Following the scandal over the interception of mobile phone calls, the government and PASOK, the Socialist main opposition party, found a new battleground on which to cross swords recently after the European Union’s statistics service (Eurostat)’s ruling on the proper way to record expenditures on military equipment in the budget. Even though this issue may be important for political reasons, it is clearly out of touch with the economic reality, which is dominated by the expected impact of rising interest rates on GDP growth and the real estate market in particular. Eurostat’s ruling that government expenditures should be recorded at the time of the actual delivery of each independent part of the military equipment provided PASOK with the opportunity to hit back at the conservative government’s initiative in seeking a fiscal audit after its return to power in early March 2004. The audit, which led to a major upward revision of past Greek budget deficits and put the country under surveillance by the European Commission, has been characterized as imprudent by senior PASOK officials, such as former prime minister Costas Simitis, but has been defended as the right thing to do by senior government officials, including the prime minister. Whatever the case, the fact is Eurostat’s recent ruling on the method of recording military expenditures will not lead to major changes in the country’s fiscal balances, lending more credence to the government’s argument that some 8 billion euros in military procurement spending had not been recorded in previous budgets from the 1997-2003 period. In this regard, Greece will still have to bring its budget gap below the 3.0 percent of GDP threshold this year with rising interest rates in the eurozone, paving the way for a tougher adjustment down the road. So, arguing about the fiscal audit may be useful for political purposes, but it does not really make economic sense and, at this point, doesn’t lead anywhere. On the contrary, the upward revision of expectations about interest rates in the eurozone, the US and Japan poses a greater risk to the real economy and financial markets worldwide, including that of Greece. It is known that market participants now assign greater probability to the scenario that pegs the European Central Bank’s (ECB) official rate at 3.25 percent by year-end than they did even 10 days ago. Some claim that this is not necessarily bad since it reflects better prospects for economic growth ahead and may be a blessing in disguise for a country with high inflation like Greece. They add that interest rates in Greece would have been higher if the country had its own currency to compress inflation. Assuming average inflation of 3 percent and a real interest rate of 2 percent or more, short-term interest rates should have ranged between 5 and 7 percent, that is a far cry from the current level of 2.5 to 2.6 percent, they claim. Even if one agrees with the assessment that at 3.25 percent, the level of interest rates will still be low by historic standards, one cannot dispute that it will burden borrowers, households and companies alike, and soak some excess liquidity out of the financial system. This is more so because interest rates are rising elsewhere as well. Given the high dependence of securities markets on ample liquidity to advance in recent years, this poses a threat. More so in risky assets such as stocks and local markets that have rallied the most, as has the Athens bourse. The heavy dependence of the Greek market on foreign institutional money makes it more vulnerable to international developments than before, especially if the companies fail to deliver the kind of high-earnings growth expected by market participants. It is understood that this is not the ideal environment in which to float state-controlled companies and raise more than 1.5 billion euros in privatization proceeds to help reduce the public debt as Greece intends to do. Higher long-term yields But higher short-term interest rates have also helped drive up long-term rates as more signs of a pickup in economic growth are becoming evident. The higher long-term bond yields imply deficit-ridden countries, such as Greece, will find it more expensive to borrow down the road. It is noted that the yield on the 10-year Greek government bond approached 4 percent last week. So, even though there will not be any immediate impact on the cost of debt servicing in the near future, countries with greater fiscal imbalances will feel the pinch the most. This is more so if yields continue to march higher. The combination of higher short-term and long-term interest rates in the bond and money markets will also test the strength of the real estate sector, which has played an important role in both absorbing the tremors from the collapse of the stock market and provided a boost to economic activity. According to a recent CSFB report, Greece is second to Finland among the EU countries with the highest proportion of variable mortgage rates. This means Greek borrowers will feel the pinch of the ECB’s campaign to push its official interest rate to normal levels much more than their counterparts in Austria, Belgium or France, where variable-rate mortgages account for less than 30 percent of the total compared to 90 percent or more in Greece and Finland. Property market The fact that real estate holdings account for the lion’s share of Greek households’ wealth makes the case more complex and the economy more vulnerable to rising interest rates. The property market represents about 90 percent of Greek households’ wealth and therefore plays a significant role in determining private consumption and consumer confidence. Moreover, private residential investment accounts for about 20 percent of total investment spending. Since both consumption and investment spending are the two pillars of Greek economic growth, it is easily understood that a slowdown in the property sector due to higher interest rates will have adverse implications for the economy and consequently fiscal consolidation. Of course, one cannot easily predict the exact effect of higher short-term rates on the real estate market. It is obvious, however, that it is going to be a significant hurdle, especially if the ECB jacks ups its official rate to 3.25 percent by year-end and proceeds with more increases to bring them to 3.5 to 3.75 percent in 2007. This is because Greek homeowners are more exposed to rising interest rates since they fund their mortgages via variable rate products. The fact that a large supply of new houses is expected to hit the market in the first half of 2007 also weighs. All in all, the prospect of rising interest rates in the eurozone and elsewhere constitutes a major challenge ahead for economic policymakers. Therefore, Greek current and would-be policymakers should stop fighting it out over things of the past, such as the fiscal audit, and focus instead on the future by finding new innovative ways and policies to tackle the budgetary and other economic problems that are likely to loom ahead.