Inflation could pose great challenge for government
The international competitiveness of the Greek economy continues to deteriorate as evidenced by the growing current account deficit and is likely to worsen as the appreciation of the euro against the dollar and other currencies has reached record levels. This provides the new government with another reason to speed up economic reforms and limit the erosion of competitiveness to avert its adverse effect on economic growth down the road. The conservatives were re-elected to power a week ago on promises of more and deeper economic reforms. The composition of the new government left a good taste although many market participants continue to doubt whether it will have the courage to institute painful reforms given the ruling party’s slim majority in parliament, pointing to its failure to deliver in its previous term when it commanded a comfortable majority. History teaches that moving fast early in a term to implement unpopular reforms may be key to any government’s success on that front because political pressures build up as time goes by. This is something market players never omit to underline. The government should focus on a few major reforms and deliver instead of trying to institute many reforms at once, since to do so requires a good deal of preparation and many committed individuals which appear to be lacking. In this regard, the government may be more successful by sticking to a few feasible reforms which will make the difference and help the economy become more competitive in the medium term. Nothing underlines more the need for such action than the burgeoning current account deficit and the combination of a strong euro and record high oil prices last week. The current account deficit, which is used as a broad measure of a country’s international economic competitiveness, exceeded the -19 billion mark in the first seven months of 2007, up some 4.2 billion compared to a year earlier. The appreciation of the euro against not only the dollar – with the exchange rate surpassing the 1.41 level – but also other currencies, coupled with skyrocketing oil prices (more than 82 dollars per barrel) flashed new signals that things may get even worse before they get better for countries such as Greece. International credit agencies like Standard & Poor’s have repeatedly warned Greece, the country with the highest current account deficit in the eurozone, to reduce its high public debt ratio and huge current account deficit to avoid a downgrade of its credit rating in the future. S&P rates Greece’s foreign currency debt with an «A» and a downgrade would result in higher interest costs for the budget since the investment community demands a higher interest rate to buy more risky bonds. It is no secret that the national currency would have been under extreme selling pressure and likely devalued with a current account deficit in excess of 10 percent of Gross Domestic Product (GDP) if Greece were not part of the eurozone. However, being a member of euroland has made Greece less sensitive to such external shocks and policymakers along with most commentators and the media more complacent about it. The fact that the Greek economy continues to grow at annual rates of 4 percent or better, accompanied by falling unemployment and rising employment, has helped allay fears. Unfortunately however, the government and others may continue to ignore the problem because the expected upward revision of the country’s GDP in the next few weeks is going to lower the current account deficit as a percentage of GDP. In this respect, it is worth noting that Eurostat, the EU’s statistics arm, is expected to approve the upward revision of the country’s GDP by some 25 percent to capture part of the underground economy. Still, this will not help lower Greek inflation, running at an annual rate of 2.8 to 3 percent, converge with average eurozone inflation that is expected to be between 2 and 2.2 percent in the coming months, up from an annual rate of 1.8 percent at present. This means Greek products and services will continue to lose their price appeal in Eurozone markets and coupled with the euro’s strength will get hurt further in export markets with currencies linked to the US dollar or a basket of currencies. But the narrowing of the Greek-EU inflation differential requires more competition in input and product markets in the country which in turn translates into unpopular reforms in the form of opening up protected professions, making labor laws more flexible and reforming public enterprises. Making the labor market more responsive to sector and firm-specific conditions is key for the viability of corporations and the deceleration of unit labor costs which many economists and the central bank consider the main culprit for the Greek-EU inflation differential. Even if such reforms are undertaken, one should not expect Greece’s current account deficit to be eliminated in a short period of time. This is not necessarily bad because the consumption pattern and habits of the average Greek household are increasingly converging toward those of their European counterparts and cannot be satisfied by the local production base. In addition, economic growth requires more machinery and other capital goods which have to be imported because they cannot be found locally. So, part of the current account and a good deal of the trade deficit, which is its largest component, will not be trimmed as long as Greece continues to outpace its major EU trading partners in economic growth. Even though the strong euro helps offset part of the impact of higher oil prices on Greek inflation, its adverse effect on competitiveness is more pronounced because it makes tourism services, a significant source of income for Greece, more expensive and contributes to a slowdown in most eurozone economies. There is no doubt that the widening of the current account deficit and the combination of the strong euro and high oil prices make the situation more challenging for the new government. For a country ranked bottom of EU league tables when it comes to conforming with the targets of the Lisbon Agenda, actions should henceforth speak louder than campaign words about reforms. The jury is still out but the odds, at this point, do not favor major and fast structural reforms.
