Anti-inflationary exchange rate policy in Greece in the 1990s
14/01/2004 - Speeches
Euro Mediterranean Seminar
Naples 14-15/1/2004
(discussant paper)
Anti-inflationary exchange rate policy in Greece in
the 1990s
Mr. Panayotis Thomopoulos
Deputy Governor of the Bank of Greece
I would like to thank the ECB and the Bank of Italy for the
successful organization of this meeting. Greece has been for more than three
thousand years at the cross-roads between North, South and Eastern Mediterranean
countries and, we Greeks have been able to enrich our culture and ideas from our
relationship with all the nations around the table and I am sure that to-day's
exchange of experiences will be to the mutual benefit of all present. I look
forward to an even closer cooperation in the future between the Eurosystem, with
the ECB taking the appropriate initiative, and the rest of the Central banks
from the other regions of the Mediterranean.
When the Maastricht treaty was signed, Greece was meeting all
the criteria of a country in crisis. Stagflation, with mounting macro-economic
imbalances, were the main characteristics of the economy. In the 15 years up to
1993, average inflation was almost 17%, GDP growth was barely 1% per annum,
while the fiscal deficit was creeping upwards reaching some 13,5% of GDP by 1993
and pulling up the debt - to - GDP ratio to over 110%. It was, therefore, not
surprising that the government's commitment to prepare Greece for the
satisfaction of the Maastricht criteria in 1999 and membership of the Euroarea
by 2001 (2 years after its creation) was received with disbelief by almost all
foreign and domestic observers. From the beginning of 1994, when the new
stability oriented policy was initiated, a managed exchange rate was a key
policy plank in the stabilization process and contributed importantly to
disciplining economic agents and setting in motion wage and price restraint,
which brought the rate of inflation down to some 2% on average in the twelve
months to early 2000 thus making possible our Euroarea membership.
Between end 1994 and early 1998, i.e. in the period preceding
our ERM I membership, the Bank of Greece and the government had decided to
follow a policy of managing the exchange rate by not allowing the drachma to
depreciate as fast as was needed to compensate for the inflation differential
vis-a-vis our trading partners. This was done purposefully in order to put a
break on inflation and inflationary expectations, which in the past were
strongly fed by the recurrent devaluations of the drachma, which, sometimes,
more than fully accommodated the excessive wage and price rises. While there was
some real appreciation of the drachma, the resulting disequilibrium was not as
large as some argued, especially participants in the financial markets. Studies
conducted by the Bank of Greece indicated that the real overvaluation of the
currency was of the order of 10 percent after taking into account the Balassa-Samuelson
effect and a number of other factors. This anti-inflationary exchange rate
policy started having its impact on inflation after less than one year and was
accompanied by other policy measures, with the result that domestic
disequilibria were narrowing and our policy was gradually gaining credibility.
This permitted the government to persuade the labor unions to
abandon the backward looking wage indexation scheme, which by its nature had
perpetuated the inflationary spiral for years and instead to move to forward
looking wage increases, based on the continuously declining annual inflation
target set by the government. Lower inflation was, in turn, facilitating fiscal
consolidation as a result, of (a) the progressive narrowing of the very high
interest rate risk premia on government debt and, (b) the actual decline in
interest rates in line with inflation. As a consequence, government expenditure
on interest payments fell from 13% of GDP in 1993 to less than 7% in 2001, when
Greece joined the European Union. Falling inflation was also making our managed
exchange rate easier to operate. However, we were conscious that an exchange
rate adjustment would have to take place at the time of joining the ERM I, so as
to offset the loss of external competitiveness reflecting the previous few years
of real appreciation of the drachma. We had fixed 10% as an upper limit for the
real appreciation, because, first, a moderate appreciation would not frighten
the markets and, second, the subsequent necessary correction of the exchange
rate would be limited. We were aiming at a limited correction that would not
impact unfavorably on other macroeconomic variables, in particular inflation and
would not generate expectations for further depreciations. Indeed, central banks
which follow a managed exchange rate policy have to be very careful not to allow
a big appreciation of the real exchange rate, that would subsequently open the
stage for big speculative attacks, which because of the usual overreaction of
markets could trigger capital flight. Indeed, there are numerous examples,
starting with Argentina and going backwards, that capital flight on the one hand,
deprives the domestic economy of much needed investable funds and, on the other
hand, drives the exchange rate to abnormally low levels, which immediately set
the stage for a wave of price rises and drive the economy into recession. If
this situation is allowed to develop the original anti-inflationary exchange
rate policy would ultimately cause much more damage than if a pure free floating
policy was followed.
Anti-inflationary exchange rate policies, which aim to
eliminate imbalances and disequilibria, so as to improve domestic economic
performance, inevitably entail a cost. There is no free lunch in a global and
competitive world, especially when market makers are, sometimes, enticed by
speculators and wild rumors. Indeed, for almost 4 years the cost, borne by the
Bank of Greece, of sterilizing the excessive short-term capital inflows
attracted by the high interest rate policy, in combination with the exchange
rate policy amounted to almost ½% of GDP per annum. Furthermore, the government
proceeded with fiscal consolidation and structural reforms as well as other
measures which were introduced (notably extensive privatization) as a necessary
complement to the anti-inflationary exchange rate policy. These policies
underpinned the improvement in the functioning of the economy and gave a
significant boost to business confidence. The determination with which the three
Cs were pursued - consistent policies, continuity in policies and confidence
building, after two to three years of hesitation, swayed the labor unions,
businessman and the public at large to back the stabilization policies with the
aim of entering the Euroarea as soon as possible. In addition to targeting the
exchange rate, the Bank of Greece always kept a close watch on the growth of M3
and domestic credit expansion and through open market operations absorbed any
excess liquidity, which, if it had been allowed to reach the real economy, could
have aggravated inflationary pressures. Moreover, when necessary, we also
imposed stricter terms on banks' obligatory reserve requirement deposited at the
bank of Greece, which were already relatively tight (an amount equal to 12% of
deposits with the banking system and it can be noted that they were remunerated
at a negative real interest).
However, at the Bank of Greece we knew that this was not
sufficient to ensure a smooth run up before entering first the ERM I and
subsequently the Euroarea. Speculators are always waiting round the corner and,
sometimes, markets may wish to test the country's resolve to maintain its
exchange rate targets. Therefore, we followed throughout the six years before
entering the Euroarea a high interest rate policy so as first to keep foreign
investors happy and keep their confidence but also in order to build a high
level of foreign exchange reserves so as to be able to have sufficient reserves
to thwart speculative attacks. Indeed, when the 1997 south-east Asian crisis
spill over effects reached Greece in September-October and american hedge funds
started speculating heavily (up to $2 billion daily) against the drachma and the
word was spread that the drachma would devalue by as much as 28% we were able to
defend our parity by drawing on our foreign exchange reserves and by raising
interest rates temporarily, for a couple of days at a time. We were, however,
concerned not to scare the markets, which might have perceived our moves as
resulting from panic, and, therefore, we were very careful about how the policy
tightening was presented. Instead of raising our intervention rate (lombard rate)
from 19% to 330% we temporarily put a surcharge of 0,4% daily at the end of
October. This move looked innocuous and passed smoothly, while penalizing
heavily banks' cost of borrowing. Accordingly, we sent the right signal to the
market and this permitted us to eliminate the surcharge within a few days, so a
quasi-normal situation was soon restored. We were also very careful in the way
our foreign exchange interventions were executed. In most cases, we wanted to
show our determination to defend the parity and, therefore, the Bank of Greece's
foreign exchange department intervened directly in the market but, sometimes, we
judged that an intervention through a friendly foreign bank could be more
persuasive and influence market sentiment better.
Both the government and the Bank of Greece knew that our
fundamentals were rapidly improving and our economy had entered a virtuous cycle
of rapid growth, falling inflation and fiscal deficits and with relatively small
current account deficits by past standards, so we did not hesitate even for a
second, regarding our policies and goals. We became even more determined than
before to continue our stabilization policies and defend the exchange rate so as
not to delay our entry in to the Euroarea. Our determination paid off and
foreign exchange markets after a few months of turbulence calmed down in early
1998. Conditions were then considered propitious to achieve our intermediate
goal, to enter ERM I in calm waters accompanied by a small devaluation to
correct the previous real appreciation. We succeeded in catching the markets by
surprise and not being forced to make a devaluation under duress, with all its
destabilizing effects. Moreover, the new ERM parity agreed with our EU partners
was broadly consistent with Greece's fundamentals and costs and productivity
levels and satisfied the markets. And judging from Greece's record of the last
6-7 years: an annual growth of GDP 3.9%, inflation at the end of 2003 at 3.1%
only 1 percentage point above the Euroarea average, and a fiscal deficit at 1.5%
of GDP in 2003, the exchange rate with which the drachma entered the ERM in
1998, and the subsequent conversion rate into the euro in 2001, were appropriate
and reflected Greece's overall competitive conditions. I would like to tell you
how markets behave or rather misbehave: in the heat of speculation, many
investment banks were spreading the word (even via the monthly bulletins they
circulated and one of them through a teleconference in London) that there would
be a devaluation of the drachma of up to 28%. We disproved the pessimistic views
and the actual devaluation upon entering ERM I was 12,3%. Immediately afterwards
market sentiment changed and the drachma traded at well above its central parity.
As a result, the central parity was revalued later in January 2000 and the total
devaluation by the time the drachma entered the Euro area was only 7,9%.
The lesson that can be drawn from the greek experience is
that a managed exchange rate policy needs to be consistent with the other policy
planks, notably fiscal and structural policies which, in turn boost markets'
confidence and, therefore, facilitate the exchange rate policy. Confidence is
crucial for the successful realization of the policy goals. As I mentioned above,
the cost of sterilizing the excessive short term capital inflows (almost ½% of
GDP) may appear at first sight too high, but the benefit of stabilization,
notably the resulting sustainable investment-led high rate of GDP growth of
almost 4% since 1997, which is expected to continue well into this decade, far
outweigh any temporary sacrifice the economy incurred in order to fulfill our
stabilization goals.
The road to the Euro was not strewn with roses, it was not
smooth and I don't want to underestimate the difficulties. With regard to the
sequence of policies and priorities, we took a calculated risk starting our
stabilization policies by adopting a policy that allowed for a moderately
appreciating real exchange rate. We walked on a tightrope, sometimes for months
in a row, as there were occasional bouts of jitters based on market expectations,
even until the last moment, that our Euroarea entry would be deferred or that we
would join at a significantly depreciated rate. Accordingly, whereas our goals
were ambitious, our policies erred on the side of caution. We made gradual
adjustments and, as an insurance, always had at hand a sufficient large cushion
of foreign exchange reserves and a relatively high interest rate differential
vis-a-vis Euro rates, even until the last few weeks before entry into the
Euroarea.