Both sides have to give some ground

The Greek economy is likely to beat this year’s official GDP growth forecast and advance faster next year, but it is doubtful whether it will continue to do so in the future. A number of people argue Greece has entered a new norm of slow economic growth for years to come, putting in doubt the sustainability of the country’s public debt. So, it makes sense for Greece to implement a number of structural reforms with more rigor and the European Union to honor its commitment for debt relief based on the Eurogroup’s decision back in November 2012.

At the time of writing it was not clear what the government will choose to do next – i.e. commit to fiscal and other measures to entice the troika – the chief auditors of the lenders – to return to Athens and complete the last review of the EU program for Greece, or seek snap elections. Brussels has made it known the review has to be completed before agreeing to a precautionary credit line (ECCL) from the European Stability Mechanism (ESM) and going over the sustainability of Greek debt.

The coalition government would like the current adjustment program to end and have an agreement in place for the day after, comprising the precautionary credit line and some debt relief measures. This way, it thinks the chances of a new Greek president being elected by the current Parliament next year will be enhanced. But the fiscal measures demanded by the troika to close a disputed fiscal gap in 2015 and other actions to comply with program commitments entail a good deal of political cost.

Its task has become more difficult for another reason. The government’s publicly stated strategy of concluding the program by end-2014, replacing the remaining International Monetary Fund loans with market funding and even not getting a precautionary credit line from the ESM has raised public expectations.

We have repeated in the past that the government’s biggest mistake was to alienate its sole ally, the markets. It was not so much to fend off the troika’s demands, although the satisfaction of the markets would have meant a better working relationship with the representatives of the European Commission, the IMF and the ECB. The alienation of the markets killed its strategy.

The markets understand Greece does not need another dose of fiscal austerity, barring some minor measures, to fill the disputed fiscal gap in 2015. Whether next year’s primary surplus ends up at 2.5 or even 2.3 percent of GDP compared to the target of 3 percent is not important. They understand the Greek debt is mostly in the hands of the EU and that the latter does not want to bankrupt the country so a smaller primary budget surplus will not make the public debt less sustainable. But it can make the difference in keeping the economy growing faster and creating a virtuous economic cycle which is preferable to the debt trap of slower growth.

However, this approach on fiscal consolidation was conditioned on Greece’s continuous efforts to reform its economy. Again, the markets, as far as we understand, did not expect the government to carry out all the reforms penciled in the program. However, they wanted some reforms to be implemented to keep the positive momentum going. Instead, they got all this government talk about exiting the program, the end of the relationship with the IMF and almost nothing in reforms since last May.

Some even accuse the government of helping augment the leftist SYRIZA party’s lead in opinion polls and further raising the political risk, undermining their investments. Some of these people are angry with the government because they bought 3- and 5-year government bonds, believing in the Greek story and are now recording sizable losses, threatening their funds’ annual returns and in some cases their bonuses. This will make it more difficult for Greece to access markets at reasonable interest rates in the foreseeable future. Therefore, it will likely depend on official lending to close next year’s funding gap, estimated at 12.5 billion euros by the IMF last June.

It is ironic that all this is happening at a time when fresh GDP data are confirming early market expectations that Greece is emerging from the six-year recession in 2014. The annual real GDP growth rate is estimated around 0.6 percent for the first nine months of the year and could end up higher, beating expectations when the fourth-quarter figures come in, according to economists.

The economy will likely grow faster next year, but protracted political uncertainty and fiscal measures may undermine the goal for 2.9 percent growth. Even if that goal is attained, a number of economists and others in the market question whether Greece can maintain a satisfactory growth rate in the medium to long term. This is so because of the burden imposed by the large primary surpluses to the tune of 4-4.5 percent of GDP from 2016 on, the lack of sufficient output and input reforms and the effects of hysteresis, that is, the impact of the prolonged recession on the country’s human capital and productive capacity. In other words, they are concerned Greece has entered a new norm of slow growth in the medium to long run which may resemble Portugal’s.

By losing market access the government has become more vulnerable to the demands of the troika and is in a difficult political position. To avoid a new norm of slow growth in the medium to long run, duped “Portugalization” by some, the political system will have to accept the rigorous implementation of more structural reforms to boost competitiveness and the EU will have to provide debt relief to ease the fiscal burden by lowering the required primary budget surpluses.

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