Government risks market ire

The Greek government made the right choice in sounding the alarm over the gravity of the country?s economic situation at the Thessaloniki International Fair on Sunday, but once again it showed either it cannot or is unwilling to tackle the budget deficit and arrest debt dynamics by initiating deep spending cuts and overhauling the unproductive public sector.

This means the country cannot avoid the restructuring of its official debt but at least it may avoid the hard default scenario, meaning an exit from the eurozone, if it sticks to the new austerity measures to cut the budget deficit. The alternative is the soft default scenario, where the country defaults but stays in euroland, as we pointed out last week.

For a country like Greece facing the prospect of default after seeing general government spending shoot up to around 52 percent of gross domestic product in 2009 — a year marked by some one-off expenditure due to two elections — from around 44-45 percent of GDP in 2006, before falling to just below 50 percent in 2010, it should have been imperative to rely on spending cuts to attain the budget deficit target.

Still, the government chose to rely on raising taxes to reduce the budget hole. In so doing it succeeded last year in raising tax revenues by two percentage points to around 40 percent of GDP in 2010, although the economy contracted by some 4.5 percent in real terms.

The deeper-than-expected recession this year, now estimated close to 5.0 percent, has made it more difficult to meet the budget deficit goal of 17 billion euros from around 24 billion in 2010 by relying on the same sources since tax revenues are lagging.

Faced with the grim prospect of not receiving the next tranche of 8 billion euros from the European Union and the International Monetary Fund, the government was forced to accept cuts in the wage bill of civil servants and public sector employees and activate the so-called labor reserve pool for those employees working in state companies and organizations being shut down or merged.

But these cuts are not large enough to make a difference and the government?s unwillingness to go against its own constituency has resulted in putting a larger burden on the private sector. Yesterday the government announced a new tax on private property holdings to produce more revenues.

In so doing the Socialist government seems to lend credence to those analysts who have long suggested it will exhaust all possible tax revenue possibilities to meet the budget deficit targets, but will rather go into early elections rather than restructure the unproductive public sector and proceed with heavy-duty privatizations.

Still, this may be good enough for the country?s official creditors and their regularly visiting representatives, known as the troika, provided the budget goal is met, but it may not sit well with the markets.

The latter assign a high probability of a Greek default, in excess of 90 percent, and they will not easily change their mind because the Greek government may be sounding more alarming than before.

The troika might tolerate all the tax hikes and the state?s policy of owing more than 6.0 billion to the private sector while continuing to pay salaries to its employees, most of whom enjoy lifetime employment; however, the markets are not likely to change their mind and will demand serious, deep spending cuts to slash the budget deficit instead of the largely uncertain effect of tax hikes on revenues. In so doing, the markets will probably continue to impose pressure by all available means as long as they see the cuts are not happening.

This may translate into pushing the stock prices of large Greek banks on the Athens bourse to the point where their total market capitalization reaches the same level as Irish banks, forcing the recapitalization of some lenders before their major shareholders and the state wanted or planned.

Unfortunately for Greece, the markets have brought contagion to Italy and elsewhere, although not to full extent, so the argument of ringfencing Greece may not be so appealing as before to EU policymakers.

To sum it all up, Greece would have been in a much better position if its government had sounded as willing to act as this weekend a year ago. So it may be able to convince the troika about its determination to tackle the fiscal mess but it is unlikely to convince the markets, which demand deep spending cuts and a smaller public sector. As everybody knows, no one can fight the markets and this is also true for Greece. Having said that, the government may have succeeded in avoiding the hard default scenario and the country?s exit from the euro, provided it delivers.

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