Greece: Staff Report for the 2006 Article IV Consultation
Author: International Monetary Fund
Publication Date:
25 Jan 2007
eISBN:
9781451816273
Language:
English
Keywords:
ISCR; CR; deficit; government; reform; pose downside risk; public enterprise reform; goods export; foreign exchange; personal income; banking system; base year; Europe
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This 2006 Article IV Consultation highlights that economic growth of Greece has been strong for several years, underpinned by a rapid increase in private sector credit, following the liberalization of the financial sector and the sharp drop in interest rates. In 2006, real GDP rose by an estimated 4.1 percent, driven by private domestic demand and a pickup in goods exports. The authorities have introduced a number of significant structural measures to improve product markets. These include simplified business licensing procedures for industrial firms, more flexible overtime, and liberalization of network industries.

Abstract

This 2006 Article IV Consultation highlights that economic growth of Greece has been strong for several years, underpinned by a rapid increase in private sector credit, following the liberalization of the financial sector and the sharp drop in interest rates. In 2006, real GDP rose by an estimated 4.1 percent, driven by private domestic demand and a pickup in goods exports. The authorities have introduced a number of significant structural measures to improve product markets. These include simplified business licensing procedures for industrial firms, more flexible overtime, and liberalization of network industries.

I. Background

1. Economic growth has been strong for several years, but vulnerabilities emerged. Real GDP grew by 3¾ percent a year on average during 1995–2005 (Table 1, Figure 1).1 Financial-sector liberalization and the sharp drop in interest rates with euro adoption resulted in very large increases in private sector credit, which has underpinned strong domestic demand growth. Fiscal policy was expansionary in the first part of this decade, including to fund the 2004 Olympic games. On the supply side, capital formation and productivity growth have been strong, and substantial immigration, mainly from the Balkans, has swelled the workforce. This period of strong growth narrowed the gap in real incomes between Greece and the EU15 but, notwithstanding significant reforms in recent years (see the text table on Fund Policy Recommendations), vulnerabilities also developed:

  • The fiscal deficit widened. In 2004, the general government deficit peaked at 6.2 percent of GDP (Table 2), due principally to rapid growth in primary spending, which averaged 8.3 percent a year in 2001–04. As a result, little progress was made in cutting the debt-GDP ratio, which stood at 85.3 percent in 2005 (107.5 percent on the old national accounts estimates). In the wake of large upward revisions to historical deficit estimates, the EC launched an excessive deficit procedure (EDP) in 2004, requiring a deficit below 3 percent of GDP by 2006. In response, the authorities cut the deficit sharply in 2005 and again in the 2006 budget.

  • Private-sector borrowing expanded rapidly. Although the FSAP, conducted in 2005, found no systemic threats to the banking sector, it highlighted risks arising from lending to new and untested client classes, expansion into new activities, and rising exposures of some banks in the Balkans. To some extent, this credit expansion reflects greater financial intermediation in the wake of liberalization, a process that relatively low debt-income ratios suggest is still incomplete.

  • The external current account deficit widened. Strong domestic demand, supported by credit growth, has led to inflationary pressures, while a centralized wage bargaining system has delivered higher unit labor cost growth than elsewhere in the euro area. The cumulative wage increase of over 11 percent in the 2006–07 two-year private sector wage settlement continued this trend. As a result, the real exchange rate has appreciated steadily, opening up a growing competitiveness gap vis-à-vis trading-partner countries, and the current account deficit widened to an estimated 7½ percent of GDP in 2006 (balance of payments basis) (Box 1). 2 Membership in the monetary union keeps long-term interest rate premia low (about 30 basis points against Germany), but a substantially smaller current account deficit would be needed to stabilize the net foreign asset position.3

Table 1.

Greece: Selected Economic Indicators, 2001–07

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Sources: National Statistical Service; Ministry of National Economy; Bank of Greece; and Fund staff estimates.

Labor Force Survey. Figures for 2004 not fully comparable with those for previous years because of new sample as of 2004.

Latest data is for September.

Figure 1.
Figure 1.

Greece: Selected Indicators, 1998–2006 1/

Citation: IMF Staff Country Reports 2007, 026; 10.5089/9781451816273.002.A001

Sources: IMF, International Financial Statistics; IMF, World Economic Outlook; National Statistical Service Greece; Bank of Greece, Bulletin of Conjunctural Indicators; and Bloomberg.1/ Projections for 2006 unless otherwise noted.2/ Data for 2006 as of September.3/ Data prior to 1999 refer to public sector.4/ Data prior to 1999 refer to private sector.5/ Enterprise lending rate from 2003 onwards.
A01fig01a
Sources: IMF, Information Notice System; IMF, World Economic Outlook; and National Statistical Service of Greece.1/ Projections for 2006 unless otherwise noted.2/ Data for 2006 as of October.3/ Data for 2006 as of September.4/ Data for 2006 as of June.
Table 2.

Greece: General Government Accounts, 2001–07 (Baseline Scenario)

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Sources: National Statistical Service; Ministry of National Economy; Bank of Greece; and Fund staff projections.

Greece: General Government Expenditures, 2001–05

(Percentage change)

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Sources: National Statistical Service; Ministry of National Economy; Bank of Greece.

2. Structural reforms have been put in place, but impediments to higher productivity remain. A decade of strong growth has narrowed the gap in real per capita income with the EU-15 average. Nevertheless, businesses face unduly high start-up costs and labor restrictions (Table 3), and chronically weak FDI inflows suggest a poor investment climate. Labor markets perform very poorly by international comparison (Figure 2).

Table 3.

Greece: Doing Business—Selected Indicators, 2005 1/

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Source: World Bank, Doing Business 2006.

Data are benchmarked to January 2005.

Unless otherwise indicated, the figures are indices which range from 0 to 100, with higher numbers indicating greater rigidity.

Figure 2.
Figure 2.

Greece: Labor Market Indicators, 2005

Citation: IMF Staff Country Reports 2007, 026; 10.5089/9781451816273.002.A001

Sources: Eurostat; IMF, World Economic Outlook; and OECD, Economic Outlook.1/ Youths are between 15 and 24 years of age.

External Competitiveness

Indicators suggest a significant erosion of cost and price competitiveness since EMU accession. The real effective exchange rate has appreciated by 20–30 percent on a ULC basis and by 10 percent on a CPI basis, and the export deflator rose by 10 percent, the highest among euro-area countries. Staff estimates based on the macroeconomic balance and external sustainability approaches, though subject to high margins of error, imply a real overvaluation of 12–22 percent. In addition to cost measures, Greece scores low relative to other euro-area members on international competitiveness rankings.

The erosion of competitiveness is reflected in weak export performance, notwithstanding a recent pickup. Greece has lost export market share, and export growth in the past five years has been the second weakest among euro area countries.

uA01fig01

Measures of the Real Effective Exchange Rate

(2000=100)

Citation: IMF Staff Country Reports 2007, 026; 10.5089/9781451816273.002.A001

uA01fig02

Export market shares

(1990=1.00)

Citation: IMF Staff Country Reports 2007, 026; 10.5089/9781451816273.002.A001

Source: IMF, Directions of Trade.

Greece scores low in international competitiveness rankings

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Greece: Policy Recommendations and Implementation

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II. Policy Discussions

The short-term economic outlook is strong, but challenges to sustained medium-term growth are posed by a weakening international competitive position, a large current account deficit, and sustained high private-sector credit growth. Against this backdrop, the discussions focused on how to foster a soft landing in the medium term. The mission discussed the pace and nature of medium-term fiscal adjustment, reform of tax administration and expenditure management, the pension reform process, financial sector vulnerabilities, the need for further structural reform in product and labor markets, and the national accounts revisions.

A. The outlook

3. Growth is set to remain strong in the short term in a context of global expansion, and in particular a revival of activity in the EU. Staff projects real GDP will rise by 4.1 percent in 2006, slightly above the staff estimate of potential (3.9 percent).4 Indicators from the first half of the year suggest continued strength in private domestic demand (Figure 3). The external sector remains a drag on growth, but, benefiting from the pickup in world growth, goods exports have recently shown surprising resilience in the face of eroding cost competitiveness. For 2007, while the key factors contributing to recent strength seem likely to continue, staff projects growth to ease to 3¾ percent, reflecting a mild slowing of consumption and investment from the rebound in 2006. Inflation is projected to ease somewhat as oil prices stabilize at levels lower than were seen earlier this year, while the current account deficit is projected to remain at about 7½ percent of GDP. Projection uncertainties for 2007 include the robustness of both consumption and investment and, on the external side, the effects of an appreciation of the euro and a slowdown in the United States.

Figure 3.
Figure 3.

Greece: Cyclical Indicators, 1999–2006

Citation: IMF Staff Country Reports 2007, 026; 10.5089/9781451816273.002.A001

Sources: IMF, International Financial Statistics; OECD; Bank of Greece, Bulletin of Conjunctural Indicators; and Bloomberg.1/ Data for 2006 as of November.2/ Data for 2006 as of September.3/ Seasonally adjusted.4/ Data for 2006 as of October.

4. For the medium term, staff projects a gradual slowing of growth, but continuing economic imbalances pose downside risks. The staff baseline projection assumes growth will fall somewhat below potential (about 3 percent) as consumers’ taste for increased debt begins to wane and lost competitiveness weighs on the traded goods sector and weakens investment. As a result, inflationary pressures ease and the current account deficit narrows, although adjustment is incomplete over the projection horizon as competitiveness and export market share deteriorate somewhat further (Table 4 and 5). However, persistent real exchange rate appreciation and unsustainable current account deficits raise the prospect of a sharper slowdown. The experience of other euro area countries suggests that such a slowdown could be triggered by lower consumption growth as households adjust to rapidly rising debt burdens, the cumulative effects of deteriorating competitiveness, or the end of asset (house) price increases (Box 2). In Greece, a very pronounced slowdown—growth of about ¾ percent a year for two years in Figure 4—while unlikely, would result in a higher fiscal deficit and a rise in the debt-GDP ratio.

Table 4.

Greece: Medium-Term Baseline Scenario, 2004–11

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Source: Fund staff estimates and projections.

Assumes broadly constant ratio of revenue and primary expenditures to GDP as in 2005, and full utilization of EU structural funds.

Table 5.

Greece: Summary of Balance of Payments

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Sources: National Statistical Service; and Fund staff estimates.
Figure 4.
Figure 4.

Greece: Public Debt Sustainability: Bound Tests 1/

(Public debt in percent of GDP)

Citation: IMF Staff Country Reports 2007, 026; 10.5089/9781451816273.002.A001

Sources: International Monetary Fund, Country desk data, and staff estimates.1/ Shaded areas represent actual data. Individual shocks are permanent one-half standard deviation shocks exept for the interest rate and growth shocks. The growth shock assumes that real GDP growth drops to 0.7 percent in 2007 and it recovers gradually to 2.8 percent by 2011. Figures in the boxes represent average projections for the respective variables in the baseline and scenario being presented. Ten-year historical average for the variable is also shown.2/ Permanent 1/4 standard deviation shocks applied to real interest rate, growth rate, and primary balance.3/ One-time real depreciation of 30 percent and 10 percent of GDP shock to contingent liabilities occur in 2007, with real depreciation defined as nominal depreciation (measured by percentage fall in dollar value of local currency) minus domestic inflation (based on GDP deflator).

The Greek Cycle in a Euro-area Context

This box compares Greek economic developments in the last 10 years with those of four other high-growth euro-area countries. Two of them, the Netherlands and Portugal, suffered sharp economic downturns in the first half of this decade (Figure 5), while Ireland and Spain continued to grow strongly (Figure 6), as has Greece. As all countries except the Netherlands began the 1990s with per capita incomes well below the euro-area average, their high growth could be viewed as catch-up.

Indications of demand pressures are evident during large parts of the 10-year period in all five countries. Credit grew strongly and rose substantially in relation to GDP. House prices also increased strongly in the Netherlands, Ireland, and Spain, although less so in Portugal and Greece. All countries experienced sustained inflation rate differentials, declining competitiveness, and deteriorating current accounts, although Ireland began from a strong surplus position. A key policy development in all countries except Greece and Portugal was the correction during the 1990s of substantial fiscal deficits.

The Netherlands experienced a sharp slowdown in the early 2000s, as eroding competitiveness hurt exports, and slowing house price increases and higher pension contributions sapped domestic demand. However, many of the imbalances that had built up were reversed: inflation differentials were closed, competitiveness erosion stopped, and the current account recovered.

The Portuguese economy fell into recession in 2003, as households curtailed demand in response to high debt levels, while investment collapsed amid low business confidence and weak economic prospects. The resulting adjustment of imbalances has been far from complete, although the inflation differential with the euro area closed.

Greece (like Ireland and Spain) has escaped such a slowdown, but vulnerabilities remain. The fiscal position has improved, although it is not as strong as it was in the Netherlands, which benefited from an established medium-term budget framework. Also, credit growth remains very high. However, Greece does not have the high levels of indebtedness that characterized both the Netherlands and Portugal, nor the rapid house price increases of the Netherlands, prior to their slowdowns. These factors suggest that imbalances may unwind gradually, in line with staff’s central projection.

Figure 5.
Figure 5.

Greece, Netherlands and Portugal, 1990–2006

Citation: IMF Staff Country Reports 2007, 026; 10.5089/9781451816273.002.A001

Sources: IMF, International Financial Statistics; IMF, World Economic Outlook; Bank of Greece, Bulletin of Conjunctural Indicator; and Bloomberg..1/ Data for 2006 as of September.2/ Break in series for 1998 with adoption of Euro.3/ Data for 2006 as of October.
A01fig05a
Sources: IMF, World Economic Outlook; and IMF, Direction of Trade.1/ Data for 2006 as of September.2/ Data for 2006 as of August.
Figure 6.
Figure 6.

Greece, Ireland, and Spain, 1990–2006

Citation: IMF Staff Country Reports 2007, 026; 10.5089/9781451816273.002.A001

Sources: IMF, International Financial Statistics; IMF, World Economic Outlook; Bank of Greece, Bulletin of Conjunctural Indicator; and Bloomberg.1/ Data for 2006 as of September.2/ Break in series for 1998 with adoption of Euro.3/ Data for 2006 as of October.
A01fig06a
Sources: IMF, World Economic Outlook; and IMF, Direction of Trade.1/ Data for 2006 as of September.2/ Data for 2006 as of August.

5. The authorities shared concerns about competitiveness and the current account, but were optimistic about medium-term growth prospects. They pointed to the room for productivity catch-up, a resurgence in tourism, and promising Greek commercial prospects in southeastern Europe. They expected aggregate supply to be augmented by robust investment, supported by EU funds, and structural reforms. They noted that export growth picked up in 2005, and expected another strong result in 2006; they felt that improved efforts to market Greek products abroad had bolstered exports. The mission agreed that the Greek economy has consistently surprised on the upside in recent years, and that the staff projection that potential will slow by nearly one percentage point in the next 5 years may not materialize, but argued that sustaining this performance would require further structural reform. Moreover, the substantial erosion of competitiveness will take time to reverse, requiring strong productivity growth and considerable wage moderation (Box 3).

Restoring External Competitiveness

Restoring competitiveness will require cutting unit labor cost growth below the corresponding growth rate in other euro area countries, either by moderating wage growth or further raising productivity growth. To illustrate the difficulty involved, on the staff’s baseline productivity assumptions it would take 5 years to eliminate the estimated competitiveness gap if nominal wages were frozen, and twice as long if nominal wages grew at 2 percent a year.

Structural reforms could contribute significantly to the process by boosting labor productivity and, by strengthening competition, holding down prices. For example, a 1 percentage point increase in productivity growth and a 0.3 percentage point decline in inflation (a temporary effect lasting only while competition intensified) would shorten the time needed to close the competitiveness gap by 1½ years.

The elimination of the competitiveness gap could, all else equal, reduce the current account deficit by about 3 percent of GDP. Completing the adjustment in 5 years through exports alone, however, would require nominal export growth of about 12 percent a year for 5 years, some 4¼ percentage points higher than in the staff baseline scenario. Notwithstanding the rebound in exports in 2005–06, this is ambitious, and suggests that some of the adjustment will have to come from lower demand.

B. Fiscal Policy

6. The authorities began cutting the deficit sharply in 2005. The deficit fell to 4.2 percent of GDP in 2005, and the 2006 budget targets 2.1 percent of GDP (2.6 percent on the old national accounts basis). For the two years 2005–06, 2.4 percentage points of the cumulative estimated deficit decline of 4 percent of GDP was primary spending restraint (including 1.3 percentage points attributable to the end of the Olympics); 0.9 percentage point was accounted for by revenue increases. However, in contrast to 2005, the focus in 2006 shifted to revenue increases, reflecting progress in combating tax fraud, a 1 percentage point increase in the VAT, and the introduction in mid-2006 of higher excise taxes on tobacco and mobile phones.

7. It was agreed that, notwithstanding the adjustment to date, further deficit cuts will be needed in the years ahead. The authorities have announced their intention of achieving budget balance or surplus by 2012, although since they have not articulated medium-term policies to achieve this outcome the deficit reductions in the staff baseline scenario are much smaller. This goal is somewhat less ambitious than the staff’s recommendation of a cyclically adjusted balance by 2010 and a surplus after that (Table 6). The mission argued that further declines in the deficit would be appropriately countercyclical in the short term, provide greater room for a fiscal cushion should the economy slow, and foster a rapid reduction of the public debt before the costs of population aging begin to mount around the middle of the next decade.

Table 6.

Greece: Medium-Term Staff Policy (Adjustment) Scenario, 2002–12

(In percent of GDP)

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Sources: National Statistical Service; Ministry of National Economy; and Fund staff estimates and projections.

8. The mission emphasized the need for high-quality consolidation that would leave room for needed investment and tax cuts. International experience strongly suggests that a focus on restraint of current primary spending promotes sustained fiscal adjustment.5 By comparison with other countries, the Greek public-sector wage bill, defense, and, to a lesser extent, social transfers are relatively high, suggesting restraint in these areas might be warranted. The authorities agreed on the need to control spending, especially in view of their intention to continue with tax reform (see below).

9. The 2007 budget targets little deficit reduction. As a fraction of GDP, the general government deficit falls by only 0.2 percent of GDP, reflecting lower interest payments, while both revenues and primary spending are little changed. The authorities stressed that, having front-loaded deficit cuts in 2005–06, it is appropriate for the pace of consolidation to ease. Moreover, they noted that temporary measures built into the 2006 budget (worth 0.3 percent of GDP) will not be repeated in 2007, which they viewed as implying a structural improvement of 0.5 percent of GDP. The mission, while welcoming the end of the temporary measures and the consequent improvement in the quality of adjustment, argued that a larger actual deficit cut was warranted, both for countercyclical purposes and as a step toward the medium-term objective of budget balance.

Greece: Budget 2007

(In percent of GDP)

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10. The authorities are introducing tax reforms which may entail some fiscal cost. The corporate tax rate is scheduled to fall to 25 percent (20 percent for smaller firms) in 2007. The government is also reforming the personal income tax to increase the basic exemption and reduce marginal tax rates (except the top 40 percent rate for incomes over €75,000). Because the reform is phased in, the authorities judged the revenue implications for 2007 to be very small. The mission underscored that revenue losses should be minimized by reducing distortionary exemptions—especially since a simplification of the tax code would help to improve tax administration—or compensated by further spending compression.

11. Crucial reforms of tax administration and public expenditure management are beginning to be put in place. In 2005, FAD provided advice on these issues, as well as a fiscal transparency ROSC.

  • On the tax side, the authorities noted the formation of a compliance improvement committee, reform of auditing services, strengthening of VAT operations, stronger enforcement of arrears collection, and improvements in the penalties and appeals process. Nevertheless, a number of measures—including regional tax directorates, risk-based enforcement and auditing, simplification of VAT returns, and adjustment of penalties to improve compliance—are under consideration but not yet implemented, and the larger problem of widespread tax evasion persists.

  • On the expenditure side, a new audit directorate is to be established in the Ministry of Economics and Finance (MoEF). The mission emphasized that its audits would have to go well beyond the current practice of focusing on proper paperwork, and instead examine whether programs meet objectives and spending is efficient, a point the authorities agreed with. Initial steps have been taken on program-based budgeting (PBB), with the current administratively based spending system being translated into nine broad program categories. The mission argued that this approach would have to be developed further to ensure that the categories are detailed enough to match policy objectives and that budgeting start with PBB and then be translated into specific spending items. The authorities had no immediate plans to introduce a medium-term budget framework, which the mission argued would help in setting fiscal priorities.

12. Pension and health-care costs will begin to rise early in the coming decade and deep reforms will be needed to avoid jeopardizing the public finances. Estimates dating from 2000 imply that these costs will rise by some 10½ percent of GDP by 2050, among the largest increases in the EU. The mission urged that the reform process be stepped up, noting that the preparation of new cost estimates seemed to be taking longer than expected, in part because the National Actuarial Authority (NAA), which is charged with the task, is still understaffed. These estimates are to be used by a high-level commission (the “Analytis Commission”) to inform the political debate and by the ILO to provide a pension model. The mission also expressed concern that the social dialog needed to prepare the ground for reform had not advanced far. The authorities planned no reforms before the next election, in accordance with a previous election pledge, but did intend to step up enforcement of certain past reforms and had intensified efforts to reduce contribution evasion. They also felt that the process of formulating policies was on schedule, and agreed that discussion among the social partners and the public would be key. Regarding health care, the authorities are introducing better controls, especially over procurement (a source of overruns and arrears in the past). The mission agreed that these measures would prove useful, but cautioned that international experience illustrated the difficulties of containing costs while providing high quality medical services.

C. The Financial Sector

13. The banking sector appears generally sound. Solvency and liquidity are satisfactory and recent stress tests conducted by the Bank of Greece (BoG, the banking supervisor) indicate that capital adequacy ratios would remain well above regulatory thresholds even if credit risks materialized.6 Profits are robust, driven by rising lending volumes in Greece and southeastern Europe, wide margins (themselves, however, potentially a sign of insufficient competition), and some cost cutting (Table 7, 8, and 9).

Table 7.

The Core Set of Financial Soundness Indicators for Deposit Taking Institutions 1/

(1998-June 2006 unless otherwise indicated)

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Source: Bank of Greece.

These may be grouped in different peer groups based on control, bsuiness lines, or group structure.

June 2006 figures refer to Greek quoted banks unless otherwise indicated

June 2006 figures refer to all banks

Data on a consolidated basis

This figure does not include ATEbank and rescheduled loans. If rescheduled loans were included, then the relevant ratios would become 18.7 for 2005 and 20 for June 2006.

This figure does not include ATEbank and rescheduled loans. If rescheduled loans were included, then the relevant ratios would become 5.6 for 2005 and 5.6 for June 2006.

2006 figures refer to July 2006 and to all banks on a non-consolidated basis (i.e. commercial, cooperative and foreign branches)

On a non-consolidated basis. From 2004 in accordance with IFRS.