Nicholas C Garganas: The Greek economy - developments, prospects
and economic policy challenges
Speech by Mr Nicholas C Garganas, Governor of the Bank of Greece, at the presentation of
the Bank of Greece Annual Report to the Annual General Meeting of Shareholders, Athens,
22 April 2008.
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The main features of economic developments and prospects
The main features of economic developments during 2007 were the international financial
turmoil and the rise in food and oil prices. These phenomena marked the second half of 2007
and have continued into 2008, leading to an intensification of inflationary pressures and a
slowdown of economic activity.
These events in the international economy have, not surprisingly, adversely affected inflation
and the rate of growth of the Greek economy. The annual growth rate of GDP showed a
significant deceleration during the second half of 2007. Lower growth is also expected to be
a feature of 2008. High uncertainty internationally increases the downside risks to growth. At
the same time, inflation has accelerated in recent months, reflecting mainly increased
imported inflation and, to a smaller degree, higher production costs.
The consequences of the international financial turmoil for the Greek banking system during
2007 were limited and, largely, indirect. Greek banks continued to have healthy profits and
satisfactory capital adequacy ratios in 2007. Nonetheless, there is little room for
complacency. Continued turmoil in international financial markets, the fast pace of domestic
credit growth and the increasing penetration of Greek banks into new markets in
Southeastern Europe all contribute to raising banks' risks. Hence, managing these risks
effectively is of the essence.
Macroeconomic imbalances continue to pose a problem for the Greek economy. The current
account deficit widened further in 2007 and reached a very high level as a percentage of
GDP, as domestic savings (which are relatively low) fell well short of domestic investment
(which is relatively high). Whilst the general government deficit remained for the second year
in a row below 3% of GDP, imbalances remain high, as reflected in the debt-to-GDP ratio.
If the negative consequences of the continuing crisis in international financial markets are to
be minimised, efforts to make the Greek economy more resilient to external shocks have to
be stepped up. This highlights the importance of continuing fiscal consolidation and efforts to
raise national savings, increase productivity growth and contain production costs, in order to
improve the international competitiveness of the economy.
The international and European economic environment
The international financial turmoil had its origins in the sub-prime mortgage market in the
United States. Rising delinquencies in that market disrupted various segments of the money
markets, in particular the asset-backed commercial paper market. The drying up of liquidity in
that market caused large losses and asset write-downs by a number of financial institutions
which had significant exposures to complex structured finance products whose valuation was
now very uncertain. More generally, international financial institutions are still reducing their
leverage and the outlook for the international financial system continues to be uncertain. The
process of significant market correction is still ongoing and has triggered a deep and candid
review of practices, rules and procedures that influence the functioning of international
financial markets and the behaviour of market participants.
Whilst the world economy continued to grow at a high rate in 2007, the fallout from this
turmoil is expected to cause growth to slow to 3.7% in 2008, according to IMF forecasts, from
4.9% in 2007. This slowdown is also expected to affect the euro area, where growth -
according to the ECB staff projections made at the beginning of March - is expected to be
between 1.3% and 2.1% in 2008, compared with 2.6% in 2007. The risks to growth are
clearly on the downside internationally. Aside from the fact that financial turbulence has been
spreading to other markets, uncertainty remains high. Rapid economic growth in recent years
has been accompanied by a build-up of global imbalances, as low US interest rates
encouraged high consumer spending and lax lending standards. The problems in the
subprime market could be interpreted as merely a manifestation of the deeper problems of the
world economy, which might jeopardise growth prospects over the medium term.
At the same time, inflation has been accelerating, as oil and food prices rose sharply again in
the first quarter of this year. Inflation in the euro area hit 3.6% in March and is expected to
remain high in the coming months, falling back gradually later in the year.
Macroeconomic developments in Greece in 2007 and the outlook for 2008
Economic activity
These international developments had a limited impact on the Greek economy in 2007. The
rate of growth was 4.0% in 2007, down slightly from 4.2% in 2006. Thus, the Greek economy
continued to grow significantly faster than the euro area as a whole in 2007, with growth
driven mainly, as in previous years, by the increase in domestic demand (both private
consumption and investment); however, growth decelerated in the second half of 2007.
According to Bank of Greece projections compiled at the beginning of the year and published
in February, GDP growth was expected to be around 3.7% this year. However, the growth
rate of the Greek economy will probably be lower, to the extent that the slowdown in world
growth and external demand is sharper than initially assumed, rises in oil and food prices
steeper and financing costs higher. That having been said, it is still expected that growth will
be higher than in the euro area as a whole.
Employment and unemployment
The increase in economic activity in 2007 was accompanied by employment growth of 1.3%
and a reduction in the rate of unemployment by around half a percentage point to 8.3%.
Nonetheless, it seems that the Greek economy is still characterised by a smaller capacity to
create jobs compared with other countries in the euro area. This can be attributed to the
continuing restructuring of the Greek economy (most notably, the decline in agriculture and
the ensuing heavy job losses), labour market rigidities (e.g. lower use of part-time
employment), as well as some mismatches between supply and demand in the labour
market. Because of these factors, employment rates, especially for women, remain much
lower than the EU-15 average.
Inflation and international price competitiveness
Average inflation in 2007 fell to 3.0%, mainly as a result of oil price developments, which
were later reversed, as well as a slowing of the annual increase in processed food prices
(until September). However, inflation picked up significantly in the last quarter of 2007 and
the first quarter of 2008, reaching 4.4% in March of this year. It is expected that inflation will
remain at high levels in the coming months, mainly because of the sharp increase in
imported inflation, but will gradually decline thereafter. According to Bank of Greece
projections compiled at the beginning of the year and published in February, average annual
inflation in 2008 was expected to be 3.4%. However, certain risks then highlighted now seem
to have materialised, mainly as regards developments in oil prices internationally and unit
labour costs domestically; hence, average inflation will be higher than initially projected and
is expected to be around 4%. There are significant elements of uncertainty surrounding these
projections as regards international developments; the outcome of wage negotiations will
also be of particular importance. It is worth noting that the new National Collective Labour
Agreement provides for average annual increases in minimum wages of 6.2% in 2008 and
5.7% in 2009, higher than under the previous two-year agreement (6.2% for 2006 and 5.4%
for 2007). Therefore, the rise envisaged for this year is higher than the one in 2007.
Inflation in Greece remains significantly higher than in the euro area as a whole; as a result,
the price competitiveness of the Greek economy continues to deteriorate. The persistent
positive inflation differential can be attributed to both macroeconomic factors, related to
developments in aggregate demand and production costs, and the fact that certain markets
do not operate efficiently due to unsatisfactory conditions of competition.
External balance
Deteriorating price competitiveness and low structural competitiveness are two factors
explaining the continuing increase in the current account deficit (from 11.1% of GDP in 2006
to 14.1% in 2007). In addition, high rates of growth of private consumption, which is the
counterpart to low savings, have also contributed to the high and widening current account
deficit. The impact of high trade deficits on the net foreign debt of the Greek economy is
reflected in increased net interest payments, which act to further increase the current
account deficit. Prospects for reducing the deficit are not particularly favourable and it is
expected that in 2008 it will remain almost unchanged as a percentage of GDP, if not
increase.
Fiscal developments and prospects
As regards fiscal aggregates, the general government deficit reached 2.8% of GDP in 2007,
compared with 2.6% in 2006, mainly as a result of one-off factors. The consolidated general
government debt fell only slightly from 95.3% to 94.5% of GDP and remains the second
highest among the EU-27 countries.
The Updated Stability and Growth Programme for the period 2007-2010 envisages a fiscal
tightening in 2008, with the general government deficit projected to fall to 1.6% of GDP and
debt to 91%. Nonetheless, the pace of debt reduction remains slow, especially in the context
of the expected increases in expenditure in the coming years as a consequence of
population ageing.
Monetary policy, interest rates and credit expansion
In the euro area, the risks to the short-term inflation outlook are on the upside; the latest data
on macroeconomic aggregates point to ongoing but moderating real GDP growth; uncertainty
due to the financial turmoil remains high. In the light of these developments, the European
Central Bank has kept its key interest rates unchanged since June 2007. In its last meeting
on 10 April 2008, the Governing Council of the ECB confirmed, on the basis of an analysis of
the latest data, its assessment of prevailing upside risks to price stability over the medium
term. As price stability is the ECB's primary objective according to its mandate, the
Governing Council judged that stabilising medium- and long-term inflation expectations is its
highest priority; hence, it kept the interest rates unchanged. Thus, the minimum bid rate on
the main refinancing operations remains at 4%. The Governing Council also underlined that
the current monetary policy stance will help achieve this objective and reiterated its strong
commitment to preventing the materialisation of upside risks to price stability over the
medium term.
The hikes in the minimum bid rate on the main refinancing operations of the ECB, along with
higher money market rates, had an upward effect on interest rates on both deposits and
loans in Greece (although their rise was, in general, smaller than in the euro area as a
whole). However, whilst the rate of growth of the overall financing of the economy slowed
during 2007, it remained at the relatively high level of 13.1% in the fourth quarter. This
reflects the high rate of financing of the private sector (both firms and households), while the
rate of financing of the government sector was negative throughout 2007. These figures
suggest that the international financial turmoil had no impact on the supply of bank financing
to the domestic private sector until the end of 2007.
Stability of the banking system
In spite of the continuing international financial turmoil, the stability of the Greek banking
inter alia
system has remained high, supported by - - satisfactory levels of profitability and
capital adequacy. Greek banking groups' capital adequacy ratio, which stood at 11.2% at
end-2007, continues to provide satisfactory leeway for ensuring the stability of the banking
system. Greek banks had very little exposure to instruments associated with the US
subprime mortgage market and this largely explains the fact that the impact from the
international turbulence was limited and indirect.
Nonetheless, one should not lose sight of the fact that the current turmoil in the international
financial system has acquired a dynamic driven by self-feeding and interdependent risks.
Therefore, its impact does not regard only the degree of individual banks' direct exposure,
but also the risk that the turmoil may take on a more systemic character. At the same time,
competition in the domestic Greek banking market is becoming more intense and the cost of
financing is increasing, leading to a small decline in net interest rate margins in 2007 over
2006 (at bank level). It is important that banks do not try to make up for this decline by further
credit expansion, especially to borrowers of low credit quality. While the ratio of
nonperforming loans to total loans fell further to 4.5% at end-2007, from 5.4% at end-2006, it is
still considerably higher than the EU average.
In the light of these developments, the points that the Bank of Greece has been stressing for
some time have become even more relevant. In particular, banks need to further improve the
quality of their loan portfolios by implementing stricter criteria when selecting borrowers. The
implementation of the new supervisory framework ("Basel II") should help in this respect.
Also, households must weigh carefully their ability to service a loan before resorting to
lending.
Growth prospects, structural weaknesses and macroeconomic imbalances
The high levels of growth witnessed over the last 12 years have led to considerable progress
in the real convergence of the Greek economy on the more advanced economies of the EU.
However, Greece still lags behind in terms of levels of development and social welfare, as
per capita GDP (in purchasing power parities) falls short of the EU-15 average by 11.6%, as
a result of lower productivity (measured per hour of work) and lower employment rates. In
addition, there are serious macroeconomic imbalances and structural weaknesses, which are
reflected in relatively high inflation, a large current account deficit, which has pushed up
Greece's external debt considerably, and high public debt. Finally, challenges such as
population ageing, globalisation and, more immediately, a slowdown in world growth will
make it difficult for such growth rates to be maintained in the future without more intense
efforts to tackle the structural weaknesses of the economy.
The average growth rate of almost 4% achieved over the last 12 years was primarily driven
by boosting domestic demand. Private sector consumption and investment were bolstered by
the fall in interest rates following Greece's euro area entry, as well as by rapid credit growth.
Relatively high fiscal deficits, although declining in recent years, also helped to boost
aggregate demand, but at the same time contributed to a further accumulation of public
sector debt. Productive capacity, which has increased, has responded to the growth of
demand, but not to a sufficient extent, thus resulting in an excess demand situation.
Demand-led growth has its own natural limits. Based as it is on the build-up of debt (both
private and public) to finance consumption, ultimately an increasing proportion of GDP will
have to be devoted to its repayment. As a consequence, only through a transformation of the
economy into a more productive and outward-looking one will it be possible to maintain such
high growth rates. Such a transformation should focus on three areas: first, continuing fiscal
consolidation; second, adopting wage and pricing policies consistent with price stability; and
third, promoting structural reforms to improve productivity and the supply conditions of the
economy and to strengthen competition.
Correcting fiscal imbalances
The demands that population ageing will place on government expenditure make the need
for continued fiscal consolidation even more pressing. In particular, a reduction in public debt
by 2015 (when the effects of population ageing on government spending will be first felt) to
60% of GDP is of the essence. Hence, more intense efforts are needed, focused on both the
revenue and the expenditure sides of the budget. It is not in the interests of the low
competitiveness of the Greek economy to raise tax rates; there is, however, still room to
reduce tax evasion as a means of raising revenue. However, crucial to achieving surpluses is
the control of expenditure, in particular of certain categories such as personnel outlays,
subsidies or guarantees for public sector companies, which account for a large part of
government expenditure and have been growing very fast.
Wage increases, pricing policy and competition
Wage bargaining should take into account productivity developments, the implications of
wage increases for price competitiveness, as well as the level of unemployment. The rise in
oil prices inevitably represents a transfer of income from oil-importing to oil-exporting
countries, which cannot be effectively offset by nominal wage increases, since these lead to
higher inflation which erodes the purchasing power of domestic incomes. At the same time,
competition should be strengthened in markets operating inefficiently, so that firms can
contribute, through their pricing policies, to an evolution of prices which is compatible with
production cost developments and with keeping profit margins at levels that do not
undermine price stability and competitiveness.
Structural policies for increasing employment and improving productivity
Structural reforms must continue in order to improve productivity and the structural
competitiveness of the Greek economy.
Increasing employment
Greece has lower employment rates and higher unemployment rates in comparison with the
EU-15 averages. Demographic projections suggest that Greece will experience over the
coming years a decline in the working-age population. Growth will therefore depend, in part,
on raising employment rates by increasing the flexibility of labour markets, bringing into the
labour market sections of the population with relatively low participation rates (especially
women and older people) and continuously upgrading the skills of the labour force.
Improving productivity
Growth should also be based on bolstering labour productivity. Improving productivity
requires first and foremost a modernisation of the business environment. Policies in a
number of areas could help here.
The strengthening of competition in product markets can encourage innovation and the
implementation of measures to reduce production costs. Competition can be encouraged by
removing barriers to business start-ups and reducing the complexity of the regulatory
environment surrounding firms.
Productivity levels in business also depend on the efficiency of public administration. It is
commonly agreed that inefficient staff allocation and the operational framework of public
administration do not meet the requirements of the Greek society and economy in an efficient
manner, while reform proceeds at a relatively slow pace. In order to reap the full benefits of
the introduction of information and communication technologies in public administration,
training of personnel and upgrading administrative procedures are essential.
Creating the conditions in which economies of scale can be exploited is also important for
improving productivity levels. In the past, the small scale of Greek enterprises severely
hindered their ability to exploit economies of scale. However, globalisation and the opening
up of markets in the region have weakened this constraint. Additionally, the creation of
clusters of firms with similar activities can also help smaller companies benefit from
economies of scale by cooperating in cost sharing, know-how transfer and specialisation of
services and products.
A second area which can contribute considerably to raising productivity is that of
infrastructure. Despite the progress made, there is ample room for improvements in the
areas of both transport (land, sea and air) and network industries (energy, water and
communications).
Finally, investment in both human and physical capital has an important role to play. With the
opening up of new markets in the region, investment in physical capital has now become
more attractive. Of equal importance is investment in human capital through education and
vocational training. Whilst in Greece the percentage of 20-24 year olds who have finished at
least high school education is higher than in the EU-15 countries (84.1%, compared with
76.4%), the results of the PISA exams designed by the OECD to test knowledge and skills
showed Greek students performing much worse than students from the other EU-15
countries. At the same time, although technology is evolving rapidly, the percentage of
companies in Greece offering on-the-job training for their employees is lower than in the
EU15, while the participation of the population in life-long training programmes is low. These
observations suggest a need for closer cooperation between the education system, firms and
research centres.
Since many of the interventions proposed can be financed by the Community Support
Frameworks, they will not place an undue burden on public finances.
Conclusions
The best way to minimise the negative consequences for the Greek economy from the
continued crisis in the international financial system, external inflationary pressures and the
expected slowdown in the growth of world economic activity is to continue the efforts to
improve the fundamentals of the economy.
The aforementioned policies will bear fruit in terms of further raising living standards. In the
per capita
last 12 years, real GDP has risen by a cumulative 51%. However, despite strong
growth, 13% of employed persons, 25% of pensioners and 33% of unemployed persons are
still below the poverty line. Moreover, in between households that have already benefited
from growth and enjoy increasingly high incomes, on the one hand, and poor households, on
the other hand, there is also a considerable number of households living on the verge of
economic and social insecurity.
While the establishment of the National Fund for Social Cohesion is a positive step towards
tackling poverty and inequality, in itself it is not enough. It is also necessary to implement
policies for reducing unemployment, raising the percentage of skilled workers and facilitating
labour market entry.
To conclude, therefore, if living standards are to continue rising and the problems of poverty
and inequality are to be tackled, it is necessary to place much greater emphasis on
productivity-driven growth. Demand-driven growth which is not accompanied by rising
productivity has its own natural limits and cannot be expected to shelter the Greek economy
from the impact of a possible slowdown in world growth and a rise in world inflation. By
contrast, policies to improve productivity can better insulate the economy from external
shocks and lay more solid foundations for higher living standards in the future.