OPINION

Greek economy at a difficult crossroads

After a year of fiscal adjustment and structural reform involving many sacrifices, Greece is still facing major challenges in a highly adverse and turbulent market environment. Therefore, the better part of wisdom suggests the need for Greece to intensify and accelerate its efforts to build a firm foundation for financial stability and sustainable growth.

It should be recalled that, about a year ago, the Greek economy was on the verge of total collapse and debt default. After three decades of generally inappropriate policies and public practices, including widespread corruption and tax evasion, Greece faced the serious dual problem of a very large public sector deficit and debt and a substantial loss of external competitiveness; this was exacerbated by the delayed impact of the global financial crisis on the domestic economy. According to the latest official data, in 2009 the overall fiscal deficit of the general government widened to as much as 15.4 percent of gross domestic product, or more than five times the ratio allowed under the euro area?s rules, the public debt soared to the equivalent of 127 percent of GDP, and the loss of competitiveness relative to trading partners reached some 25-30 percent. These key indicators continued to worsen in early 2010, while economic activity declined and unemployment grew, to the point that market confidence virtually evaporated and Greece effectively lost access to borrowing from international capital markets at reasonable interest rates.

Under these conditions, which for far too long had been ignored due to the strong resistance of vested interests and a lack of political will, in May 2010 the Greek authorities undertook an ambitious three-year program of macroeconomic adjustment and structural reform, with unprecedented financial support (totaling 110 billion euros or about $145 billion) from euro-area partner countries and the International Monetary Fund. As set out in the government?s economic policy memorandum (the now-famous and controversial ?mnimonio? in Greek), the program?s basic objectives are to restore fiscal sustainability and bring the public debt under control, improve the outward orientation and competitiveness of the economy, and safeguard the financial sector while protecting the most vulnerable population groups. Most important, the overriding goal is to re-establish policy credibility and revive the economy and job situation as soon as possible.

The government made a strong start in program implementation, particularly in seeking to reduce the overall fiscal deficit through a combination of painful expenditure cuts in wages and pensions and of substantial increases in value-added and other taxes. The fiscal strategy has been anchored on the fundamental objective of reducing the overall fiscal deficit from 15.4 percent of GDP in 2009 to less than 3.0 percent in 2014 and, especially important, turning the so-called primary fiscal balance (which excludes public debt interest) from a deficit of 10.1 percent of GDP to a surplus of 6.0 percent respectively. In the event, the overall fiscal deficit was brought down by about five percentage points of GDP in 2010, a large adjustment indeed in one year. At the same time, the authorities adopted a far-reaching pension reform (characterized by Greece?s partners as one of the most ambitious undertaken by any country in one step) and initiated a number of other structural reforms, especially a liberalization of collective bargaining arrangements.

But this encouraging initial phase of program implementation has not been without major problems and concerns. Not unexpectedly, the economic recession deepened (with real GDP declining by about 4.5 percent in 2010), though labor costs started to fall and the external position improved fractionally; and there have been considerable political and social tensions and resistance to reform. On the fiscal side, there have been significant revenue shortfalls, not only because of the drag of a worsening economy but also because of the persistence of substantial tax evasion; and there have also been weaknesses in expenditure controls and overspending by sub-national entities. Thus, the overall fiscal deficit for 2010 was reduced only through larger-than-programmed cuts in central government spending, which are evidently unsustainable. These problems apparently became more acute toward the end of the year, contributing to a most recent upward revision of the overall fiscal deficit for 2010 by about 1 percentage point to an estimated 10.5 percent of GDP. There has also been a further fiscal slippage of roughly the same order in the first few months of 2011. As to the pace of structural reforms, indications are that a number of recent reform measures have ?remained basically on paper? following their legislative approval, while others have been delayed due to technical difficulties or political considerations.

Therefore, despite the government?s initial adjustment efforts, the Greek economy is now at a difficult crossroads, requiring more resolute, deeper and accelerated macroeconomic and structural reforms to achieve the program?s medium-term objectives. These are also essential to ensure uninterrupted European and IMF financial support. In particular, the following actions are urgently needed to secure fiscal sustainability, improve competitiveness, and revive the economy and jobs:

a) In the fiscal area, much stronger and more balanced measures should be implemented in order to achieve the programmed reduction of the overall fiscal deficit to the equivalent of 7.5 percent of GDP in 2011, as well as ensure fiscal consolidation over the period 2012-15. First, as further tax increases are unlikely to be productive, priority should be given to strengthening tax administration and vigorously combating tax evasion. Legal prosecutions of tax evaders (particularly the largest and wealthiest) should be speeded, as they would not only help improve revenue performance but also foster a sense of fairness that would assist social cohesion in support of the program. Second, the civil service should be downsized more rapidly. Third, non-priority outlays should be reduced and expenditure controls tightened, especially at the levels of local governments, the social security funds and public hospitals, while ensuring the protection of the poorest groups. Fourth, every effort should be made to boost public investment from both national and external sources. And fifth, the large deficits of state enterprises, notably in the transportation sector, should be reduced if not eliminated rapidly through appropriate tariff increases, permanent reductions in operating outlays, improvements in management, and privatization arrangements.

b) In the area of structural reforms, which are so critical for promoting competitiveness and economic recovery (in the absence of an independent exchange rate policy), high priority should be given to fully implementing already legislated reforms, including liberalizing labor markets, opening up the many highly regulated professions, and simplifying and boosting the business environment for investment and growth. In addition, other key reforms should be expedited, notably cutting administrative barriers to exports, as well as tourism and the retail trade sectors, strengthening public procurement procedures, and enhancing the competition authority. Evidently, major reforms will also be required to develop a more effective education system, rationalize the national health system, and foster research and development.

c) In the financial sector, continued efforts should be made to reinforce bank liquidity (as banks gradually reduce their reliance on the exceptional support of the European Central Bank); restructure fragile banks, notably the Agricultural Bank of Greece (in light of the results of the recent stress tests); and strengthen financial supervision and regulation of the banking and insurance sectors.

d) Lastly, accelerated efforts should be made to rationalize the use of the large portfolio of state assets through a strong privatization and real estate development program. Although there are certain administrative and legal issues constraining the sale of certain state assets, Greece has the potential to achieve the tentatively set target of 50 billion euros via its privatization program by 2015 (through various means, including sales of at least part of the state?s considerable holdings in a host of enterprises, as well as in infrastructure and Olympic Games facilities). With decisive government action, this could become a very successful element of the reform program, providing the country with substantial resources to reduce a significant portion of the public debt (possibly through buybacks of Greek government bonds from the secondary market and the European Central Bank).

These reform efforts will have to be sustained for many years, not only because they are much needed for the transformation of Greece into a more vibrant and competitive economy but also because they are required to come to grips with the country?s large public debt overhang. Even if the Greek economic program were fully implemented, the public debt would peak at the equivalent of nearly 160 percent of GDP in 2012, before declining moderately in the next few years; and under a baseline scenario, it could drop further to some 130 percent of GDP by 2020, still a very high level. But if the medium-term growth of the economy could be accelerated by one percentage point to say 3.5 percent a year in real terms, this would bring the debt down to about 92 percent of national output by 2020. Nevertheless, substantial vulnerabilities and risks remain, particularly in the years immediately ahead, when Greece?s continued commitment to reform will be scrutinized, financing requirements will remain substantial, and a return to capital markets for long-term borrowing will be seriously tested.

At the March 2011 meetings of the European Council, where major decisions were taken to foster competitiveness and growth in the euro area, Greece obtained in principle some debt relief from its European partners through a virtual doubling of the average maturity of their program loans to 7.5 years, coupled with a reduction in the interest rate on the loans by 1 percent to about 4 percent. The IMF intends to provide similar relief to Greece through a conversion of the current standby arrangement into an extended arrangement, as soon as European governments confirm the above changes. Clearly, while alleviating the debt profile of Greece, particularly over the period 2013-15, these changes do not alter the country?s public debt stock (estimated at about 330 billion euros at end-2010).

Although the recent decisions in the euro area have been significant, there are continuing market concerns about developments and prospects in the periphery, especially Greece, Ireland and Portugal. In the case of Greece, market sentiment has been excessively adverse these days, with interest rate spreads reaching all-time highs, notwithstanding the country?s ongoing adjustment efforts. In this climate, there has been an intense debate and feverish speculation about the sustainability of Greece?s public debt situation. On the one hand, many prominent academics, investment analysts and pundits in the mass media have been arguing in favor of a restructuring of the Greek public debt, sooner rather than later. On the other, the Greek government and most European government officials have consistently ruled out debt restructuring as neither necessary nor desirable. But given the country?s large financing needs in an adverse environment, there is a question as to what would happen if Greece is unable to reaccess international capital markets in 2012 and subsequent years even if its program remains on track. Greece?s medium- and long-term borrowing needs from the markets are now estimated at 27 billion euros in 2012, 38 billion in 2013, and much more in the following two years. The presumption is that if Greece indeed continues to pursue its reform efforts in earnest, it is unlikely to lose the support of its euro area partners and the IMF.

Under the current euro area financing facility, no debt restructuring is envisaged. However, the recent euro area decisions establishing the permanent European Support Mechanism (ESM) as of 2013 indicate that in the event that the debt of a member state requesting ESM assistance is deemed unsustainable, an adequate and proportionate form of private sector involvement will be expected to help restore debt sustainability, i.e., some form of debt restructuring will be required. In light of the experience with debt restructurings over the past three decades, various scenarios have been advanced recently. According to some analysts, to be most effective, a debt restructuring would need to involve a ?haircut? of the privately held Greek sovereign debt by some 50-65 percent. But there is a strong fear in many quarters that such a haircut would seriously affect the position of some European banks and especially Greek banks and insurance funds, as well as fuel contagion across the monetary union as a whole. Alternatively, a debt restructuring could take the milder form of a voluntary stretch-out (or reprofiling) of the debt maturities of the bonds without significantly altering their net present value (as in the case of Uruguay in 2003); this would probably require some form of credit enhancement to ensure acceptance. Of course, such debt rearrangements would be no panacea for Greece and would still require determined adjustment and reform measures.

In conclusion, there is no doubt that Greece needs to focus its efforts on fully implementing the current program, as it may need to be adapted, with a view to consolidating its public finances (and especially generating a sizable primary fiscal surplus to service interest payments) and ensuring an early economic recovery and growth. Continued progress toward these goals would help Greece regain policy credibility, while leaving its options open to restructure its debt as this may become necessary in cooperation with its partners. In this process, the most recent euro area decisions augur well for the future of the monetary union. But these should be reinforced with more consistent and credible arrangements and pronouncements that would buttress ?cohesion? and ?solidarity? within the union.

*Evangelos A. Calamitsis is a former director at the International Monetary Fund.