To be tough or not to be?

Prime Minister Costas Karamanlis made it clear in his inaugural policy address this weekend that he wants to secure the maximum possible social consensus in implementing the government’s economic agenda. This could be a good short-term strategy and may serve well the government’s political goals in view of the short-term challenges, but it may have to be revised down the road as economic reality takes hold, requiring bolder and unpopular economic measures. There is no doubt that the new government inherited a number of difficult problems to solve in a relatively short period of time, namely the ongoing negotiations for the reunification of Cyprus ahead of its entry into the European Union (EU) and delays in the preparations for the Olympic Games. There is also no doubt that the conservative government will have to pay attention to the upcoming elections for the European Parliament, because any unpleasant surprise in their outcome could weaken its mandate, shore up the defeated Socialists and energize the pro-Socialist labor unions for a round of strikes and work stoppages in the fall. It is clear that the pre-announced revisions in the 2003 budget figures will drive the previous year’s deficit sharply up, with the estimates ranging from 2.7 percent to 3.3 percent of Gross Domestic Product (GDP), pushing the public debt-to-GDP ratio even higher. This may be bad news as far as economics is concerned but good news as far as politics is concerned, because it gives credence to the conservatives’ previous claim of bigger than initially estimated disparities in fiscal imbalances, enabling them to pinpoint the blame on the Socialists. The fact that the European Union pays lip service to the Stability and Growth Pact’s 3.0 percent of GDP threshold means Greece does not have to worry that much about being reprimanded by the European Commission for running a large deficit – at least this year. It is likely, though, that the first signs of discontent will come from the impatient capital markets. Some analysts do not rule out the possibility that a large deficit, especially if it ends up higher than 3.0 percent of GDP, will trigger a selloff in Greek government bonds, driving the yield spread of Greek bonds over bunds (the 10-year German government bonds) to 20 basis points from 16-17 basis points at present. (One percentage point is equal to 100 basis points.) Even these analysts, however, admit the impact is relatively small and may become negligible a few days after the initial spike, so that the Greek State does not feel the pinch when it seeks to borrow some 7.5 billion euros in the second quarter. In addition, they say that Greek government bonds with maturities of less than five years pay yields similar to other EU countries, such as Italy, which enjoy a higher credit rating. Greece’s long-term foreign debt is rated A+ by Standard & Poor’s (S&P) while Italy’s is rated AA. The widening of the budget deficit and the ensuing higher public debt-to-GDP ratio may not even compel the international credit agencies, such as S&P and Moody’s, to revise their outlook on Greece. Some analysts, like Piraeus Bank’s Miranda Xafa, contend these international organizations are fully aware of the situation, adding that the auditing of the fiscal accounts provides transparency. Others point to a recent S&P study showing Greece’s fiscal flexibility as relatively high, placing Greece in 11th place among 28 countries regarding to its ability to raise tax revenues if necessary because of its still relatively small tax base and low marginal tax rates. Other European Union countries such as Sweden, Germany, France are considered less flexible than Greece. Even so, however, the government has to be concerned for another reason. With the revised fiscal figures pointing to a deficit of around 3.0 percent of GDP in 2003 and most economists projecting a similar or even higher deficit-to-GDP ratio this year, this means Greece has to forget about getting a credit upgrade in 2004 and even 2005. Even if euro interest rates continue to stay at the current low levels, an expected cyclical economic slowdown and the government’s need to make good on some pre-election promises does not make a lot of room for fiscal consolidation even in 2005. Even if one assumes away the possibility of early general elections in case the current Parliament fails to agree on a new President of the Republic, the improvement in the budget deficit and the debt-to-GDP ratios may not be so drastic as to entail a credit upgrade by S&P or Moody’s or Fitch in 2005. What’s the real concern? The new rules for capital adequacy and credit risk management (Basel II) are supposed to come into effect in 2006, and it is known that Greek government bonds will be penalized if Greece fails to have its credit rating upgraded by then. Under the current regime, foreign banks buying government bonds of OECD countries, such as Greece and Turkey, do not have to set aside capital to do so. This makes these bonds attractive to them compared to others from non-OECD countries. Under the new rules of Basel II, this will change and Greek government bonds will carry a credit risk weighting of 20 percent from 0 percent at present, forcing foreign financial institutions to set aside additional capital. If Greece fails to put its public finances to the point where it merits a credit upgrade by then, it will find out it will have to pay a higher yield to the foreign banks to entice them to buy its bonds. This means higher borrowing costs and a larger deficit, ceteris paribus. So, acting to produce a much smaller budget deficit even this year may be necessary to avoid this trap. Undoubtedly, the new government deserves a grace period to prove it has what it takes to steer the Greek economy toward a sustainable growth path. From this point of view, ruling by consensus is a good strategy. However, economic realities dictate the need for the new government to take initiatives on the fiscal front and elsewhere, even if it means displeasing large segments of the population. Under these circumstances, a tougher approach may be required relatively soon to help Greece converge with the wealthier EU members in the mid-term and avoid the pitfall of setting in motion a vicious economic cycle. This tougher line though may prove incompatible with the ruling-by-consensus approach.

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