings of Greek bonds as promised—is also shrinking fast, helped by banks repaying government aid. Athens is even talking about issuing a bond, raising the possibility it won't need a third bailout.

This improving outlook also tilted the balance in the negotiation with the troika over the scale of the required recapitalization of the banking system. The Bank of Greece conducted an asset-quality review and stress test with help from BlackRock Solutions and Rothschild that concluded that Greece's biggest banks required an aggregate $6.4 billion of extra capital to cover expected future losses. The troika thought this too low, with the IMF in particular pushing for a far higher figure.

How the IMF arrived at its figures remains a mystery to the Greek government, the central bank and its advisers. But the compromise was to proceed on the basis of the Bank of Greece numbers. In return, Athens agreed that any of the remaining €11 billion in bailout cash currently earmarked for bank recapitalizations that isn't needed immediately would continue to be available to fill any further shortfalls identified by the ECB when it conducts its own stress tests later this year.

But the market seems willing to take the Bank of Greece exercise on trust, reflecting confidence in BlackRock. Alpha Bank and Piraeus have announced fully underwritten plans to raise €1.2 billion and €1.75 billion respectively—more than required under the stress test—which bankers say are attracting substantial interest from a broad range of investors.

Of course, buying shares in a Greek bank right now is risky. The banking system is saddled with €70 billion of nonperforming loans, equivalent to 30% of gross domestic product. Residential mortgage books are a particular source of uncertainty since the housing market has barely functioned during the crisis amid a continued ban on foreclosure, opaque property and transaction taxes and a reluctance of banks to lend. If the banks don't raise enough capital, then the economy will continue to be starved of credit.

But some investors are willing to bet that as the economy recovers, arrears will fall, asset quality will improve and the prospect of large losses will fade. Funding costs are falling fast, borrowing from the ECB has halved, and banks are reaping the synergies of sector consolidation, boosting margins.

Of course, the strength of the recovery will also hinge on progress with structural reforms, essential to help the economy rebalance. Disputes over the pace of reforms have dogged Greece's bailout program from the start amid complaints that Athens is too reluctant to confront vested interests.

Last year, the Organization for Economic Cooperation and Development identified 329 measures that it said could boost Greece's GDP by 2.5% by removing specific impediments in the retail, tourism, building and food-processing industries. The troika wanted Athens to commit to implementing these measures in full. Athens wanted flexibility over the timing given its fragile political position with a parliamentary majority of just three and European Parliament elections in May.

Not so long ago, Mr. Samaras's plea for sympathy might have fallen on deaf ears. Even now, some troika officials privately accuse him of blackmail. But he believes he deserves credit for holding the country together while delivering the fastest pace of reforms in the OECD.

What's more, the radical left-wing Syriza party is only one percentage point ahead of his New Democrats in the polls—not enough for a decisive breakthrough—and facing tensions within its ranks. Independent parliamentarians may be more willing to back the government in tight votes to prevent early elections.

That suggests Mr. Samaras continues to offer the best insurance against what euro-zone leaders and markets agree is the biggest risk to the Greek recovery and the prospects of ending the crisis: fresh political instability. No wonder they are willing to give him the benefit of the doubt.

Write to Simon Nixon