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03/12/2012 - The Bank of Greece Interim Report on Monetary Policy 2012

Today, in accordance with its Statute, the Bank of Greece submitted its Interim Report on Monetary Policy 2012 to the Speaker of the Greek Parliament and to the Cabinet.

1. A new start is now possible

After considerable delays and much uncertainty, Greece now faces fresh circumstances that – under certain conditions – open up new prospects for the economy. In previous months, a drawn-out election period held up policy implementation already under way, sparked uncertainty and rekindled speculation about a Greek exit from the euro area. The coalition government formed after the elections has undertaken the task of turning this adverse climate around and getting the economic adjustment programme back on track.

A first substantial step in this direction was the adoption of Law 4093 on 7 November, whereby Greece fulfils commitments made under the Memorandum of Understanding of February 2012 (Law 4046/2012) – commitments which, in many cases, should have already been implemented. Law 4093 also introduces new measures envisaged in the Medium-Term Fiscal Strategy (MTFS) framework 2013-2016. At the same time, the Budget for 2013, passed by Parliament on 11 November, incorporates a large part of the fiscal measures covering the entire 2013-2016 period.

Thus, all the conditions of the loan agreement have been met, sending a clear message that Greece has fully delivered on its part of the agreement. This was expressly acknowledged by the Eurogroup on 20 November and again on 26-27 November, when procedures for the disbursement of €34.4 billion by mid-December of this year and of an additional €9.3 billion within the first quarter of 2013 were set in motion and a decision was taken to adopt various measures that reduce Greece’s debt burden. These measures aim to ensure that the debt-to-GDP ratio will fall to 175% by 2016, 124% by 2020 and to substantially lower than 110% by 2022.

These are positive developments, which create plausible expectations of a recovery of the Greek economy, perhaps even earlier than projected at present. This outcome, however, hinges upon a consistent implementation of all the measures legislated, together with policies that will speed up the onset of recovery, including a broader programme of structural reforms. Any delays will push the recovery back, with consequences that will be far more severe than anything that has so far happened.

2. The international environment

The global economic environment is adverse. GDP growth across the world in 2012 has been slowing. In the euro area, GDP is expected to contract by 0.4% this year, while projections for 2013 point to only a marginal recovery in the euro area in the face of a very limited pick-up in global GDP growth. Heightened uncertainty in the European Union, the prospect of a “fiscal cliff” in the US and the weakening dynamism of emerging economies are far from ideal conditions for the Greek economy to increase its openness. They are, however, all the more reason for Greece to persevere in its effort with increased vigour.

At the same time, though, there are some positive developments. For two and a half years now, the institutional architecture of the EU and the euro area has been in the process of being extended. In addition, the Eurosystem’s interventions in the context of the single monetary policy have mitigated the adverse impact of the crisis on the economies of euro area countries. Among the changes being made at the EU level, it is particularly worth mentioning the creation of a banking union, planned to include European-level banking supervision and unified frameworks for deposit guarantees and bank resolution.

The changes underway in the EU call for Greece’s active involvement. The new architecture being created will comprise not only decisions that concern Greece but that also deal in a definitive manner with problems brought to light by the crisis. Greece must therefore be actively involved in the process, on a par with its euro area partners, and participate in decision-making that will determine our own future as well.

3. Macroeconomic developments

Macroeconomic developments in Greece over recent years have been particularly adverse and have largely contributed to the missing of the targets set in the economic adjustment programme and to the pessimistic projections for debt dynamics. The trough occurred in 2011, with GDP contracting by as much as 7.1%, after declines of 4.9% in 2010, 3.1% in 2009 and 0.2% in 2008. Based on plausible assumptions about the implementation of the adjustment programme, the Bank of Greece projects that GDP will decrease by slightly more than 6% in 2012 and by 4-4.5% in 2013. Positive growth will be witnessed in the course of 2014. This means that the cumulative decline in GDP over the past five years (2008-2012) will have reached 20% and may come close to 24% in the six-year period 2008-2013. Meanwhile, the cumulative decline in total and dependent employment over the past four years (2009-2012) has exceeded 16% and 17.5%, respectively. The unemployment rate has shot up from 7.6% in 2008 to 17.7% in 2011 and to slightly above 23.5% in 2012 (yearly averages); it is estimated that it may rise further and exceed 26% in 2013 and 2014.

A recession of this intensity and duration is unprecedented in Greece’s peacetime history and has taken a heavy toll not only on incomes, but also on potential output and social cohesion, as the lack of investment coupled with prolonged unemployment result in a depreciation of physical and human capital. The recession not only hampers fiscal adjustment by reducing government revenues and increasing social spending, it also causes banks’ deposit base to shrink (thereby reducing their capacity to extend credit), creates a negative climate of opinion towards the acceptance of structural reforms and ultimately worsens the debt-to-GDP ratio.

4. The causes of the recession

The main causes of this deep and protracted recession are the fiscal contraction, hesitance in undertaking reforms, heightened uncertainty and tight financial conditions. First and foremost, the recession reflects a slump in domestic demand, which was the main driver of growth up until 2008. This slump was a consequence of the imperative fiscal consolidation and its stronger-than-foreseen effect on output coupled with a severe deterioration in financial conditions and a contraction of credit to the private sector caused by the uncertainty perpetuated by the sovereign debt crisis. At the same time, the depth of the recession can also be explained by delays in legislating and, more importantly, implementing structural reforms, which – by improving market functioning – would have boosted business investment, thereby partly offsetting the contractionary effects of fiscal adjustment.

5. The liquidity issue

While the reduced ability of the banking system to finance real economic activity by extending credit to firms and households has compounded the recession, liquidity constraints are also having longer-term repercussions. They are hampering the transfer of resources to export-oriented activities, which is key to achieving sustainable growth.

The liquidity constraints affecting the real economy and the difficulties in accessing bank credit would have been far more severe without the recourse to Eurosystem monetary policy operations and without support from the Bank of Greece. The extensive liquidity support provided by the Bank of Greece and the Eurosystem has contributed to containing the rate of decline in credit to firms and households below that of nominal GDP and certainly well below that of the rate at which banks’ deposit base has contracted. To this extent, the Bank of Greece, as a member of the Eurosystem, has helped to mitigate the adverse effects of the debt crisis and the fiscal adjustment on economic activity.

Furthermore, through its enhanced supervision of credit institutions, the Bank of Greece has succeeded in safeguarding financial stability, at a time when the undermining of financial stability could very well have triggered mass deposit withdrawals and a collapse of the economy.

6. Progress made so far

Despite the significant shortcomings and problems pointed out in the present report, progress has been made in the last few years and, in fact, has been substantial. However, this progress has been uneven, as fiscal consolidation has been relatively rapid, whereas structural reforms have lagged behind. More specifically:

- The fiscal consolidation of the past few years has resulted in a significant reining-in of fiscal deficits.

The general government deficit on a national accounts basis decreased from 15.6% of GDP in 2009 to 9.4% in 2011 and is expected to fall considerably further this year (to 6.6% of GDP) according to the Introductory Report of the 2013 Budget. Even more remarkable is the decrease in the primary deficit, which – from 10.5% of GDP in 2009 – was reduced to 2.3% of GDP in 2011 and is expected to be further cut to 1.2% of GDP (again according to the Introductory Report of the 2013 Budget). Progress with fiscal consolidation would have been even faster, if the economy was not in a deep and protracted recession. Indicatively, had nominal GDP remained at 2008 levels, the estimated public debt-to-GDP ratio in 2012 would have been some 30 percentage points lower.

It is estimated that, in the three-year period 2010-2012, a large part (72%) of the loss in international cost competitiveness incurred during the nine years 2001-2009 has been recouped. This is already an important positive development. It is furthermore estimated that, in the course of 2013, all of the loss incurred in 2001-2009 will have been recouped. Certainly, a sustainable improvement in competitiveness cannot – after a necessary initial phase of “correction” – be based on a combination of nominal wage reductions and falling or stagnant productivity, as the negative effects on domestic demand of the continued wage decreases would more than offset the positive effects of external demand. The improvement in cost competitiveness must therefore also be based on productivity gains. The structural reforms directed at the more efficient functioning of product and labour markets are designed to produce precisely this result and will make possible both a higher rate of potential growth (inter alia by encouraging investment) and an improvement in structural competitiveness.

Despite the delays, progress with structural reforms over the last two and a half years has not been negligible. In the area of fiscal structural reforms, what stands out is the overhauling of the social security system. Other notable reforms include the introduction (in 2010) of medium-term fiscal planning, the drastic improvement in the quality of fiscal statistics, as well as the recent establishment of a structure to ensure the monitoring of compliance with fiscal targets by ministries and general government entities and automatic corrective mechanisms in case of target shortfalls. In the area of labour market structural reforms, there have been far-reaching interventions, mainly concerning the decentralisation of collective bargaining and the introduction of more flexible provisions for employment and working time. Finally, product market structural reforms include the marked simplification of licensing for starting up and operating a business, advances in the deregulation of land freight transport, important steps towards the opening up of “closed” professions and the lifting of cabotage restrictions on cruise ships.

– There are signs of a corrective adjustment of key magnitudes, which constitutes the beginning of a process of rebalancing and restructuring the economy.

First, the current account deficit is declining. After peaking at 14.9% of GDP in 2008, the current account deficit gradually fell to 9.9% of GDP by 2011. The Bank of Greece expects it to drop further to 4.5-4.7% of GDP in 2012 and 2013 and to below 3.5% in 2014. This improvement was largely driven by the substantial decrease in imports, as a result of the fall in investment and consumption. However, non-oil exports, which began their rebound in mid-2010, also played their part, reflecting a strengthening in external demand as well as the gains in cost competitiveness mentioned previously. At the same time, it is estimated that the improvement in the external balance also has a structural component, related, first, to the reorientation of enterprises towards foreign markets and, second, to changes in consumption patterns which could help contain imports of consumer goods on a more permanent basis.

Thus, reliance of growth on domestic demand is declining. The changes in the external balance are gradually reversing an earlier trend of many years during which the growth of domestic demand was the main driver of GDP growth, whereas the change in external demand made a negative contribution. Since 2008, the change in net exports has made positive contributions to growth. Enhancing this trend and expanding exports of goods and services as a percentage of GDP will be pivotal to bringing about a permanent change in the growth model, which in the past had depended on domestic demand.

Second, unit labour costs have been declining since 2010, thereby contributing to competitiveness gains. Previously, unit labour cost growth in Greece had outpaced that of the euro area for many years, contributing to higher Greek inflation with respect to the euro area average and to a steady erosion of cost and price competitiveness.

Third, there are also signs of an adjustment in consumer prices and of a fall in inflation. In 2012, for the first time since Greece adopted the euro, Greek inflation is expected to fall below the euro area average (1.2%, compared with 2.4-2.6%), and is projected to decelerate further to 0.3% in 2013. Moreover, average annual core inflation (which excludes energy and unprocessed food prices) is expected to be 0% in 2012 and to turn negative (-0.5%) in 2013. Indeed, if the impact of indirect tax increases is excluded, average core inflation is expected to turn clearly negative (-0.6%) as early as this year. The present Report also examines why the fall in consumer prices has not been even more marked.

7. Financial stability and the banking system

The banking system continues to face unprecedented challenges as regards both liquidity and capital adequacy, as a result of the sovereign debt crisis. Greek banks have been cut off from international markets for some time now, have faced a large outflow of deposits and incurred significant losses from the haircut on public debt in the context of Private Sector Involvement (PSI). Under these circumstances, the stability of the Greek banking system needed to be safeguarded, as it became apparent that any false moves could trigger a banking crisis, with negative repercussions also beyond Greece.

Against this background, the contribution of the Bank of Greece to safeguarding financial stability has been decisive. Despite the very negative conjuncture, the Bank ensured that adverse developments did not threaten financial stability and that depositors were not affected. No depositor has incurred any losses. At the same time, the Bank of Greece has fully met its primary obligation to ensure that the public's demand for cash was met and it has achieved this at a time when the demand for cash was highly volatile due to heightened concern among the public.

Since the onset of the crisis, the central bank has not only imposed enhanced and strict supervision; it has also established and implemented rules which safeguard financial stability and fully protect depositors. More specifically, actions taken by the Bank of Greece have served to:

- meet banks’ emergency liquidity needs, enabling them to satisfy depositors;

- design and set up, in collaboration with the government, a framework for the resolution of credit institutions. The procedures envisaged in this framework have already been successfully applied in the case of six banks, without affecting financial stability and whilst fully protecting depositors;

- secure, through the support programme, the necessary funds for bank recapitalisation. Recapitalisation constitutes a crucial step towards improving confidence in the banking system, safeguarding deposits and increasing liquidity in the market. Part of these funds will be used for the restructuring and consolidation of the credit system;

- assess the viability of Greek banks and estimate their capital needs for the period 2012-2014.

Since the beginning of the crisis, the Bank of Greece has considered it both necessary and inevitable that banks undergo internal restructuring to modify their business models and that the Greek banking system should restructure and consolidate.

It is encouraging that this necessary consolidation of the banking system has begun. Within a short time, we have seen (a) the resolution of ATE Bank and the transfer of its healthy assets to Piraeus Bank; (b) the conclusion of agreements for the acquisition of Geniki Bank by Piraeus Bank and of Emporiki Bank by Alpha Bank; and (c) a proposal from the National Bank of Greece to acquire Eurobank, which could lead to the creation of the largest financial group in South-Eastern Europe. Meanwhile, it is almost certain that there will be further consolidation down the road. As banks become stronger, this will facilitate their access to foreign markets and will provide incentives to private investors to take part in future share capital increases.

When this process is completed, it is estimated that three large and well-capitalised banks will remain, alongside a few smaller ones. The expected market shares of these smaller banks will ensure a competitive environment, while banks in general will be in a position to benefit from the economies of scale and synergies resulting from the process of consolidation. The completion of the recapitalisation process and the restructuring of the Greek banking system are reforms of pivotal importance, as the existence of well-capitalised banks will boost the confidence of domestic savers and international financial markets in Greek banks. Such a development would help relieve the liquidity constraints faced by banks, by favourably affecting the inflow of deposits and banks’ ability to regain access to international money and capital markets. At the same time, the strengthening of banks’ capital bases will increase their ability to supply credit to the economy and to thereby mitigate the contractionary effects of fiscal adjustment.

The Bank of Greece has already communicated to all banks estimates of their capital needs and the deadlines for submitting their recapitalisation plans and implementing them. Banks must complete the required capital increases by end-April 2013.

8. Speeding up the onset of recovery and returning to growth

Recovery and the return to positive growth are now a priority. The adoption of the Medium-Term Fiscal Strategy and the Budget for 2013 signals the end of a series of delays; the adjustment programme is now back on track. At the same time, the Eurogroup statements of 20 and 26-27 November will ensure the financing of the programme in the current crucial phase. Future developments will now crucially depend on the Greek economy’s ability to exit the recession as soon as possible and achieve positive GDP growth.

The preconditions for a return to positive growth are:

- The lifting of uncertainty about Greece’s place in the euro area. As long as the issue remains open, this threat will hang over Greece, undermining the effort for an orderly exit from the crisis. The Eurogroup statement of 26-27 November and the strong reassurances of our partners that Greece will remain in the euro area are a major step forward. However, regaining confidence fully will require a sustained and stronger effort to make up for lost ground and convince that the recession has a visible turning point and is not an endless cycle of burdens to no avail.

- Finalising a national plan for the transition to a new growth model. Aside from setting the conditions for continued financial support, the Memorandum of February 2012 and the additional measures under the Medium-Term Fiscal Strategy 2013-2016 and Law 4093 map out the policies that need to be implemented without delay. In no way do the provisions of the Memorandum waive Greece’s responsibility to finalise a comprehensive action plan – a national strategy for radically changing the structures of the economy and in particular its structure of production.

The key aim of such a strategy is to promote structural reforms that will eliminate the twin deficits and ensure that all institutional and economic conditions for a modern, competitive economy are in place. A competitive economy does not mean a low-cost economy. The conditions for encouraging competitiveness are far more complex; they involve the quality and functioning of the state and other institutions, the adequacy of infrastructures, the quality of human resources, the existence of effective competition and an environment conducive to entrepreneurship.

A speeding-up of structural reforms is particularly necessary at the current unfavourable conjuncture. Conditions in the economy will quickly become even more adverse if the causes of the deficits are addressed by measures with only a temporary effect. Avoiding structural reforms would prolong the recession, stifle growth and undermine debt sustainability.

As regards speeding up the onset of recovery, efforts need to focus on:

First, the immediate implementation of measures that will help restart the economy. These measures include the faster absorption of funds under the National Strategic Reference Framework, the establishment of the Hellenic Investment Fund, the use of all the financial tools made available by the European Investment Bank and restarting construction in the major motorways projects.

Second, an improvement in financial conditions. The lack of liquidity and the problem of undercapitalisation limit the ability of the Greek banking system to finance new business initiatives and support viable enterprises facing liquidity problems. Recapitalisation and restructuring of the banking system will contribute to a return of deposits and to an improvement of liquidity conditions, thereby allowing support for the export activity of enterprises and facilitating their reorientation to new markets and new products. The removal of uncertainty, especially as regards Greece’s place in the euro area, will also contribute to a return of deposits.

Third, improved efficiency of public administration and simplification of the legal and regulatory framework. This condition is crucial for the effective implementation of all other reforms and policies, for improving relations between the state and its citizens and between the state and businesses and for promoting a sense of equity.

Fourth, the establishment of a stable tax regime and a reduction in the tax burden. As the tax system is currently being redesigned, a primary concern should be to ensure that the provisions to be adopted will remain in place for a long time. Additionally, the new tax system must be simpler and rely extensively on information technology. It should focus on widening the tax base by curbing tax evasion; it would then be possible to lighten the burden of those who already pay taxes, which has increased excessively. Tax provisions should also aim at encouraging entrepreneurship and speeding up the onset of recovery.

Fifth, pressing ahead with privatisation. Apart from generating proceeds that will directly reduce public debt, privatisations also enhance growth and bring about sustainable job creation.

Sixth, the effective utilisation of EU funds. Given the existence of significant budget constraints at the national level, EU resources are currently a particularly important source of funding. Any remaining obstacles to a faster absorption and more effective use of funds under the National Strategic Reference Framework must be removed as soon as possible. In the EU’s next multiannual financial framework, Greece will probably be allocated significantly lower funds. Irrespective, however, of the quantity of funds available, a strategy must be formulated for the optimal use of these resources. They can function as powerful tools for growth; to this end, they have to be integrated into the national plan for the transition to a new growth model.

9. Uncertainties and risks still exist

At the national level, two factors will ultimately determine the ability of the Greek economy to overcome the crisis: First, the elaboration and the consistent and speedy implementation of a national strategy. This strategy needs to be broader in scope than the Memorandum and include the completion of fiscal consolidation, the policies needed to bring the recovery forward and the vital reforms that will generate sustainable gains in competitiveness and satisfactory growth rate in the future. Second, continued financing from our partners-creditors.

Both factors are subject to considerable uncertainties, both domestic and external. With regard to the domestic uncertainties, note must be made of the following possibilities:

- that public administration might not be able to implement the reforms decided upon at the political level. It is for this reason that priority has to be given to improving the efficiency of public administration;

- that there could be strong social reactions, which could test political stability;

- that the targets set might not be fully met, resulting in the need for additional corrective measures.
Among the external factors, the main uncertainty relates to the materialisation of downside risks to the global economic outlook. Such a materialisation would weigh heavily on the outlook for the Greek economy as well. The institutional reforms to be decided at the euro area level are another external uncertainty. This is why Greece must be actively involved in the deliberations and in the EU decision-making process.

10. The sentiment could improve rapidly

The latest developments in Greece and the EU send out positive signals.

Greece is mobilising both at home and abroad to make up for the delays and has achieved a constructive agreement with the troika that ensures continued funding.

The EU and the IMF have given emphatic assurances concerning Greece’s continued membership of the euro area. The Eurogroup has, in successive meetings, acknowledged the substantial progress that has been achieved. The disbursement of the installment of loans that had been put on hold was endorsed and the public debt burden will be alleviated, through a series of measures detailed in the Eurogroup statement of 26-27 November.

Domestic effort must now be focused on containing the recession, speeding up the onset of recovery and establishing the conditions for sustainable growth.

Despite the delays, the progress that has been achieved in key sectors is tangible. Despite the risks and the ongoing recession, the economy is changing. As soon as the first clear indications emerge that past practices are being broken with and a new strategy for the future is being drawn up, the sentiment can rapidly turn around and the conviction take hold that the end of the recession is at hand. This would be the first step towards a new course of growth.

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The full text of the Report is available on the website of the Bank of Greece: www.bankofgreece.gr.