The Greek economy is facing the prospect of a much more painful economic slowdown in the first half of 2005 than envisaged a few months ago, threatening to surprise on the downside even the most pessimistic GDP growth forecasts for next year. At the core of the problem lies a developing liquidity squeeze among private sector firms which is likely to result in a surge in non-performing loans, putting more pressure on many banks at a time they are striving to cope with issues related to the introduction of IFRS (International Financial Reporting Standards). Businessmen and bankers alike talk of serious liquidity problems facing a growing number of firms, spanning different sectors and emanating in many cases from a common source – their interdependence with the state. It is known that a good deal of large local private sector firms have relied on state contracts to grow and become dominant in their sectors in the last few decades. As a consequence, their suppliers and subcontractors also became indirectly dependent on the state for survival. The influx of EU structural funds and the larger Public Investment Budget (PIB), the easy monetary conditions resulting in the lowest interest rates seen in generations, and the boost in investment spending linked to the Olympics all helped oil the private sector machine the last few years. This in turn helped fuel both investment spending and to a lesser extent private consumption, paving the way for above average EU growth rates in the area of 4.0 percent. However, the widening of the fiscal budget deficit to more than 5.0 percent of GDP this year along with the steep upward revision of past deficits, which has put Greece under the EU’s microscope, has made it more difficult for many private sector firms as the state cannot fully honor its commitments. It is known that the state owes some 1.3 billion euros to construction firms for projects related to the Olympics but most of this money will not be paid before next year. Construction company executives also complain of delays in awarding major projects, pointing out it may take more than six months into 2005 before they are actually assigned. Relatively small scale projects in the order of 10 to 30 million euros may keep them going for a while, provided the State makes timely payments, but even so cannot satisfy all construction firms whose backlog of is projects dwindling. In addition, the absorption of EU structural funds is below the expectations of year-to-end November, putting another liquidity constraint on private sector firms participating in infrastructure and IT work under the PIB auspices co-financed with EU funds. The supply chain effect has ensured that smaller firms in these and other related sectors feel the pinch, making it imperative that they try to reduce costs and delay some investments. Firms in other sectors, such as pharmaceuticals, seeking money owed to them by state-controlled entities, are also feeling the squeeze. In most cases, they have been forced to borrow and service debt while awaiting their money, compounding the problem. Others exist in sectors such as retail clothing, spinning mills and hotels which face similar problems for other reasons, relating more to their competitiveness in a changing environment. Given the situation, deterioration is likely in the business environment in these sectors, which may spill over to other segments of the economy in the months to come. This will surely put a brake on economic activity in the first half at the same time the government strives to contain the budget deficit to avoid straining its relationship with the EU. Fully aware of the above possible developments, bankers express in private concern that the economic slowdown may indeed turn out to be worse than expected. Even though they do not rule out a marked improvement in the second half of 2005, provided the tourist pick up meets and exceeds expectations, they say the 3.0 percent GDP growth rate forecast should not be taken for granted. This has led some to expect an rise in non-performing loans, especially for firms in the financially battered sectors. This in turn raises the issue of the quality of banks’ loan portfolios and their provisioning policies at a time some strive to find solutions to their unfunded pension liabilities and assess the impact of participations along with stock and bond portfolio valuation on their profits and equity. Unfortunately, there is no way out. With the government aiming for a 2.8 percent of GDP deficit on an optimistic 3.9 percent growth target and Brussels watching, the room to maneuver is very tight and the prospect of state aid is non-existent. In this regard, a number of noncompetitive firms will be forced out of business, lay off staff or be sold to cash rich competitors. Even so, the impact on financial institutions’ balance sheets should be limited in most cases, although a few banks are likely to feel it more than others. Of course, the announced cuts in corporate tax rates and the new development law may provide relief on aggregate investment spending but experience shows there are time lags in execution and, whatever the positive impact, this will not be felt before the second half of 2005. Remember that the corporate tax rate will be slashed to 25 percent in three years’ time, from 35 percent at present, starting next year. One can also not rely on other schemes, such as public-private partnerships and private finance initiatives, which could have had a positive impact on economic activity, before early 2006 as it is not likely the relevant legislative framework will be in place before the summer. Could the external sector then surprise on the upside and lift Greek economic growth. Perhaps, but this is likely to be felt at the most in the second half of 2005. All in all, Greek GDP growth may suffer a setback in the first half of 2005 if the effect of liquidity squeeze on a number of local firms becomes evident, putting pressure on some banks’ bottom line along the way.