Strong currency bad news

It may mean little to politicians and others. However, the prospect of a strong euro for a country like Greece, facing a large current account deficit, is not a welcome development since it helps aggravate its international competitiveness, putting at risk its strong economic growth record in the medium term. Standard & Poor’s (S&P), the international rating agency, warned in a report recently that eurozone countries with huge current account deficits, such as Greece, ran the risk of being downgraded in the future if they did not take proper action to reduce the deficit. A lower credit rating leads to higher interest costs because investors demand a higher interest rate as compensation for the higher risk they assume. S&P rates Greece’s foreign currency debt with an «A,» the lowest among eurozone members, because of its high debt and interest expenses, lack of budgetary transparency and weak primary expenditure discipline. It was the first time since Greece joined the EMU (European Monetary Union) in 2001 that S&P explicitly linked the country’s credit rating with its burgeoning current account deficit amounting to some 9.0 percent of GDP. A Greek official rushed to downplay the report, pointing out that the country’s improving fiscal situation witnessed in a budget deficit of less than 3.0 percent of GDP this year and next along with a lower public debt-to-GDP ratio justified an upgrade and not a downgrade in the next few years. It was a correct assessment of Greece’s credit rating prospects on the condition the country does more to take care of its ailing pay-as-you go social security system and to institute more reforms in product markets and professions. Of course, this would not have been the case if Greece were not a member of the eurozone and had not adopted the euro as its currency. The country would have long before faced a currency crisis, prompting a devaluation followed by a sharp adjustment in fiscal, monetary and incomes policies reminiscent of similar episodes in the 1980s when the drachma was the national currency. Fortunately, Greece does not have to go through this unpleasant experience even if it has run a current account deficit in excess of 7.0 percent of GDP on average in the last five years or so. Moreover, it has been able to finance its external deficit at more favorable terms. Of course, the higher current account deficit reflects a number of factors which stem from the success of its economy to grow faster than its main trading partners. The strong economic growth translates into higher imports of capital goods needed for investment and higher consumer good imports. In addition, the trade deficit, which is a subset of the current account deficit, was augmented by higher oil bills as the price of oil more than tripled in the last five years. Nevertheless, a good deal of the sizeable current account deficit has more to do with the erosion of Greece’s international competitiveness than anything else. According to Eurobank EFG Research, Greece’s EU-harmonized core inflation differential vis-a-vis the EU-15 averaged 1.3 percentage points over the 2001-2005 period. Core inflation is basically the headline inflation minus the prices of volatile fresh produce and energy components. Headline and core inflation differentials have eased this year but continue to add to cumulative losses in competitiveness. Fast wage growth Economists have always attributed Greece’s large inflation differentials via the other EU countries to faster growing unit labor costs, which take into account both nominal wage growth and productivity gains. Nominal wage growth has outstripped strong productivity growth in excess of 2.0 percent per annum, producing higher growth in unit labor costs which along with other market imperfections leading to limited competition account for a good deal of the observed inflation differentials. This is unlikely to change in the next couple of years or so. Existing collective labor agreements and the economy’s strong growth will continue to support higher unit labor cost growth underpinning Greece’s higher inflation. Moreover, the preference of the government and in general the two major political parties to gradual structural reforms ensures that the country’s competitiveness will continue to deteriorate. This is more so as we enter 2007 which is likely to be an early election year. In this kind of environment, the appreciation of the euro against the dollar and other currencies is not the best news for the Greek economy. The euro rose above 1.30 dollars on Friday as markets became more convinced that the European Central Bank will continue to hike its main interest rate in the months to come due to better economic prospects in the EMU area and the Fed may even cut its main intervention rate next year to help boost the US economy. The appreciation of the euro may not be only bad news since it may help contain «oil sensitive» Greek inflation. It will do little though to alleviate the pain of Greek companies exporting in countries with dollar or dollar-linked currencies. In addition, Greek companies will see their sales in these countries translated into lower sales and earnings figures in euros, which may have an adverse effect on their shares if listed on the Athens bourse, other things being equal. Tourism may also be partly adversely affected. One may even go a step further and argue that the combination of a stronger euro and higher euro interest rates will put a damper on eurozone GDP growth in a year or so from now, therefore depriving the local economy of a growth driver. This, however, is not so obvious. Of course, the best remedy for the strong euro and the other factors undermining the international competitiveness of the Greek economy would have been a strong reformist agenda which would tackle the country’s longstanding problems. This could have even turned euro strength into a blessing by forcing private companies and the public sector to shape up and become more efficient. Despite the fact that a number of private companies have embarked on such a project long time ago, they have not been given the necessary institutional tools to bring about the optimal result and, given the politicians’ will to do little, the strong euro simply will add to Greece’s competitiveness woes.

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