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20/12/2018 - The Bank of Greece Interim Report on Monetary Policy 2018

Today, in accordance with its Statute, the Bank of Greece submitted its Interim Report on Monetary Policy 2018 to the Speaker of the Greek Parliament and the Cabinet.

Continuing the reform effort is a necessary condition for growth and a sustainable market return of the Greek State

This Interim Report on Monetary policy is the first to be submitted by the Bank of Greece since the completion of the third economic adjustment programme in August 2018. The completion of the programme is an important milestone, with a positive impact on economic sentiment and the prospects of the Greek economy. However, as pointed out in the Bank’s Monetary Policy Report of July 2018, a sustainable return of the Greek State to the international sovereign bond markets would be the safest indication that the economy has indeed exited the crisis.

In the months since the programme’s completion, the Greek economy has continued its recovery. However, sovereign bond yields remain high, amid turbulence in the international financial markets, especially in Italy, but also amid concerns about a possible reversal of reforms agreed upon under the programme. As a result, Greek businesses and households face high borrowing costs, indicating that the Greek economy has not yet returned to normality.

Structural reforms that support potential growth are a necessary condition for bolstering foreign investors’ confidence and enabling the Greek State to return to the international financial markets on sustainable terms. At the same time, it is necessary to safeguard the reform achievements made so far, to avoid a reversal of agreed policies, which poses additional risks for the economy and undermines policy credibility, and, finally, to deal with court rulings that overturn measures adopted by Parliament and jeopardise the achievement of the fiscal targets in the medium term as well as debt sustainability.

Robust export growth and a recovery of consumption are the main drivers of the economy

Following the 2017 recovery, economic activity accelerated in the first nine months of 2018, with GDP at constant prices increasing by 2.1% relative to the same period of 2017. The key drivers of growth were exports of goods and services and private consumption.

Based on the latest available indicators of economic activity on both the demand and the supply side, the recovery is expected to have continued in the fourth quarter of 2018, despite signs of an increase in uncertainty arising mainly from the external environment, as recorded in the evolution of the Economic Sentiment Indicator (ESI) in recent months and in the slowdown of industrial production growth relative to the previous year.

Inflation, as measured by the Harmonised Index of Consumer Prices (HICP), returned to positive territory in 2017, but rose at a more subdued pace in the course of 2018 due to base effects in the energy and unprocessed food components. International oil prices pushed inflation upward, while non-energy prices continue to post negative rates of change.

On the public finance front, developments are positive – policy remains heavily reliant on taxation

On the fiscal front, developments are positive. The general government primary balance in 2017, under the programme definition, turned out a surplus of 4.1% of GDP, significantly overachieving the target of 1.75% of GDP for the third consecutive year. This overachievement in recent years helps contain public debt and boosts market confidence both in the efficiency of fiscal management and in the commitment of the Greek authorities to achieve the agreed fiscal targets. However, the fiscal overperformance has a negative impact on the real economy, as it relies on increases in the tax burden and cutbacks on public investment expenditure, thus discouraging investment, weakening GDP growth and increasing informal economy activity.

Mixed trends in the financial sector

The improved outlook for the economy has bolstered economic sentiment, leading to an increase in the bank deposits of the non-financial private sector and to upgrades in Greece’s credit ratings, thereby reducing Greek banks’ reliance on Emergency Liquidity Assistance (ELA) from the Bank of Greece. The improvements in bank liquidity and in confidence made it possible to lift most of the capital controls.

Despite these positive developments in the financial sector, the stock of non-performing loans of banks remains overly high. The annual change in bank credit to the non-financial private sector remains negative, and the average interest rate on bank lending to that sector increased slightly over the past four months. In addition, Greek government bond yields remain high, mainly on account of turbulence in international markets, especially in Italy, and concerns about a possible reversal of legislated policy measures and reforms agreed upon under the programme. Thus, Greek businesses and households continue to face high borrowing costs.

An acceleration of economic activity

According to forecasts by the Bank of Greece, economic activity is projected to increase by 2.1% in 2018, 2.3% in 2019 and 2.2% in 2020, driven by business investment, exports and private consumption.

Private consumption is expected to have a positive contribution to growth, supported by an increase in real disposable income, as a result of a gradual rise in compensation per employee and of continuing employment growth. Investment is expected to increase, in particular from 2019 onwards, in line with improving confidence and a gradual restoration of credit to the private sector. Exports of goods, benefiting from competitiveness gains, are expected to continue to grow at strong rates over the next two years, albeit decelerating, on account of a slowdown of world growth amid increasing trade protectionism and rising interest rates in international markets. Imports are also projected to increase. Employment growth is expected to continue, mainly on the back of positive performance in specific sectors of economic activity, such as tourism, trade and manufacturing, contributing to a further decline in the rate of unemployment.

The Harmonised Index of Consumer Prices (HICP) is expected to fluctuate, reflecting the impact of external factors, such as international oil prices. Core inflation is expected to trend upward, mainly on account of a pick-up in domestic demand, but also of a mild increase in unit labour costs.

Risks and uncertainties

This projected economic outlook is subject to significant downside risks and uncertainties. As far as the domestic environment is concerned, excessive taxation and any reversal or delays in the implementation of structural reforms and the privatisation programme could negatively affect the prospects of the Greek economy. Turning to the external environment, risks could arise from a possible slowdown of global economic activity amid increasing trade protectionism and turmoil in international financial markets, especially in Italy, and in the foreign exchange markets, as well as from a failure by the British Parliament to ratify the Brexit deal.

On the fiscal front, the Bank of Greece estimates that the non-implementation of the legislated pension cuts in 2019, in conjunction with the enforcement of the Council of State ruling that the pensions cuts of earlier years were unconstitutional, weigh negatively on the public debt sustainability analysis, as they lead to an upward revision of pension expenditure and represent the major fiscal risk in the medium term.

Contraction of banks’ profitability

In the first nine months of 2018, the pre-tax profitability of Greek banks remained weak and significantly lower than in the respective period of 2017, while after tax and non-recurring activities Greek banks registered greater losses year-on-year.

The capital adequacy of the banking system is satisfactory

In terms of capital adequacy, the Common Equity Tier 1 (CET1) ratio and the Capital Adequacy Ratio on a consolidated basis remain satisfactory (at 15.6% and 16.2%, respectively, at end-September 2018). The stress test exercise conducted early this year identified no capital shortfall in any of the four significant Greek banks. The results for each bank are used as input in the Supervisory Review and Evaluation Process (SREP) by the Single Supervisory Mechanism (SSM), in the context of Pillar II requirements. The objective of the exercise was to assess the resilience of banks to economic and financial shocks over the period 2018-2020, using as a starting point the figures as of 31 December 2017, adjusted for the impact of International Financial Reporting Standard 9 (IFRS 9).

The stock of non-performing exposures (NPEs) of banks is gradually declining – however, more ambitious solutions are needed to speed up their reduction

Greek banks have made significant progress in reducing their non-performing exposures (NPEs). NPEs at end-September 2018 came to €84.7 billion, having declined by roughly €9.7 billion from end-December 2017 and by roughly €22.5 billion (i.e. over 20%) from their March 2016 peak. NPE reduction in the course of 2018 was driven mainly by loan write-offs (€4.4 billion) and loan sales (€5.2 billion). Proceeds from liquidations also improved, with e-auctions producing their first results. However, the total amount recovered by banks in this manner remains low. Overall, despite the improvements in the economic and institutional environment, the recoveries from active NPE management remain limited. Furthermore, during the first nine months of 2018, the default rate exceeded the cure rate.

Overall, and based on the trends observed over the past two years or more, the pace of NPE reduction, despite having improved, is not sufficient to bring about a significant decrease in the stock still outstanding. Greek banks have already submitted their revised operational targets for NPE reduction which extend to 2021. Going forward, NPL sales, collections, collateral liquidation and loan curing are expected to play a more important role: as a result, NPEs as a percentage of total exposures should decline to about 20% or lower by 2021. In this light, other solutions will need to be considered that make it easier to transfer NPEs from bank balance sheets to other entities, for instance to a centralised Asset Management Company (AMC), without generating additional fiscal risks and after taking into account the potential impact on banks’ capital base. In this context, the Bank of Greece, in its recent Overview of the Greek Financial System, presented a proposal to set up a Special Purpose Vehicle, to which roughly €40 billion in NPLs would be transferred, along with deferred tax assets amounting to €7.5 billion.

The economy still faces important challenges

The Greek economy has made remarkable progress since 2010. Among the major achievements are the unprecedented fiscal adjustment and high sustainable primary surpluses, improved competitiveness, a narrowing of the external deficit, widespread structural reforms, as well as the restructuring, consolidation and recapitalisation of the banking sector and, more generally, the safeguarding of financial stability. Greece, however, still faces important challenges, some of which are the legacies of the protracted economic crisis.

The main challenges ahead include: a high public debt-to-GDP ratio, although debt sustainability has been ensured in the medium term; a high stock of NPLs; a high rate of unemployment; a brain drain during the crisis; a large investment gap and a relatively high rate of poverty in the population. Structural competitiveness remains very low compared with other EU countries and has, in fact, worsened in the past two years.

In the long term, the projected decrease in population (owing to demographic ageing) is expected to exert downward pressure on potential growth. Also, the assumption of high primary surpluses being maintained over a long period of time represents a risk to the public debt sustainability analysis, given its dampening effect on growth, as estimated by the Bank of Greece. This dampening effect of large primary surpluses will be markedly stronger if accompanied by high taxation.

The greatest challenge facing the Greek economy in the near term is the return of the Greek State to international financial markets on sustainable terms. Despite the successful completion of the adjustment programme last August and the debt relief measures decided by the Eurogroup in June 2018, which ensure debt sustainability in the medium term, Greek government bonds have yet to regain investment grade status, and their yields remain high, volatile and susceptible to turbulence in international financial markets and to uncertainty about the economic policy’s continued commitment to reform.

Policy recommendations for strengthening the growth dynamics

These challenges need to be promptly addressed so as to speed up the growth of the economy and enhance its resilience to external risks. To this end, the following policy interventions are recommended:

1st Reducing the high stock of non-performing loans. The high stock of non-performing loans has a negative impact on the supply of credit by tying up bank funds and resources in non-productive assets. Moreover, creditless recoveries tend to be weaker, mainly because the shortage of bank credit affects investment. In order to speed up the reduction of non-performing exposures, apart from the actions taken by banks, other systemic solutions will need to be considered. In this context, the Bank of Greece recently presented a plan for setting up a Special Purpose Vehicle to manage non-performing loans, with the use of part of deferred tax assets.

2nd Changing the fiscal policy mix. The excessive reliance of fiscal consolidation on taxation creates disincentives for work and investment, while also leading to a growing informal economy. In addition, the under-execution of the Public Investment Programme over the past two years has affected the level of investment in infrastructure and medium-term growth dynamics. Instead, emphasis must be placed on implementing those reforms that allow a rebalancing of the current fiscal policy mix towards lower tax rates and a reallocation of public spending in favour of those categories that have a permanent growth-enhancing impact.

3rd Implementation of structural reforms, so as to safeguard the fiscal achievements made so far and to enhance policy credibility as reflected in Greece’s international credit ratings. Furthermore, the enhanced post-programme surveillance framework calls for the timely completion of the agreed reforms-commitments, in order to restore the transfers to the Greek State of profits from holdings of Greek government bonds by the Eurosystem (SMP and ANFA). This would have a positive impact on Greece’s attempt to access the markets. Any reversal of agreed policies would act in exactly the opposite direction.

4th Speeding up the privatisation programme, especially with privatisations that have a strong signalling effect and growth impact (such as the development of the former airport of Hellinikon). This would have a positive impact on total investment expenditure.

5th Attracting foreign direct investment, as domestic savings are insufficient to meet the investment needs of the Greek economy. Thus, emphasis should be placed on policies aimed to make Greece more attractive to investors. More specifically, such policies involve reducing the tax burden, improving the efficiency of public administration and reducing red tape.

6th A speedier delivery of justice, legal certainty, a clear and stable legal framework are essential conditions for strengthening the public sense of fairness and justice, for improving the investment climate and for accelerating economic growth.

7th Enhancing the “knowledge triangle” (education, research, innovation) and fostering a closer link between businesses and research centres. The systematic use of innovative technologies and proper utilisation of the human capital stock in tradeable sectors could support the shift of the Greek economy to a new model of knowledge- and export-led growth.

8th Improving structural competitiveness, which requires continuing the reform effort, particularly in the goods and services markets. There are strong indications that the increased extroversion of certain sectors of the economy over the past three years is closely associated with an increase in total factor productivity (TFP) and the structural reforms that took place in recent years.

9th Maintaining labour market flexibility. The economy is currently at a stage where recovery has started but has yet to gain traction in the form of robust growth and higher employment rates. Therefore, any regulatory intervention for the protection of workers must preserve labour market flexibility, as well as the gains from the broader painstaking reform effort of the period 2010-2017.

10th The proposal under consultation to raise the minimum wage must be consistent with labour productivity growth, so as to preserve the competitiveness gains made so far by Greek businesses and the Greek economy in general. An increase in the minimum wage would also need to be accompanied by targeted measures in support of those workers, businesses and sectors that are likely to be affected the most, including targeted active employment policies or a reduction of non-wage labour costs, as well as by more effective labour market supervision so as to minimise the scope for abuse of the flexibility provided by the current regulatory framework and to avert an increase in the informal economy.

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Despite the successful completion of the third adjustment programme in August 2018 and the positive debt relief measures agreed by the Eurogroup in June 2018, the yields on Greek government bonds remain high and volatile, amid recent turbulence in international financial markets, notably Italy, and concerns about a possible reversal of already agreed and legislated policy measures and reforms.

The high cost of public sector borrowing passes through to the domestic financial sector, thereby keeping the cost of borrowing for Greek businesses and households at high levels. Thus, the main challenge in the period ahead remains the refinancing of public debt from international markets on sustainable terms.

The existing cash buffer gives the Greek State the advantage of not having to attempt an immediate return to international markets through new bond issues. In no way, however, does this justify complacency. It is of the utmost importance to regain the confidence of markets as soon as possible and well before the available cash buffer is depleted. This would enable the Greek State to use the remainder of the cash buffer to buy back debt. Furthermore, it would allow the private business sector and banks to access the international markets on sustainable terms.

To this end and taking into account the global economic slowdown and the major challenges faced by the Greek economy, the reform effort must continue with unwavering resolve. This is imperative in order to contain future fiscal risks, reduce uncertainty, speed up the recovery of the economy and strengthen investor confidence in the medium-to-long-term prospects of the Greek economy. This would facilitate the Greek State’s sustainable return to the international sovereign bond markets and signal a definitive exit from the protracted crisis.

The full text of the Report is available (in Greek) here.