By Dimitris Kontogiannis
Moody’s Investors Service may have surprised the markets with a multi-notch cut of Greece’s credit rating but the downgrade itself was hardly surprising.
The move underlines the increasing risk of a restructuring event and the country cannot hide from it. At some point, the government and other political forces will have to make up their minds and face the challenge head-on.
In the history of the European Union, there are a few cases where successful fiscal consolidation policies led to a sizable reduction in the public debt-to-GDP ratio over a long period of time.
The cases of Ireland and Belgium stand out. Ireland managed to slash its budget deficit by 20 percentage points of gross domestic product between 1978 and 1989, averaging a fiscal tightening of about 2.0 percent per annum over the 11-year period.
By 1989, its primary budget surplus adjusted for the ups and downs of the economy reached 4.4 percent of GDP and averaged 3.5 percent of GDP over the next five years.
It is reminded that a primary surplus results when revenues exceed expenditures excluding interest payments on public debt. A large primary surplus is important in bringing down a high public debt-to-GDP ratio along with nominal GDP growth surpassing the average interest rate paid for servicing the debt.
Belgium, a highly indebted country, managed to produce a large-scale fiscal adjustment over a long period of time to cut its debt from 141 percent of GDP in 1993 to below 100 percent in 2007.
Even Greece has a sizable fiscal consolidation to show. It managed to slash its budget deficit by 12 percentage points between 1989 and 1995, producing a cyclically adjusted primary surplus of about 5.0 percent of GDP at the end of the period and averaging over 4.0 percent by 2000.
In contrast, the country had a cyclically adjusted primary deficit of about 10 percent of GDP in 2009.
Before drawing any conclusions, one has to remember that Ireland, Greece and Belgium to a large extent had their own currency during the period of fiscal consolidation.
Moreover, the external economic environment was largely favorable as world trade picked up and Belgium benefited from the introduction of the euro and its low interest rates as of 2000.
Lastly, all fiscal adjustments lasted for many years and not just three as Greece’s economic program approved by the International Monetary Fund and the European Union entails.
Coming back to the present and Greece, one cannot but notice the economy entering its third consecutive year of recession with visible signs of deterioration as the fiscal tightening bites.
Fiscal tightening may be necessary for an economy to move toward a large primary surplus.
However, if it is significant and is applied to an already weak economy in a relatively short period of time with the private sector deleveraging, the GDP is bound to decline more than expected unless strong exports make up for the anemic domestic demand.
But Greece’s external sector is relatively small to offset such a drop in domestic demand and therefore nominal GDP growth remains subdued lagging the state’s average cost of funding.
This creates the so-called snowball effect compounding the public debt problem. This is more so for countries like Greece which have a high public debt to start with.
It is clear that only a reduction in the stock of public debt via privatizations and asset sales via pro-growth policies can turn things around. However, Greece has lost precious time in doing the necessary homework to prepare the ground for privatizations of state-controlled enterprises and selling public property.
Instead, it has focused most of its efforts on the strict implementation of the fiscal side of the economic program which the markets are unwilling to buy since it has helped dig the economy into a deeper recession.
It is ironic that Moody’s and the other credit rating agencies downgrade Greece by claiming that it has not done enough on the revenue side when tax revenues rose by 6.0 percent in 2010 despite an annual drop of 4.5 percent in the real GDP.
However, this is normal since their benchmark is the economic program approved by the IMF and the EU.
Few understand that the problem lies with the benchmark itself, that is, the unrealistic high targets on tax revenues for an economy mired in a multi-year recession and having a different structure than others in the EU with a high number of professionals and small firms.
Still, Greece cannot wait to hear the same song of downgrades from other rating agencies.
The government and other political forces will have to determine whether the country can serve its huge public debt and assume the economic, social and political cost or this cannot be the case.
If they decide the latter is the case then they will have to decide whether it is best to reduce the debt to sustainable levels, that is, between 80 and 100 percent of GDP, from its peak after consulting our eurozone partners and the IMF.
In our view, time is not on Greece’s side and therefore the sooner the better, assuming they decide sizable debt reduction is necessary and desirable.