Greece: Selected Issues

This Selected Issues paper examines three areas of key policy importance for Greece in the coming years. The paper documents the loss of international competitiveness in recent years, as well as the accompanying widening of the current account deficit. It analyzes fiscal consolidation episodes in advanced economies, and confirms the conclusion found in the literature that, for durable consolidation, control of current spending is superior to revenue increases. The paper also estimates European banks’ vulnerability to rapid credit growth and economic slowdowns.


This Selected Issues paper examines three areas of key policy importance for Greece in the coming years. The paper documents the loss of international competitiveness in recent years, as well as the accompanying widening of the current account deficit. It analyzes fiscal consolidation episodes in advanced economies, and confirms the conclusion found in the literature that, for durable consolidation, control of current spending is superior to revenue increases. The paper also estimates European banks’ vulnerability to rapid credit growth and economic slowdowns.

I. Greece’s Competitiveness Deficit: How big is it and how could it be unwound?1

A. Introduction

1. The Greek economy has been experiencing a renaissance, but lately external imbalances have been mounting. Output and employment have grown robustly and respectable productivity gains have started to narrow the income differential vis-à-vis the euro area.2 However, growth has been driven mainly by domestic demand stimuli (financial system liberalization, lower interest rates following EMU accession, procyclical fiscal relaxation, and EU transfers), inflation has consistently exceeded the euro area average leading to a loss of competitiveness, and the external current deficit has widened to an unsustainable level. Looking forward, the stimuli that have propelled the economy are running their course.

2. This state of affairs raises a number of important policy questions. To what extent is the erosion of competitiveness a benign phenomenon? Should the widening of the external current account deficit be of concern for an EMU member country? Could export growth pick up the slack when the demand stimuli have run their course or would they be inhibited by overvaluation? What policies could engineer a soft landing?

3. The main conclusions of this chapter are:

  • The external performance of the Greek economy has been weak on a number of dimensions. By all measures, the real exchange rate has become overvalued by some 17 percent (but with quite wide margins of error) since euro adoption due to high inflation and wage growth; non-price competitiveness compares poorly with other EU countries; export growth has been weak; and the current account deficit has expanded to an unsustainable level.

  • To a large extent, the real appreciation and the widening current account deficit are driven by two shocks, the interest rate drop and financial liberalization. As these shocks fade, pressures on the exchange rate and the current account should ease.

  • While the current account deficit itself may not reflect underlying economic distortions, and while Greece does not face a binding external financing constraint, external adjustment will have to occur over the medium term. Reversing the competitiveness deficit will take a combination of wage restraint, productivity improvements, export growth, and domestic demand moderation. Prudent fiscal policies, bold structural reforms, and strong forward looking prudential oversight can help foster a soft landing.

4. The chapter is organized as follows: the next section looks at indicators of external performance, Section C estimates the underlying overvaluation of the real effective exchange rate, Section D analyzes export market performance, Section E examines the relevance of current account deficits and exchange rate overvaluation for EMU member countries, and Section F concludes with policy implications.

B. Indicators of External Performance

5. All measures of the real effective exchange rate have appreciated significantly since EMU accession, reaching historically high levels. ULC-based measures have appreciated by 20-30 percent and CPI-based measures by about 10 percent, reaching their highest level in a quarter century. The appreciation reflects rapidly rising unit labor costs (their annual growth has exceeded the euro-area average by 2.2 percentage points), relatively high inflation (on average, 1.2 percentage points above the euro area average), and the strengthening of the euro. Export prices (as measured by the export deflator) have been among the fastest growing in the euro area, indicating eroding competitiveness vis-à-vis other euro area partners;3 their growth having fallen short of ULC growth points to a possible compression of profit margins in the export sector. These are clear indications that Greece has not yet fully adjusted to the currency union setting.

Unit labor costs in manufacturing in selected euro area countries, 2000-06

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Sources: WEO databank and IMF staff calculations.

Measures of the Real Effective Exchange Rate

(2000 = 100)

Citation: IMF Staff Country Reports 2007, 027; 10.5089/9781451816280.002.A001


Deflators of GNFS exports

(2000 = 100)

Citation: IMF Staff Country Reports 2007, 027; 10.5089/9781451816280.002.A001

6. Eroding price/cost competitiveness has been accompanied by weak non-price competitiveness. Broad-based indicators—such as the international competitiveness rankings of the World Economic Forum (WEF) and the International Institute for Management Development (IMD)—which take into account the business environment, infrastructure, the quality of government and other factors that ultimately influence production costs, rank Greece low among EU countries.4 Poor non-price competitiveness is reportedly the main reason for chronically weak inward FDI.

Greece gets low scores in competitiveness rankings

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Inward FDI as a percent of gross fixed capital formation

(Average 2003-05)

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Source: Eurostat

7. The erosion of competitiveness is reflected in export performance. Export volume growth has been the second lowest among euro area countries in the period since EMU accession, notwithstanding the very fast growth in Greece’s export markets. Correspondingly, exporters have been losing market share, notably in the rapidly expanding neighboring Balkan countries.


Export growth has been the second slowest among euro area countries

Citation: IMF Staff Country Reports 2007, 027; 10.5089/9781451816280.002.A001

Source: OECD, Analytical Databank.

Greece: Export market share

(Constant prices)

Citation: IMF Staff Country Reports 2007, 027; 10.5089/9781451816280.002.A001


Export market shares

(1990 = 100)

Citation: IMF Staff Country Reports 2007, 027; 10.5089/9781451816280.002.A001

8. The external current account deficit has been high and widening. From the savings-investment perspective, the deficit reflects high investment and low savings rates by international standards. In particular, the recent widening of the deficit reflects mainly an uptick in investment associated with improving economic prospects and a pick-up in infrastructure projects. From a payments perspective, the recent widening of the current account deficit is related to the deterioration in the net income balance (owing to the rise in foreign liabilities, which at 84 percent of GDP at end 2005 are the highest among EMU member countries), and the decline in EU transfers. The terms of trade did not have an appreciable impact on the current account.


Greece: External Current Account and its Determinants

Citation: IMF Staff Country Reports 2007, 027; 10.5089/9781451816280.002.A001

Source: OECD, Analytical Database, and IMF staff calculations.

9. The widening of the current account deficit and the real appreciation since EMU accession are associated with two demand shocks, the surge in credit growth and fiscal expansion.

  • The credit surge is the result of (i) financial liberalization which has relaxed liquidity constraints (especially for households), fostered innovation, and induced banks to aggressively extend credit in their quest for market share, (ii) expectations of higher real estate taxation, which boosted residential construction, and (iii) the drop in real interest rates in the wake of EMU accession, which increased real incomes, improved growth prospects, and raised current expenditure as part of intertemporal consumption smoothing.5

  • The fiscal expansion, which with the benefit of hindsight was unhelpful from a cyclical perspective, reflects a relaxation following the arduous effort to meet EMU accession criteria, and perhaps difficulty in assessing the cyclical position of the economy at a time of high unemployment.


Demand stimuli have strengthened since EMU accession

Citation: IMF Staff Country Reports 2007, 027; 10.5089/9781451816280.002.A001

10. However, the demand stimuli are running their course. The ongoing fiscal consolidation, which aims to eliminate the structural deficit by 2010-12, should withdraw stimulus, as will the gradual winding down of net transfers from the EU. Credit growth could remain strong for a while, but will decline as the leverage of the private sector plateaus. Taking other EMU economies as a benchmark, a further increase of the private sector leverage ratio by 30 percentage points of GDP in the next five years would sustain average credit growth at 12 percent per year.


Greece: Demand Stimuli, 1991-2006

Citation: IMF Staff Country Reports 2007, 027; 10.5089/9781451816280.002.A001

Source: OECD, Analytical Databank; Bank of Greece; IFS, WEO and IMF staff calculations.

C. How big is the competitiveness deficit?

11. The competitiveness deficit is quantified using three methodologies: the Macroeconomic Balance (MB), the Equilibrium Real Exchange Rate (ERER) and the External Sustainability approach (ES).6 All three approaches proceed in two steps: first, estimate the gap between external indicators (e.g. current account, effective exchange rate, external indebtedness) from the levels consistent with fundamentals and, then, calculate the exchange rate adjustment needed to eliminate the gap.

12. The MB approach is based on the gap between the underlying and the equilibrium current account balance. It then calculates the exchange rate adjustment that would be needed to eliminate this gap using the elasticity of the current account with respect to the real exchange rate.

13. The CAU excludes the effect of transitory factors (the cyclical position in Greece and trading partners, temporary changes in the import content of domestic demand, and spikes in freights, oil prices and exports of ships, which are taken to be orthogonal with each other) and is calculated as:7

CAU = CA(M/Y)ψM YGAP + (X/Y)ψX YGAPF(D/Y) α [(I/Y)(I/Y)avg] − other one-offs

where CA, M, X, I, D and Y denote nominal current account, imports, exports, domestic demand, investment and GDP, ψM and ψX are the elasticities of imports and exports with respect to activity, α denotes the differential import content in investment relative to consumption, and YGAP (YGAPF) is the domestic (foreign) output gap. A positive output gap driven by domestic demand temporarily raises the current account deficit by raising imports and discouraging exports. Similarly, a negative output gap in partner countries temporarily lowers Greek exports and so raises the current account deficit. Above average investment, owing to its higher import content, also tends to temporarily swell the current account deficit. Net exports of ships are excluded because they relate to the large scale renewal of the mercantile fleet, an operation that is expected to be completed in the next few years. Finally, deviations of freight and oil prices from their trend generate corresponding temporary swings in the current account.

Greece: Actual and Underlying Current Account Deficit

(In percent of GDP)

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Source: WEO and IMF staff calculations.

Calculations based on MULTIMOD elasticities as discussed in Isard and Faruqee (1998)

Calculations using import content coefficients as specified in Sideris and Zonzilos (2005).

The calculations sets the baseline for the Baltic Exchange Dry Index at 2,800.

The baseline for the oil price is set at US$ 60 per barrel.

14. The underlying current account has averaged 6.3 percent of GDP in recent years (see table below). This suggests that the deterioration in the current account reflects primarily cyclical/transitory factors and thus, barring other shocks, the deficit should return to its underlying level of 6 percent of GDP when the transitory factors have run their course. This leads to the question whether a deficit of 6.3 percent is sustainable.

15. The equilibrium current account (CAE) for Greece is estimated at 2.7 percent of GDP. This estimate is based on the levels of economic fundamentals (fiscal balance, demographics, wealth, oil balance, economic growth, etc) that are expected to prevail in the medium term. The “equilibrium” is of a statistical nature—in the sense that the current account matches the prediction of a reduced form econometric model—and, as such, reflects average behavior of industrial countries. The main factors that underpin the value of the CAE for Greece are the high growth rate (i.e. convergence) and population aging.

16. The gap between CAU and CAE suggests a real overvaluation of about 24 percent of GDP.8 The confidence interval around this estimate is rather wide, reflecting the fact that the calculations are based on assessments about the cyclical position of the economy at home and abroad, the underlying levels of oil prices and freights, and the equilibrium level of the current account, all of which are difficult to estimate precisely. Robustness checks using alternative assessments of the key parameters suggest a confidence interval of ±6 percentage points around the point estimate.

17. The ERER approach assesses compares the actual to an equilibrium exchange rate. Intuitively, it assesses whether the real exchange rate appreciation is a benign equilibrium phenomenon that does not require a policy response (for instance, the result of catching up or price level convergence) or the manifestation of external imbalances that need to be rectified (e.g. eroding competitiveness). The equilibrium exchange rate is the one consistent with internal and external balance. Several approaches have been proposed in the literature for defining and estimating the equilibrium exchange rate.9 The variant used here estimates it from a panel regression that relates the real effective exchange rate (CPI based) to a set of fundamentals—net foreign assets, productivity differential (Balassa-Samuelson effect), commodity terms of trade, government consumption, trade restrictions, and price controls.

18. This approach suggest that the exchange rate was about right at the time Greece acceded to the EMU but has since appreciated, and in early 2006 was 18 percent above the level implied by fundamentals. This overvaluation reflects the appreciation of the REER as well as a fall of the equilibrium rate. The former stems from the higher inflation whereas the latter is driven by the accumulation of net foreign liabilities (NFL), which more than offsets a weak Balassa-Samuelson effect.


Main contributors to the change in the ERER

Citation: IMF Staff Country Reports 2007, 027; 10.5089/9781451816280.002.A001

19. Several factors account for the relative weakness of the Balassa-Samuelson effect in Greece. First, the traded goods sector is the smallest among EMU countries and, as a result, does not play a leading role in wage setting.10 In fact, the tone for wages is set by the large government sector. As a result, the traded goods sector is forced to adjust employment and raise productivity (including through exit of firms).11 Second, the productivity growth differential between the traded and nontraded goods sectors averaged only 2 percentage points in 1995-2003, which is not much higher than in other EMU countries. Finally, a cross-country comparison of the evolution of tradables prices provides evidence that demand stimuli have been driving the real appreciation. The evidence is most clear in the case of audio-visual, photographic and information processing equipment (traded goods par excellence) whose prices in 2000-06 registered the smallest decline in Greece among EMU countries, reflecting the large non-traded component of the price and relatively slow progress in strengthening competition. The decrease was low also in other EMU countries experiencing strong domestic demand.

Change in the prices of audio-visual, photographic, and information processing

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Source: Eurostat, HICP databank.

Greece is the least open among the smaller European economies

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Source: OECD Analytical Database.

20. The ES approach looks the current account balance from the vantage point of the sustainability of the country’s foreign asset (NFA) position. It consists of three steps: first, it assesses the sustainable level for the net foreign asset position; second, it uses this to determine the current account balance that stabilizes the net foreign asset position at a sustainable level (CAS); and finally, it measures the external misalignment by the adjustment in the real effective exchange rate needed to close the CAU-CAS gap. Unlike the MB and ERER approaches, which rely on econometric estimation, the ES approach requires assumptions about the country’s potential growth rate, inflation, and rates of return on external assets and liabilities, as well as an assessment of what constitutes a sustainable level of NFA.

21. The sustainable current account deficit (CAS) is estimated at 3.9 percent of GDP, which is higher than the CAE. It is given by:12

CAS = −γ(1+γ)−1 NFAS

where γ stands for nominal GDP growth and NFAS denotes the sustainable level of the net foreign asset position. In the calculations, γ is set at its projected medium-term value of 5.5 percent and NFAS at -85 percent, its level at end-2005 (the highest among EMU countries 13).

The sustainable level of NFA is difficult to pin down with precision, especially in the case of an EMU country because the elimination of the country-specific exchange rate risk has made the supply of foreign credits more elastic, eased financing restrictions, and made the level of NFA largely demand determined.14 However, the current level of the underlying current account deficit (about 6 percent of GDP) is unlikely to be sustainable, as it implies a rather high steady-state NFA of 115 percent of GDP.

Greece has the lowest NFA among EMU countries

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Sensitivity of CAS to variations in γ and NFAS

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Robustness of the overvaluation estimate

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22. The ES approach suggests an overvaluation of 12½percent.15 Uncertainty regarding the choices of medium term nominal growth, sustainable NFA, and the elasticity of the current account with respect to the exchange rate imply a margin of error of ±6 percentage points around the central estimate.

D. Constant Market Shares Analysis of Competitiveness

23. The structure of exports changed profoundly during the past decade. There has been a shift of merchandise exports from the EU towards neighboring countries in the Balkans and Turkey. The share of agricultural products and textiles has fallen, while that of services in has risen to 66 percent, more than double that in other EU member countries.16 Constant Market Shares (CMS) analysis provides a platform for assessing the extent to which the increase in exports reflects greater penetration of existing markets or a shift towards more dynamic regions/markets.

24. CMS analysis decomposes the growth in exports (X1-X0) into four components: global market growth, commodity composition, market distribution, and competitiveness (see Annex I):


where Xtij = value of Greek exports of commodity i to country j during period t

r = growth rate of world exports

ri = growth rate of world exports of commodity i

rij =growth rate of world exports of commodity i to country j

ρij = growth rate of Greek exports of commodity i to country j

  • The global market growth effect (first term) calculates by how much Greek exports rose to keep Greece’s share in world trade unchanged. This sets the benchmark against which competitiveness is assessed. A faster increase of exports is prima facie evidence of improving competitiveness.

  • The commodity composition effect (second term) examines whether export growth has benefited from the concentration of exports on commodities for which demand has been growing rapidly. It reflects the specialization of the exporting country and the income and price elasticities of demand for its exports.

  • The market distribution effect (third term) examines whether export growth has benefited from the concentration of exports in rapidly growing markets/regions.

  • The competitiveness effect (fourth term) captures changes in export market share after adjusting for the impact of the other effects. That is, it is the residual. Moreover, it is assumed to be independent of the other effects and is taken to reflect largely exchange rate developments and the role of domestic factors in the exporting country such changes in the quality and composition of exports. When trade flows are in nominal terms (as it is the case with the Comtrade databank used here) the competitiveness effect also incorporates the effects of terms of trade changes.

Changes in the Composition of Greek Exports

The Geographic Composition of Greek Merchandize Exports

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Sources: IMF, Direction of Trade.

Sectoral composition of Greek Merchandize exports, 1992-2005

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Source: Comtrade databank and IMF staff calculations.

The share of services in total exports has been increasing …

Citation: IMF Staff Country Reports 2007, 027; 10.5089/9781451816280.002.A001

… and is the highest among OECD countries

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Greece: CMS Analysis of Exports Changes

(Value in billion US dollars; unless otherwise indicated)

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Source: Comtrade databank and IMF staff estimates.

Based on the commodity composition of exports in 1992.

Based on the commodity composition of exports in 2000.

25. The results of the CMS calculations for Greece can be summarized as:17

  • The growth of Greek merchandise exports in 2000-05 is explained largely by rising world trade, with the competitiveness effect having only a small, though negative effect. In contrast, in 1992-2000 export growth fell well short of what would be expected from world trade developments (that is, market share was lost), implying a large competitiveness (residual) loss. 18 In view of the significant REER appreciation since 2000, the small loss of market share suggests that chronic problems in export sectors are being rectified.

  • The negative commodity composition effect, though very small for the recent period, indicates that Greek exports are tilted towards items for which world demand has been growing at below average rates.

  • The positive market distribution effect reflects that the rapidly expanding southeastern European economies have been a significant driver for Greek exports, although again less so in recent years.

  • The negative competitiveness effect indicates a significant erosion of competitiveness. The bulk of the this erosion occurred in the 1990s when the Greek economy was slow to take advantage of the opportunities opened up by increasing globalization and the surging imports of emerging market economies. Since the euro adoption there has been a further small loss of export market share that is consistent with the appreciation of the real effective exchange rate.

26. Several caveats apply to these conclusions. First, the analysis excludes services exports, which are double the size of merchandise exports. Moreover, the erosion of competitiveness could be underestimated by the rapid expansion in recent years of intra-industry trade with neighboring Balkan countries. Finally, the analysis is based on values and, thus, cannot distinguish between volume and price effects.

E. Should external imbalances be of concern in a euro-area country?

27. Adoption of the euro has reduced the significance of the current account deficit and external indebtedness as risk factors. First, there are statistical measurement problems, shared by all EMU member countries: the deepening of economic and financial integration is making it increasingly more difficult to capture trade and financial flows vis-à-vis other EMU countries. In Greece, an additional complicating factor is still extensive tax evasion and the large underground economy.19 Second, and more important, the elimination of country-specific exchange rate risk has made the supply of foreign financing elastic and CA and NFA largely demand determined. In such an environment, and to the extent that the economy is free of distortions—external borrowing is contracted mainly by the private sector and is based on capacity to repay, risks are correctly priced, prices are flexible, and the corporate and household balance sheets are sound—the current account deficit and external indebtedness are equilibrium outcomes that reflect primarily time preferences and expectations of future income. All this does not mean, however, that endogenous adjustment will not eventually occur, and the key policy issue is how best to ensure a smooth unwinding of imbalances.

Evolution of Greece’s net International Investment Position

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Source: IMF, IIP databank.

28. Greece’s recent high current account deficits have not encountered financing problems. Enterprises have relatively small net foreign liabilities (see table above) and encounter no difficulty in attracting external financing, and the banking system is sound. In addition, households have large real estate holdings that can used to finance current consumption. Moreover, external deficits have been financed almost exclusively by running down assets (mainly holdings of government securities) at a time when international financial markets were generously endowed with liquidity and the ratings of Greek government securities were raised.20 As a result, the bulk of external indebtedness comprises government securities. About ¼ of these securities have remaining maturity of less than 2 years, a short maturity that creates vulnerability because in the event of turbulence in international financial markets. Lengthening the maturity of public debt or, preferably, creating propitious conditions for replacing public debt by foreign direct investment could mitigate this vulnerability.


Greece’s sovereign ratings have improved…

Citation: IMF Staff Country Reports 2007, 027; 10.5089/9781451816280.002.A001


… and spreads have become comparable to Italy’s

Citation: IMF Staff Country Reports 2007, 027; 10.5089/9781451816280.002.A001

29. A real appreciation could pose serious challenges for euro-area economies. If the appreciation is unsustainable (in the sense of being inconsistent with the expected evolution of fundaments) and nominal wages are characterized by downward rigidity, there is need for policy action: with exchange rate realignment not an option, a large real depreciation may necessitate a correspondingly large real wage contraction to bring ULC growth below that in euro-area partners. For example, the elimination of an 18 percent real overvaluation (the average of the estimates in Section C) requires a 5 year long nominal freeze.21 Wage restraint of this order is unlikely to happen without a deep recession.

30. The factors that have been boosting domestic demand in recent years are running their course. In particular, when financial liberalization matures and households’ indebtedness approaches its new higher equilibrium level, consumption growth will decelerate towards its new steady-state level,22 and will accordingly dent GDP growth. The decline in growth could be averted by replacing faltering domestic demand with exports. But this will require a reduction in the relative price of nontradables so as to (i) facilitate the transfer of productive resources to the export sector and (ii) restore the competitiveness of the export sector. Box 1 sketches the adjustment of a small open economy to a demand shock.23

A Simple Model of Internal and External Adjustment

The gist of adjustment can be captured by a simple IS model:

y = DD(y,s) + NX(ɛ,y)

where y stands for output, DD(…) denotes domestic demand, and is assumed to be an increasing function of output and an index of fiscal policy, g, and a demand shock, s; NX(…) is net exports, assumed to be a decreasing function of the real exchange rate, ε and output. Internal balance requires that y = y*, where y* is potential output. External balance requires NX(…) = 0. The model is closed with a Phillips curve, which stipulates that internal imbalance leads to higher inflation and to real appreciation.

The relations are plotted in the figure below, with the real exchange rate on the vertical axis and output on the horizontal axis. The IS curve is drawn for given values of g and s and is downward sloping: an appreciation decreases the equilibrium level of output. The internal balance is vertical at y = y*. To the right of y*, the real exchange rate appreciates and the economy moves up along the IS curve. To the left of y* the real exchange rate depreciates and the economy moves down along the IS curve. The external balance is given by the NX = 0 curve and is downward sloping and flatter than the IS curve (because the marginal propensity to spend is less than one). Let the economy be in internal and external equilibrium at point A.

Now suppose that a shock (say, financial liberalization) raises domestic demand. This will shift the IS curve to the right to IS’, while the NX = 0 locus remains unchanged; and will bring the economy to A’. At this point, output is above potential and external trade in deficit. If the economy is left to run its course unhindered, inflation will increase, the real exchange rate will appreciate and the trade deficit will widen. The economy will move along the IS’ curve and eventually reach A”. At this point, output is back at potential but the real exchange rate is overvalued, the trade balance in deficit, the IIP worse than in the initial equilibrium (due to the accumulation of external deficits). The servicing of external debt will reduce disposable income, lead to a contraction of domestic demand, reduce output below potential and put in motion a competitive disinflation. The contraction of demand will eventually take the economy, along path A” A, to the original equilibrium. The adjustment will be faster if the demand shock weakens over time.


Macroeconomic adjustment to a demand shock

Citation: IMF Staff Country Reports 2007, 027; 10.5089/9781451816280.002.A001

This boom-bust cycle could have been attenuated with a fiscal contraction at the beginning of the cycle. Although the real appreciation is an equilibrium phenomenon, the case for policy intervention can be made on the fact that the costs of departures from potential output are not symmetric. They are higher when the economy is below potential. Also, costs are smaller when the economy is growing rapidly (the adjustment requires a growth recession) than slowly (the adjustment may require stagnation or even contraction of output).

F. How could the lost competitiveness be clawed back?

31. Several channels can help recover competitiveness, in the absence of a nominal exchange rate depreciation. Wage restraint lowers ULC and, to the extent that it reduces domestic absorption, facilitates the transfer of resources to exportables. Structural reform raises productivity growth, lowering ULC and raising potential growth. Fiscal consolidation eases inflationary pressures, thereby lowering ULC growth and, by reducing absorption, facilitates the transfer of resources to the export sector. Finally, the recovery of competitiveness will be assisted also by the fading of the financial liberalization shock and possible wealth effects (for instance, social security funding or asset price corrections).

32. The almost 20 percent competitiveness deficit is too large to be eliminated within a reasonably short period via any single channel. Policy intervention on a broad range of areas and policy complementarities will shorten the adjustment period and ameliorate side effects.

  • Wage restraint. Any effective strategy of restoring competitiveness needs to reduce ULC growth below that in euro-area countries. Restraining nominal wage growth to productivity growth plus euro area inflation would stop further widening of the competitiveness gap, but would not close it.24 To illustrate how the effect of wage growth on closing the gap, consider the following examples. A nominal wage freeze would take 5 years to eliminate the competitiveness deficit. It would take twice as long with nominal wage growth of 2 percent a year, that is, zero real wage growth at the ECB’s inflation target. Wage restraint of this order is not feasible in the absence of a deep recession.

  • Structural reforms can significantly reduce the need for wage restrain by cutting labor costs and raising potential growth. They operate primarily through two channels, the reduction of labor costs and the increase in potential growth. Reforms can boost labor productivity and dent inflation (by strengthening competition and align wages better with productivity). For example, a rise in productivity growth by 1 percentage point and a decline of inflation by 0.3 percentage points (a temporary effect lasting only while competition intensifies) would shorten the time needed to eliminate the competitiveness gap by 1½ years. Potential growth is increased by aggregate productivity increases, but also through improved non-price competitiveness that allows a shift in production to higher-value items. Higher potential growth would, in turn, permit deflationary pressures (an output gap) to arise while still maintaining acceptable actual growth.

  • Export growth. The current account can be brought to its fundamental or sustainable level through higher import growth. To illustrate, eliminating 3 percentage points of current account deficit within five years would require 4.2 percent (±0.7 percent) higher export growth.25 The broad based rebound of exports in 2005-06 suggests that faster export growth is feasible if the world economy continued to grow at its current fast pace, although sustaining such a performance for 5 years would be a challenge. The removal of administrative impediments to exports and active export promotion would help, as would structural policies that facilitate the reallocation of resources from the non-traded to the traded sector and eliminate bottlenecks.

  • Higher net savings. From the savings-investment perspective, the current account deficit could be cut by increasing cyclically adjusted net savings. The authorities announced medium-term fiscal consolidation target implies a reduction in the cyclically adjusted deficit by about 3 percent of GDP. Private savings could rise as the effects of financial liberalization and lower interest rates on euro adoption wane. Other factors, such as concerns about the viability of the social security system could also raise the savings rate. Finally, external adjustment could be supported also by the discouragement of investment from the real effective appreciation.

Additional export growth needed to close the gap

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33. Depending on the constellation of policies and luck, adjustment might follow three alternative scenarios:

  • In the good scenario, lost competitiveness is clawed back without the economy having to go through a recession. This presupposes the gradual unwinding of the demand stimuli and strong policy bundle comprising fiscal consolidation, structural reforms, wage moderation, and strong financial oversight.

  • The bad scenario involves a hard landing triggered by a sudden unwinding of the demand stimuli and accumulated vulnerabilities. A weak fiscal situation (that is, a fiscal deficit close the Maastricht threshold) would limit the scope for the automatic stabilizers while the overvaluation and structural rigidities would prevent an offsetting increase in exports.

  • In the ugly scenario, the hard landing is exacerbated by financial sector problems. A sudden economic slowdown might reveal banking-sector vulnerabilities that have heretofore been masked by strong growth (these are hypothetical, as the banking sector appears to be strong by the usual indicators). A resulting contraction of credit would exacerbate the downturn.

34. What can we learn from other countries? A relevant and instructive episode from Europe is the recent hard landing of the Portuguese economy. A sharp drop in interest rates and expectations of faster growth—both, as is the case in Greece, triggered by the prospects of EMU accession—led to a decrease in private savings and an investment boom. The result was fast output growth, rising wages, real appreciation, and widening current account deficits. However, the investment boom came to an end, and with disappointed expectations, private savings increased. Countercyclical fiscal policy could not prevent the slump.26 The main lessons from the Portuguese experience are the importance of having a strong fiscal position to allow automatic stabilizers to operate fully when the demand stimulus unwinds, withdrawing some stimulus during the “lending boom” phase of the cycle to temper the subsequent size of adjustment, and pursuing structural reform.

35. The growth cycle in Greece shares many common elements with the Portuguese one. Important similarities include the rapid growth in credit and domestic demand, the large real effective appreciation, the widening current account deficit, and a weak fiscal situation. However, other factors work to Greece’s advantage. The private sector is less leveraged and real estate price increases have been less extreme, suggesting smaller vulnerabilities. Productivity has been growing fast, compared to stagnation in Portugal, and the recent attention to improving the business climate should bolster productivity further. And the fiscal situation has recently improved; if this is sustained, fiscal room to maneuver may be enough to help stabilize the economy in the event of an adverse shock. These considerations provide hope that the “good scenario” will prevail over the medium term.

36. Restoring external competitiveness will require concerted action on four fronts:

  • Wage restraint, especially in the public sector, which sets the tone for national wage negotiations.

  • Structural reform, to boost productivity, lower inflation (by strengthening competition and improving the wage bargaining process), and create an environment that nurtures innovation and encourages specialization in less price sensitive products.

  • Fiscal consolidation, to alleviate current appreciation pressures and allow room for automatic stabilizers to operate fully when the demand shock dissipates.

  • Proactive and forward looking prudential oversight, to safeguard financial stability.

Annex I. Derivation of the CMS Decomposition

The decomposition of the change in exports (X1 -X0) is derived as follows:


An early statement of the CMS methodology can be found in see Richardson, D. 1971, “Constant-Market-Shares Analysis of Export Growth”, Journal of International Economics, 1, pp. 227-239. For alternative formulations and refinements of the methodology, see Milana, C. 1988, “Constant-Market-Shares Analysis and Index Number Theory”, European Economy, Vol. 4, pp. 453-478


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Prepared by Anastassios Gagales (EUR).


Unless otherwise stated, all figures are based on the national accounts prior to the September 2006 revision owing to the lack of sufficiently long GDP series (the new estimates, which are still provisional, are available only since 2000). The revision raised GDP by about 26 percent and reduced correspondingly all ratios to GDP. Although underlying economic conditions are unaffected by the revision, external imbalances appear less acute than previously.


Cross country differences in export deflators need to be interpreted with caution because, in addition to price effects, they reflect changes in the commodity composition and quality of exports, and the degree of market power. These are welfare improving and do not imply competitiveness loss.


See also the 2006 Report of the Greek National Council for Competitiveness and Development.


Credit to households, the main beneficiaries of financial liberalization, has been growing at almost 30 percent annually and its “contribution” to nominal GDP growth (measured by the ratio of credit expansion over last year’s GDP) reached 8½ percent in 2005. Although indicative of very easy monetary conditions, this rapid credit expansion is not entirely exogenous as it incorporates the effect of higher growth (actual and prospective), lower real interest rates, etc. Moreover, its impact on aggregate demand has been blunted by the increase in financial asset holdings and the substitution of bank for non-bank credit.


These methodologies are discussed in Isard and Faruqee (1998) and Isard et. al. (2001).


See Isard and Faruqee (1998), Chapter V, for a detailed discussion of the methodology of calculating CAU. The present paper deviates in that it abstracts from lagged exchange rate effects.


The elasticity of the current account with respect to the exchange rate is given by (X/Y)ηX + (M/Y) (ηM − 1) where (X/Y) and (M/Y) denote the shares of exports and imports to nominal GDP and ηX and ηM the export and import elasticities with respect to the exchange rate. The calculations are based on MULTIMOD elasticities (ηX = 0.71, ηM = 0.92). The quarterly BoG component (Sideris and Zonzilos, 2005) reports similar long-run elasticites X = 0.6, nM = 0.9).


A comprehensive discussion of the different approaches for estimating the equilibrium exchange rate can be found in Driver and Westaway (2004). See also MacDonald (2000, 2006), MacDonald and Stein (1999), and Williamson (1994).


The two cornerstones of the Balassa-Samuelson effect is that the price of tradables are the same at home and abroad and wages are set so as to ensure the competitiveness of the traded goods sector. The latter is assumed to set the tone for the level of wages at home.


n assessing the significance of the Balassa-Samuelson effect it is important to identify whether the productivity growth stems from efficiency gains or from the closure of unprofitable firms. Only the former can support a thriving export sector and raise productivity growth on a sustainable basis.


CAS is derived from the equation of motion of NFA under the simplifying assumption of zero valuation effects on NFA and zero transfers.


To some extent, the high net foreign liabilities reflects measurement problems in the numerator and the denominator. Official statistics are unlikely to fully capture real estate and financial assets that Greek residents accumulated abroad prior to financial liberalization; extensive tax evasion continues to contribute to the under-reporting of foreign assets; and the recent upward revision of the national accounts (which has not been used in these calculations) reduces the ratio of net foreign assets to GDP to 56 percent.


Nevertheless, a large rise in external indebtedness would bring increasingly more risky borrowers into the picture raising (at the margin) the cost of borrowing.


The calculations are based on MULTIMOD elasticities, as detailed in footnote 6.


A discussion of long term trends in Greece’s external trade can be found in the BoG Annual Report for 2005 (Box IX.2). See also Dimelis (2004, 2004a) and Arghyrou and Bazina (2002).


Calculations are based on the UN Comtrade (Commodity Trade Statistics) database using annual data for the period 1992-2005. Commodities are grouped in nine categories (food, mineral fuels, chemicals, raw materials, textiles, metals, manufacturing items, transportation equipment, and other manufacturing goods) and export markets in 13 regions (Germany, Italy, UK, France, Spain, Cyprus, Rest of EU15, USA, Turkey, Bulgaria, Romania, Albania, and the rest of the world).


This negative competitiveness effect is consistent with econometric evidence, based on longer samples, which suggest a below unity elasticity of exports with respect to world demand (Zonzilos, 2006).


New national accounts data, which capture better the underground economy, revised the 2005 current account deficit from 8 percent to 6 percent and the IIP from 82 percent to 65 percent.


According to preliminary flow of funds data, the decumulation of assets reflects banks’ running down of their government securities holdings to finance more profitable credit expansion. Households’ net financial position has declined very little, as the increase in bank borrowing was largely offset by an increase in households’ financial assets.


The calculation assumes that productivity in Greece remains on its current trend and wage moderation continues in the rest of the euro area. In this scenario nominal wages take the brunt of the adjustment. Supportive structural policies can take off some pressure from wages. For example, if structural reforms and capital deepening raise productivity growth by 1 percentage point to3½ percent per year, the adjustment period will be shortened to 4¼ years.


The new level of steady-state consumption is lower than the current rate and roughly equal to productivity growth plus population growth.


See Blanchard (2006a) for a similar analysis based on an optimizing model. In related work, Krugman (1987) argues that a long period of low production may permanently lower productivity and emphasizes the role of external learning by doing.


The above calculations refer to average wages. Actual wage settlements should ideally be guided by productivity and demand conditions in each individual industry. Wage restraint can be effected through fiscal policy and, in particular, by showing restraint in setting the public sector wage bill. This is of particular importance in Greece, where the public sector is large and sets the tone in wage negotiations.


The calculation assumes that the import content of exports is 30 percent. An import content of 40 percent would necessitate a further acceleration of exports by 1½ percentage points.

Greece: Selected Issues
Author: International Monetary Fund