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The Bank of Greece Interim Report on Monetary Policy 2011

23/11/2011 - Press Releases

Today, in accordance with its Statute, the Bank of Greece submitted its Interim Report on Monetary Policy 2011 to the Speaker of the Greek Parliament and to the Cabinet. The cut-off date for the data included in this Report was 17 November 2011, the date at which it went to press.

The Greek economy is going through a new, exceptionally critical phase

The decision of the 26 October Euro Summit represents a milestone on the adjustment path of the Greek economy. The main aim of the agreement reached concerning Greece was to lighten the burden of government debt and its servicing costs, while the adoption of a new multiannual EU-IMF support programme for Greece is envisaged by the end of 2011.

About a year ago, the Bank of Greece considered that the debt could be sustainable. The Bank based its assessment on (a) the full attainment of the fiscal targets that had been set -- indeed, the Bank strongly encouraged the overachievement of those targets, wherever possible -- and (b) a substantial improvement in competitiveness. In the event, however, the inter-related effects of an undershooting of the fiscal targets, delays in implementing structural reforms, and a sharper-than-expected decline in economic activity undercut earlier assessments about debt sustainability.

Last opportunity to reshape the economy

The new opportunity provided to Greece under the agreement of 26 October may well be the last such opportunity. Thus, the country must avoid any further delays or deviations from targets at all costs; indeed, every possible effort needs to focus on overshooting the targets. The present juncture is the most critical period in Greece’s post-war history. What is at stake is whether the country is to remain within the euro area in the future. Effectively, Greece is faced with a choice between:

– an uncontrolled downward trajectory that would undermine many of the achievements that have been attained in recent decades, drive the country out of the euro area and set Greece’s economy, standard of living, society and international standing back many decades;


– an all-out effort within the euro area, in close cooperation with our European partners and the international community, to mitigate shocks, shorten -- to the extent possible -- the difficult and long adjustment period and lay solid foundations for the restructuring of the economy and reestablishment of sustainable growth.

Clearly, the latter option entails costs. However, the overall cost to society will be lower than otherwise in the medium term, and the long-run benefits will be higher than will be the case under the former option.

The implementation of the necessary policies requires a strong and effective government

The new government is called upon to implement the agreement of 26 October consistently and to promote the policy measures stemming from it. The recent political uncertainty created additional problems for the economy and the banking system. In order to safeguard financial stability, it will be necessary for the coalition government to exert strong and effective leadership, so that it can implement the policies required to ensure Greece’s future within the euro area.

The first task of the new government is to restore confidence, which has been dealt a serious blow. However, in order to consolidate confidence in the prospects of the economy, the convergence of political forces reflected in the formation of the new government must become more substantive. Moreover, for the government to succeed, and the will of the citizens to be genuinely expressed in the upcoming elections, the true state of the economy and the international context must be described with utmost candour, possible solutions must be clearly analysed, and the costs and benefits of each option must be explained cogently.

The size of the fiscal adjustment achieved in 2010 was substantial. Meanwhile, despite delays, a number of noteworthy structural reforms were implemented, the most important of which was the reform of the social security system. However, the situation remains critical. Thus far, the pace and degree of policy implementation have failed to convince both the markets and the general public that Greece is on the road to achieving the goals set. This “credibility deficit” has its roots mainly in the fact that economic policy has often been conducted in a piecemeal manner, indecisively, with backtracking and delays, and following rather than leading developments. Thus, depending on the case:

● Measures that would move the economy in the desired direction lose impetus in their implementation, thus failing to deliver the expected results in full.

● The preparation and planning of measures do not adhere to the timetable laid down, thus making it necessary to search for last-minute “magic solutions”.

● There is a resurgence of outdated attitudes and behaviour, which treat certain issues as non-negotiable if vested interests are threatened.

● “Horizontal”, i.e. indiscriminate and across-the-board, approaches are used to curtail public spending, while the mechanisms that are inherently cost-generating remain untouched; this outcome prevails because the public administration is unable to work out targeted solutions, which would be more effective and socially more equitable.

Τhe confidence deficit is exacerbating the recession

If we are to succeed where we have so-far failed, it is necessary to eliminate this “confidence deficit” caused by, on the one hand, indecision and backtracking on economic policy and, on the other, social tensions fuelled by the illusion that a return to the policies of the past is possible.

Although it has often been argued that the deepening of the recession in 2011 and its projected continuation into 2012 are due to the impact on aggregate demand of the contractionary fiscal adjustment, international experience and numerous empirical studies have shown that a restrictive fiscal policy can have expansionary effects over the medium to long term, particularly in countries with very high levels of government debt. The negative macroeconomic impact of fiscal adjustment can be minimised and a country can return to growth faster if adjustment focuses on cutting primary expenditure – excluding investment spending – on a permanent basis and if the programme is implemented with determination, thus affecting positively households’ and businesses’ expectations.

Expectations play a crucial role

Such conditions, however, are not satisfied, which explains why confidence has not recovered and the “credibility deficit” is growing. The fall in domestic demand and the economic contraction are disproportionately large in comparison to the magnitude of fiscal adjustment, precisely because the prevailing climate and expectations prevent economic recovery and the emergence of a “confidence effect”.

In these circumstances, the recession is deepening:

— GDP should fall by about 5.5% or somewhat more in 2011. The recession is expected to continue into 2012, with GDP contracting by around 2.8%, while recovery is now expected in 2013, with GDP growth that year projected not to be higher than 1%. With exports of goods and services expected to rise this year and with imports having appreciably declined, the external sector should make a positive contribution to the change in GDP, though not yet sufficient to markedly mitigate the recession.

— The average decline in employment should be of the order of 5.5% this year, and the average unemployment rate is projected to come close to 17%; it may exceed 18% in 2012. These developments have implications for social cohesion. They also imply a loss of human capital and the stock of skills and knowhow; coupled with a reduction in the stock of fixed capital as a result of the crisis, they make the pursuit of policies for recovery and growth even more imperative.

Signs of structural changes

On the positive side, however, there are some encouraging signs, suggesting that in the midst of the crisis some underlying positive dynamics have been set in motion; provided they continue, these could lead to a significant restructuring of the economy over the medium term. These dynamics include the following:

— A reduced dependence of growth on domestic demand and a positive, albeit small (for the time being), contribution of the external sector.

—A partial recovery of the large losses in cost competitiveness recorded during the 2001-2009 period. Three fifths of the large cumulative loss in competitiveness (as measured on the basis of relative unit labour costs) over the nine years from 2001 to 2009 are expected to be recovered, following the improvement (actual and expected) in the three years 2010 to 2012. If this improvement in competitiveness is to prove sustainable, it will also have to be underpinned by productivity gains, stemming from structural reforms in product and labour markets.

— Changes in the structure of employment, with job creation shifting to the more productive businesses and branches of activity. Available data show that, while the number of employees in private sector enterprises with less than 20 employees decreased, the number of employees in those with over 50 employees rose. At the present time, these businesses effectively constitute the only option for job-seekers.

— Greater flexibility in the labour market, which can act as an antidote to unemployment. The tendency to adopt more flexible forms of employment, already apparent in the labour market, is also expected to become stronger, facilitated by the new provisions legislated in October, and will have positive effects on employment and productivity.

Uncertainty in the international environment as well

Developments in the international environment have contributed to the uncertainty in Greece. In the world economy, the major risks relate to uncertainty regarding the unfolding of the sovereign debt crisis in advanced economies, as well as the difficulty of striking a balance between necessary fiscal adjustment and policies to stimulate economic activity, at a time that unemployment rates remain high in many advanced economies. The risks associated with the sovereign debt crisis pose a threat to financial stability.

New conditions are taking shape in the EU and the euro area

In early November, the European Commission published a marked downward revision of its macroeconomic projections for the euro area in 2012. At the policy level, efforts are focusing on developing a comprehensive framework of rules to deal with the impact of both the global crisis and the sovereign debt crisis, as well as to strengthen economic governance. The new framework will imply long-term commitments by all Member States, notably on fiscal discipline and the improvement in competitiveness – i.e. precisely the two major challenges that Greece has, in any case, to face.

The contribution of the ECB is very important

The policy pursued by the ECB is contributing decisively to maintaining price stability and financial stability in the euro area, thereby helping to counter the effects of the crisis. This is achieved both through interest-rate policy and through non-standard monetary policy measures. These actions are essential for the provision of liquidity to credit institutions, operating inter alia in Greece, which have been shut out of the interbank market.

Liquidity risk and the need for recapitalisation are the challenges to which the banking system must rise

The challenges for the Greek banking system became more pressing in 2011. The deterioration in overall macroeconomic conditions and heightened uncertainty weighed heavily on deposits and the quality of banks’ loan portfolios, leading to the continued inability of banks to draw funds from the interbank market. In addition, in the first half of the year, bank balance sheets were further burdened by the impact of the loss in market value of Greek government bonds, while a further loss is expected to be recorded in banks’ annual results.

Against this background, the stability of the banking system has come under strong pressure, so that there is an urgent need for banks to strengthen their capital base, restructure their balance sheets and redefine their business models. The creation of larger and stronger institutions is a necessary choice in the context of the ongoing restructuring of the banking system and will allow banks to successfully provide financial intermediation, thereby contributing to the reconstruction of the economy.

It is necessary to strengthen capital adequacy

By the end of June 2011, capital adequacy ratios (CAR) had declined, mainly due to the impact on regulatory capital from increased provisioning, in view of the private sector involvement (PSI) associated with the initial agreement of 21 July. Moreover, given the continued deterioration in the economic environment and the effect of the reduction in value of Greek government bonds following the recent decision of the Euro Summit, further substantial recapitalisation of the banking system is necessary. In addition, banks may be required to further raise capital once the diagnostic assessment of their loan portfolios, currently under way, is completed.

The significance of the diagnostic assessment of banks’ loan portfolios

The diagnostic assessment of banks’ loan portfolios being conducted will trace loan-repayment dynamics, taking into account the great challenges posed by the recession. It will help banks to adjust their capital and provisions accordingly. Over the medium term, the results of the diagnostic assessment will have a positive effect on the ability of Greek banks to access markets. Indeed, it may make it easier for them to return to the markets sooner.

The adoption of enhanced measures of banking supervision and bank resolution

A very positive development was the adoption of the law introducing enhanced banking supervision and bank resolution measures (Law 4021/2011). The law provides new options for managing and effectively addressing vulnerabilities in individual credit institutions. Most importantly, it provides options for preventing a disturbance in one bank from evolving into a systemic disturbance. The aim is to safeguard financial stability and ensure, to the extent possible, the uninterrupted flow of credit to the real economy through the banking system.

A credit crunch has been prevented, despite the squeeze on liquidity

Today, banks remain shut out of the global markets and face the consequences of their shrinking deposit bases and the decline in value (or even ineligibility) of their collateral used to obtain refinancing from the Eurosystem. In the first half of 2011, the overall effect of these factors was a squeeze on bank liquidity. The maintenance of the Eurosystem’s liquidity-providing measures, along with the liquidity-support measures taken at the domestic level, helped to mitigate these pressures, preventing a credit crunch. It is important to note that in the first half of 2011 the year-on-year rate of decline in private sector financing (-1.2%) was very small compared with the rate of contraction in nominal GDP (-6.2%).

Without these liquidity support measures, banks would have been forced to deleverage rapidly, thus substantially reducing credit to the economy, which would in turn have led to an even deeper recession.

Furthermore, apart from the Eurosystem’s operations, since August the Bank of Greece has also provided exceptional funding to credit institutions to compensate for the withdrawal of deposits by the private and public sector and for the decline in the value of collateral eligible for monetary policy operations.


Addressing the credibility crisis with concrete action is a priority

Following the decisions of 26 October, the new government must demonstrate that the country will fully honour its commitments, i.e. the programme of fiscal adjustment and structural reforms. However, in order to convince the markets and the general public, the country’s strategy must be drawn up with a keen sense of responsibility and over a medium-term horizon. Restoring confidence in the prospects of the Greek economy is the only way to shorten the length of the recession, create the conditions for economic recovery and take advantage of the results of the Euro Summit decisions of 23 and 26 October.

Two national objectives

There are two national objectives which we must now pursue at all costs:

First, to generate primary surpluses at higher rates than currently projected on the general government accounts.

Second, to speed up recovery and then achieve higher rates of growth in the years to come.

Faster fiscal adjustment with emphasis on the expenditure side

If we overshoot the fiscal adjustment targets, with an emphasis on expenditure reduction, and if, at the same time, recovery begins, thereby reversing the pessimistic projections for growth, it will be possible to reduce the debt-to-GDP ratio to levels below the present target of 120% and, in fact, to do so sooner than currently projected (i.e. earlier than 2020). If this happens, the climate could improve drastically and a virtuous circle of growth would be set in motion.

We therefore need a strategy that fulfils certain conditions, i.e.:

1. aims to change the conditions that generate problems. To this end, fiscal adjustment should go hand-in-hand with the rapid modernisation of the state and the public administration;

2. steadfastly adheres to the targets set, continuously reaffirms them and stresses Greece’s fundamental commitment to address the current crisis from within the euro area;

3. fully respects the timetables/schedules set;

4. overshoots, where possible, the initial targets;

5. secures the broadest possible social and political consensus;

6. produces, the earliest possible, tangible proof of the will to proceed rapidly with the implementation of policy, e.g. by creating primary surpluses in the near future which rise over time, promoting major privatizations as soon as possible, attracting investors to ensure the better use of state assets (with the potential to create income and jobs), and closing down without delay those public-sector entities which do not provide useful services;

7. mobilises resources available from EU structural funds to re-launch major public investment projects;

8. convinces investors that in the future the economy will operate under a new framework which will ensure effective competition and the smooth functioning of markets, as well as encourage productivity improvements.

In order to bolster the credibility of the fiscal adjustment programme, clear and positive messages must be provided that, this time, decisions will be implemented in full. This highlights the need for: (a) specific programmes for each ministry and area of government action; (b) the coordination of individual programmes by an effective central mechanism; (c) strong and steadfast political will, expressed through concrete actions in the various policy areas; (d) measures to increase the efficiency of public administration; and (e) close cooperation with the European Commission’s task force on technical assistance.

Structural reforms for recovery and growth

Mitigating the recession and ensuring the fastest possible return of the economy to positive rates of growth call for a reversal of the economic climate and sharp progress with fiscal adjustment, which would provide a clear message that the economy is in a position to recover. At the same time, it is necessary to encourage private business activity, which has been strongly impacted by the negative impact of reduced demand, lower competitiveness, weakening credit expansion and a heavier tax burden.

The Bank of Greece has argued that there is no room for further increasing the tax burden on businesses and households and that the policy for achieving the necessary increase in revenues should focus on combating tax evasion. A further rise in the tax burden of those who already pay their taxes would not only exacerbate the recession, but would also prove counterproductive, i.e. it would reduce rather than increase revenues.

This factor must be a prime consideration in the formulation of the new legislative framework on taxation. That framework must avoid imposing new burdens, especially on those presumed to be honest taxpayers. It must also clearly describe the conditions – the first and foremost being progress with fiscal consolidation – under which the tax burden borne by honest taxpayers can be lightened.

Requirements for a reversal of pessimistic expectations

A reversal of pessimistic expectations about the future of the economy, so as to stop the outflow of deposits, encourage households to consume and enterprises to invest, and foster exports, requires, among other things, the following:

• a modernisation of the state and public administration;

• the creation of conditions for the effective operation of competition in markets for goods and services;

• rapid progress towards rationalising the regulatory environment of product markets;

• bringing network services up to date, which is necessary to increase productivity and attract foreign investment;

• promoting structural changes in the labour market in an orderly manner, on the basis of the new arrangements legislated in 2010-2011.

Financing the recovery

As the rate of credit expansion to the private sector remains negative and the decline in household income and business profits continues, economic recovery – and subsequently growth – can initially be financed through the following sources:

• advantage can be taken of the decisions on the faster disbursement of funds available under the National Strategic Reference Framework, in cooperation with the task force on technical assistance set up by the European Commission;

• the privatisation and State property utilisation programme can be implemented, becoming an important channel for attracting foreign capital and importing know-how and technology.

Tapping into the country’s growth potential and achieving social consensus

The long effort to adjust and reform the economy rests on two pillars – first, achieving fiscal consolidation and adjustment and, second, improving competitiveness and changing the model of production.

Most analysts recognise that Greece has several potential competitive advantages that are important and relate to both its geographical position and, inter alia, its natural and human resources – such as renewable forms of energy, specific minerals, climate, natural environment and ancient monuments, availability of highly-skilled workforce and an aptitude for entrepreneurship. However, at the current juncture, these advantages have been largely untapped.

This circumstance is mainly due to two factors:

• First, the “credibility deficit”. As long as Greece is viewed as an example of fiscal derailment and its ability to make further substantial progress towards fiscal consolidation and economic recovery is under question, attracting foreign investment (and know-how) in order to utilise potential advantages will remain difficult or will only be possible at unfavourable financial terms. The same lack of incentives also relates to domestic investment initiatives – although there exist some important examples of Greek enterprises that, in extremely adverse conditions, have taken initiatives and scored successes in foreign markets.

• Second, delays and underachievement in promoting and implementing reforms that would facilitate the efficient functioning of product and labour markets, speed up recovery and restore conditions for a sustainable improvement in competitiveness and steady growth.

Underlying the above two factors is the “great patient”, namely the operation of the State, which reflects and, at times, favours corporatist compromises and promotes corruption, the sweeping of problems “under the rug” ad infinitum, and the undermining of proposed solutions. The fact that the functioning of the state apparatus has not risen up to the challenge facing it has had extremely large negative consequences.

For the adjustment programme to move forward, both of its pillars - fiscal consolidation and improvements in competitiveness - must be achieved at the same time, in order to deal with the vicious circle of depression-fiscal contraction-uncertainty, support economic recovery and consolidate growth prospects. This is the only way to demonstrate conclusively that the country is creditworthy. For this to occur, a detailed and binding Action Plan for Growth, as suggested by the Bank of Greece, is needed. If the various policies are properly specified in the Action Plan, that is, their effectiveness and internal coherence are ensured, together with social justice, then society’s confidence can increase, and social and political dialogue – instead of turning out to be a “dialogue of the deaf” or a “war of all against all” – could become a meaningful and constructive dialogue focused on a socially equitable and, at the same time, more efficient allocation of the sacrifices that are urgently necessary to exit the crisis, also signaling the prospect of future benefits.

Such a road map could lead us through an arduous, but fruitful, effort undertaken by all of society, to the exit from today’s severe crisis and secure the country’s place within the euro area.

The full text of the Report is available here.








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