Inflation remains the single most important factor undermining Greece’s competitiveness
The state of Greek public finances and economic growth have captured the attention of the media and the general public for some time now and few are still paying attention to the country’s most chronic economic problem, that is inflation. With international oil prices propped up by increasing geopolitical risks, one has to wonder whether Greece can still afford to ignore the persistence of its high inflation. Even more so given the government’s intention to gradually increase the consumption tax on oil by a considerable amount over the next few years to align it with the EU average before the end of this decade. For starters, inflation has been the Achilles’ heel of the Greek economy for a long time, dating back to the first oil shock in 1973. It was put on the back burner after the country’s successful campaign in the second half of the 1990s to enter the eurozone because it fell to low single digits. Nevertheless, the inflation gap against Greece never closed as the average levels of consumer prices have remained 1.0 to 1.6 percentage points above the eurozone average since 2001. Greece’s superior growth rates have been frequently invoked to explain this inflation differential. According to this theory, which is partly correct, Greek inflation will continue to outstrip the average inflation in the eurozone as long as the actual GDP (gross domestic product) rate surpasses the country’s potential GDP growth, giving rise to bottlenecks that keep prices, especially in non-tradeable goods and services, high. The exact opposite happens in many large economies in the euro area, helping put a lid on price increases. But Greece’s consumer price inflation did not show signs of abating even in 2005 – a year of high but slower GDP growth than in 2004 – averaging 3.6 percent, according to the national definition. Given that inflation averaged a little bit above 2.0 percent in the eurozone where the country’s main trading partners are found, this practically means 2005 was another bad year for Greece’s international economic competitiveness. It is noted that the inflation rate differential is regarded by many economists as one of the most important indicators of international competitiveness. Economists here and abroad have noticed but, as before, have concentrated on this year’s projections, and taken a more positive view about the course of Greek inflation. They all project it to decline and average between 3.0 percent and 3.5 percent in 2006. Alpha Bank sees it falling to about 3.0 percent, conditional on oil prices and the euro/dollar exchange rate. According to Dimitris Maroulis, deputy general director at Alpha’s division of economic analysis, inflation could fall to 3.0 percent if the average price of oil does not surpass the 65-dollar-per-barrel mark and the euro/dollar stays in the 1.16-126 range. EFG Eurobank economist Platon Monokroussos sees it easing to about 3.2 percent this year, while Morgan Stanley’s Vincenzo Guzzo is less optimistic, putting it at 3.5 percent on average. Economists point to favorable base effects this year to explain the lower forecasts and a milder impact, if any, from world oil prices. The increase in the price of gasoline and heating oil is estimated to have added about 1.2 percentage points to average Greek inflation last year. The increase of the VAT (value-added tax) and other excise taxes on alcohol and tobacco added another 0.2 percentage points according to the calculations. But the oil price has rallied since December 28, 2005, from about 58 dollars to a high of 69.2 dollars a few days ago on strong oil demand and concerns about the adequacy of supply, prompting one after another of the large international banks to start revising upward their oil price forecasts for the year. Last week, it was the turn of French bank BNP Paribas to up its forecast for the average West Texas Intermediate spot oil price to 64.9 dollars per barrel from 56.3 dollars before by introducing a risk premium to reflect the probability of a supply disruption. Still, all these facts are underplayed by government officials who feel more comfortable talking about the high GDP growth rates and the progress on the fiscal front. The fact that the trade deficit, excluding oil and ships, narrowed by 740 million euros in the January to November 2005 period compared to the same period a year later, thanks to a pick up of 390 million euros in exports may have also influenced their attitude. Inflation is also hardly mentioned by stock market and bond market market participants. On the one hand, stock market players are more interested in economic growth since it directly affects the sales and therefore the earnings of listed companies and therefore pay little attention to the release of inflation figures, assuming the latter will not affect household consumption. On the other hand, bond market dealers and analysts are more preoccupied with progress on the fiscal deficit and the public debt than inflation since Greece joined the eurozone and official interest rates were set by the ECB (European Central Bank) in Frankfurt rather than the Bank of Greece in Athens. Still, Greece is one of the most vulnerable eurozone countries to oil price hikes, especially on the inflation front. According to an older UBS study, it is the most vulnerable country in the eurozone. The fact that domestic demand remains buoyant and price competition in key sectors of the economy is insufficient explain it. It is no coincidence that the transportation sector, which is very sensitive to oil, is one of them. Moreover, Greece has made it clear that it plans to gradually increase its consumption tax on oil to bring it in line with the average EU level in 2009. Given the overall size of the tax increase, between 20 and 25 percent, the time remaining and the urgent need to cut its budget deficit close to 3.0 percent of GDP, or even below if possible in 2006, the government has no option but to proceed with a tax hike on oil this year. This will definitely worsen the inflation outlook and will need a lot of help from unpredictable fresh produce prices to compress average inflation to well below 3.5 percent again this year. This means another year of loss in international competitiveness as average eurozone inflation is projected to average around 1.9 to 2.3 percent in 2006 depending on the estimates. If oil prices start climbing above 70 dollars per barrel and the euro does not advance significantly against the dollar to partially offset the impact, Greece more than others may have to start thinking of an older problem: the likelihood that oil induced inflation becomes a drag on GDP growth and a burden on fiscal consolidation.
