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The Bank of Greece publishes its Monetary Policy 2008 - Interim Report

08/10/2008 - Press Releases

On October 8, the Bank of Greece submitted its Monetary Policy 2008 -- Interim Report to the Greek Parliament and the Cabinet, in accordance with its Statute. The Report was handed over by the Bank's Governor, Mr George Provopoulos, to the Speaker of Parliament, Mr Dimitrios Sioufas. At the press conference that followed, Governor Provopoulos summarised the central message of the Interim Report as follows:

"The Greek economy, after several years of uninterrupted strong growth, is now at a crucial juncture. The favourable factors that supported the high rates of GDP and employment growth in recent years are losing their strength, at a time when the international economic environment is deteriorating as a result of the financial turmoil that continues for a second year, the considerable slowdown of global economic activity and strong inflationary pressures. These developments have changed the determinants and parameters underlying the growth momentum of recent years in our country.

During the 1996-2008 period, the key driver of economic growth in Greece was buoyant domestic demand (both consumer and investment expenditure), which rose strongly, outpacing the expansion of the productive base and of potential output. The consequences of this mismatch were the persistent inflation differential vis-à-vis the euro area average, the widening of the current account deficits and the increase in the net foreign financial liabilities of the private and the public sector. The size and persistence of these imbalances suggest, among other things, that the scope and depth of structural reforms implemented during this period were not sufficient to deal with these major problems. This could be partly attributed to the complacency generated by relatively robust growth combined with conditions of stability and low interest rates ensured by euro area participation.

Against the background of a worsening international economic outlook, the macroeconomic imbalances and structural weaknesses of the Greek economy become all the more clear. The only safe way of shielding the Greek economy against exogenous shocks and ensuring sustainable strong growth and low inflation is to effectively address these imbalances and weaknesses; this will help set in motion a long-term, more export-oriented and sustainable growth dynamic, which will rely primarily on strengthening the productive base through investment and the upgrading of human capital, on enhancing market competition as well as on a wide range of structural reforms, particularly in the broader public sector.

An effective boost to productivity, competitiveness and adaptability of the economy can only be provided by the implementation of a policy mix focused on the steady improvement of the productive capacity of the economy. Such a policy mix would be conducive to growth and stability and thereby also bolstering the confidence of foreign investors and markets in the prospects of the Greek economy and in the stability of the Greek financial system. Today, in the face of intensified disturbances in international markets, strong confidence is of the utmost importance if the indirect effects of the turmoil on financial stability in Greece are to be minimised; this is also a precondition for economic growth.

Despite acute tensions in international financial markets, the repercussions of which are being felt in our country too, the Greek banking system remains fundamentally sound, safe and stable. The increased risks associated with the international environment warrant vigilance and adaptability to changing conditions. The Bank of Greece has asked banks to take all necessary measures and pursue appropriate policies to safeguard stability. We are closely monitoring and assessing all developments, guided by our primary concern to protect the interests of all bank customers."

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The Report is published at a time characterised by the serious deterioration of the international economic environment: GDP growth rates are slowing down, inflation remains elevated and financial markets are experiencing exceptionally strong pressures. The worsening macroeconomic performance and outlook at a global level were caused by the concurrence and interaction of two powerful factors – the financial turmoil and the surge in the prices of oil, food and other primary commodities.

The international financial turmoil is continuing for the second consecutive year. The depth, the possible duration, the occasional peaks and the macroeconomic implications of this turmoil have already exceeded the initial assessments. The state of the international financial system is surrounded by high uncertainty. Several large financial enterprises world-wide continue to post losses, the climate in financial markets is heavy and there is now a visible risk of negative feedback loops between financial and macroeconomic developments.

In the euro area, the situation is less worrying than in the United States as far as financial stability is concerned; however, risks of a deterioration do exist. Of course, governments and central banks have been taking co-ordinated action to preclude such a deterioration and to gradually re-establish conditions of normalcy.

The rapid rise in the prices of energy, food and other basic commodities has an adverse effect on global inflation and economic activity. Oil prices, after jumping to record levels, have declined more recently and, given the slowdown of economic activity, could decline further. However, oil prices are still very high, their evolution in the period ahead is subject to considerable uncertainty and they are likely to remain highly volatile. High food prices hit harder the economically weaker within a given country and, in a global context, the emerging economies.

The adverse and uncertain international environment has negative effects on almost all economies; however these effects vary across countries, depending on the specific initial conditions prevailing in each country, as well as on the adaptability and resilience of each economy to exogenous shocks. These in turn depend on the structural characteristics of individual economies.

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In the euro area, the single monetary policy contributes to economic growth by its commitment to the objective of price stability over the medium-term. Monetary policy cannot prevent or offset short-term variations of inflation around its medium-term trend that are due to exogenous factors such as world oil prices. Monetary policy should above all ensure that any temporary inflationary pressures are not embodied in medium-term inflation expectations and do not trigger second-round effects. Second round effects exist when the price and wage-setting behaviour of economic agents anticipates that the temporary pick-up in inflation will persist in the medium term.

In addition, the Eurosystem has intervened to normalise conditions in the interbank market, seeking to contain the fluctuations of very short-term market rates around the minimum bid rate of the main refinancing operations, so that they remain consistent with the monetary policy stance and facilitate monetary policy transmission. Through these interventions, which take the form of open market operations, the Eurosystem, among other things, provides liquidity to credit institutions that face difficulties in their funding from the interbank market. In so doing, it also reduces the associated risks to financial stability.

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The Greek economy is at a crucial juncture. The most visible effect of the worsened international environment is the rise in inflation to a ten-year high. Average annual inflation is projected to be 4.6% this year, reflecting mainly exogenous factors, i.e. the rise in the world prices of oil and food commodities, but also the contribution of increased domestic production costs, particularly the acceleration of unit labour cost growth. The effect of the exogenous factors is amplified by the inadequate competitive conditions that continue to prevail in some key domestic markets. In an environment of imperfect competition, enterprises can agree to high wage increases and then pass on cost increases to the prices of their products. More generally, social partners in Greece have not yet adjusted their behaviour to the conditions implied by economic and monetary union. In addition, the “oil intensity” and “oil dependency” of domestic production remain rather high. As a result of these factors, the inflationary impact of higher oil prices has been stronger in Greece than on average in the euro area. An analysis of developments shows that the rise in fuel prices since the latter part of 2007 has already produced strong second-round effects on inflation this year in Greece, whereas second-round effects elsewhere in the euro area have been limited.

The pick-up in inflation erodes the purchasing power of incomes, in particular those of the economically weaker segments of the population. It also erodes the Greek economy’s international competitiveness, by sustaining the inflation differential vis-à-vis the euro area partners, with negative implications for growth and employment. To provide a measure, both relative consumer prices and relative unit labour costs in the whole economy, expressed in a common currency, have risen markedly since 2000 (roughly by a cumulative 18.5% and 26%, respectively), which translates into commensurate losses in competitiveness.

This serious loss in competitiveness (together with the rise in oil prices) has also contributed to a widening of the current account deficit, which is expected to come close to 15% of GDP this year. The persistently high levels of the current account deficit over the past ten years have led to an increase in the net financial liabilities of the public and private sector vis-à-vis non-residents. The very high current account deficit reflects the shortfall of national saving relative to investment, mainly the very low saving-to-GDP ratio.

The GDP growth rate has declined and is expected to be around 3.3% in 2008, still remaining well above both the euro area and the EU average. Growth continues to be driven mainly by domestic demand. However, the rate of increase in private consumption has slowed considerably, reflecting on the one hand the real income effect of higher fuel and food prices, and on the other hand the general climate of uncertainty. The growth rate of consumer credit moderated slightly in the first eight months of this year, but has nonetheless remained high. Investment recorded negative year-on-year change in the first half of 2008, on account of a drop in residential investment, while the rate of increase in housing loans slowed appreciably.

Business investment is projected to remain robust, with credit expansion to enterprises picking up in the first eight months of this year. However, business investment projections are surrounded by uncertainty, regarding the extent to which domestic and foreign demand will be affected by the international financial turmoil, the strong inflationary pressures, the appreciation of the euro, the increased cost of borrowing and the high prices of oil and raw materials.

On the positive side, employment continued to rise (at an annual rate of 1.3% in the first half of this year) and the unemployment rate (as a percentage of the labour force) dropped further to 7.7% of the labour force (again, in the first half of the year). Other encouraging signs are the decline in long-term unemployment as a percentage of total unemployment, the lower youth unemployment rate (which remains high, however) and the rise in the rate of female employment (which is still low, nonetheless).

The deficit of the State Budget widened considerably in the first seven months of 2008, reflecting the economic slowdown, as well as temporary factors, the impact of which is expected to be reversed in the remainder of the year. There are also indications that tax evasion has increased. The reversal of trends in revenues and primary expenditure over the coming months is expected to reduce the deviations from the budget targets observed in the period until July. In order to improve the fiscal balance in 2008 and, most importantly, to support next year’s fiscal programme, the government has adopted a package of measures. Law 3697/2008 contains a number of positive provisions geared to ensuring transparent and unified fiscal management, improving expenditure control and broadening the tax base. However, it also contains certain provisions (e.g. the settlement of pending tax cases and the collection of tax arrears) which merely serve as a means of temporarily offsetting the chronic weaknesses of the tax collection mechanism and do not contribute in the medium term to tackling tax evasion or to fostering a taxpayer culture.

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Despite the severe tensions in international financial markets, the repercussions of which are felt in our country too, the Greek banking system remains fundamentally sound, safe and stable. The reasons for this are the following:

• Over 90% of bank lending is financed by deposits, therefore the Greek banking groups are less reliant on the money market, where the cost of money has increased substantially, or on capital markets, which are not fully working at present.

• The profitability and capital adequacy of Greek banks have, on average, been significantly less affected in comparison with most banks in other countries, given their limited exposure to instruments directly or indirectly linked to the turmoil. The Greek banks had no pressing reasons to invest in "toxic" financial products, since a very favourable economic environment (in Greece and South Eastern Europe) has offered them considerable opportunities of profitable growth.

• The Greek banking groups have a strong capital base and comparatively low leverage ratios. Of course, there have been some negative effects on bank profitability (which, however, had increased considerably in 2007), capital adequacy ratios and funding costs; there has also been a marginal increase in the credit risk of loans to households.

• The Bank of Greece remains vigilant in the face of increased risks. It is monitoring and assessing developments carefully, with a view to protecting all bank customers. It has called upon banks to take all necessary measures and pursue appropriate policies in order to safeguard stability.

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The strong performance of the Greek economy over the last 13 years has mainly been driven by buoyant domestic demand that was underpinned by such factors as the improved macroeconomic environment ensuing from Greece's entry into EMU, historically low interest rates, the deregulation of the credit system and the substantial inflows from the EU Structural Funds. However, as the international economic conditions deteriorate, the imbalances and the structural weaknesses of the Greek economy are becoming all the more clear, while the favourable factors that contributed to sustained strong growth since 1996 are losing their strength.

It is therefore of the utmost urgency to effectively address the macroeconomic imbalances and structural weaknesses, in order to set in motion a long-term, more export-oriented and sustainable growth dynamic, which will rely primarily on strengthening the productive base through investment, on enhancing market competition as well as on a wide range of structural reforms, particularly in the broader public sector.

Securing macroeconomic stability will require:

Intensification and furthering of efforts for fiscal consolidation; the cornerstone of fiscal consolidation is the control of expenditure, especially primary expenditure, in conjunction with greater efficiency and the reallocation of expenditure to growth-enhancing purposes, such as education, R&D and infrastructure. Dealing with chronic problems such as tax and contribution evasion, improving the tax collection mechanism and broadening the tax base are also necessary steps in the same direction.

Enhancement of competition in all markets, to ensure a more efficient allocation of resources, adaptability to changing conditions and containment of inflationary pressures.

Strengthening of the growth dynamic through a set of bold structural reforms, notably in public administration, fiscal management and the broader public sector, as well as in education and training systems, so as to ensure the more efficient utilisation of available national resources and of inflows from the EU Structural Funds, encourage high-quality and high-yield investment, raise productivity and competitiveness and increase the employment rate. Thus, the economy will become more export-oriented, and the potential growth rate will increase on a sustainable basis. It is essential that the necessary interventions be carried out in a co-ordinated manner and on the basis of a clearly defined timetable.

Structural reforms are all the more necessary at the current stage also as a means of shielding the economy against the international economic downturn. In order to withstand the effects of exogenous and, to some extent, transitory shocks, policy makers and the social partners should ensure that the adverse impact of domestic macroeconomic imbalances and structural weaknesses on the medium-term prospects of output, employment and income will be reduced. A first priority is the relief of the most vulnerable social groups from the consequences of the oil shock. This should be undertaken through targeted interventions and in ways that will not jeopardise fiscal prospects. In this respect, it is of the utmost importance to enhance the relatively low efficiency of social expenditure. At the same time, enterprises and households should realise that the not immediately recoverable losses in purchasing power, which result from higher international prices of oil and other commodities and the inevitable transfer of income to the countries that export these commodities, can be effectively compensated for in the long run solely through policy interventions which will increase competition, as well as through productivity-boosting initiatives by the enterprises themselves.

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