Describes the preliminary findings of IMF staff at the conclusion of certain missions (official staff visits, in most cases to member countries). Missions are undertaken as part of regular (usually annual) consultations under Article IV of the IMF's Articles of Agreement, in the context of a request to use IMF resources (borrow from the IMF), as part of discussions of staff monitored programs, and as part of other staff reviews of economic developments.

Greece-2006 Article IV Consultation

Preliminary Conclusions of the Mission
October 20, 2006

Economic growth continues to be strong in 2006. Domestic demand is supported by low interest rates, rapid credit expansion, and rising employment. Fiscal consolidation, corporate tax cuts, and structural reforms have also begun to underpin activity. The external sector remains a drag on growth, but despite several years of eroding cost competitiveness goods exports have shown surprising strength, reflecting in part the pickup in export markets.

We expect growth in 2007 to be strong as well. The key factors that contributed to the expansion last year are set to continue, world oil prices have moderated, and Greece's prospects in Southeastern European markets seem favorable. However, euro-area monetary conditions have already begun to tighten and there are concerns that the U.S. economy may slow more sharply than now expected.

During the expansion of the past several years, the current account deficit has widened to an unsustainable level and private-sector credit has risen very rapidly. Medium-term growth is likely to slow toward its potential as these imbalances unwind. However, there is a risk of a sharper slowing of growth, and fiscal, financial, and structural policies will be needed to foster a soft landing.

The increasing current account deficit reflects years of strong domestic demand, persistent price and wage inflation differentials which have eroded international competitiveness, and, more recently, high oil prices. An orderly transition to a sustainable current account deficit will require lower domestic demand growth, more moderate wage increases-no more than Greek productivity growth plus the euro-area inflation rate-and further reform of product and labor markets.

Rapid credit growth is likely to continue for some time because financial deepening is not yet complete, as credit-income ratios are well below international levels. This development is a desirable and natural consequence of financial market liberalization, but poses risks to the financial system. Therefore, the supervisor will have to further strengthen prudential oversight and financial institutions to appropriately manage risks.

Fiscal consolidation has been the most urgent policy priority for the past three years. The authorities' substantial deficit reduction in 2005-06 is therefore commendable. This effort was appropriately concentrated on expenditure, and appears to have imposed little cost in terms of output or employment losses.

However, a steady and cumulatively significant strengthening of the public finances is still needed in the years ahead, with the objective of achieving a cyclically adjusted budget balance in 2010 and a surplus after that. Further deficit reduction would help support a gradual narrowing of the current account deficit by restraining demand and easing cost pressures, protect the public finances in the event of an economic downturn, and promote a rapid reduction of the public debt to help deal with the looming problems raised by population aging. Consolidation should focus on controlling current primary spending to preserve room for needed infrastructure investments and further tax cuts. Moreover, international experience suggests that restraining this type of spending maximizes the probability that fiscal adjustment will prove durable.

On currently available information, the 2006 budget deficit target seems likely to be attained, although the authorities will have to control outlays and vigorously enforce tax collection for the balance of the year. However, adjustment shifted toward reliance on revenues, including through some one-off measures (although not all of those in the budget have been used). In addition, according to the most recent estimates initial expenditure targets will be exceeded, although revenues will also be higher than budgeted owing to an intensified effort to combat evasion and some indirect tax increases.

The draft 2007 budget offers little further consolidation. As a fraction of GDP, the general government deficit falls only slightly, reflecting mainly lower interest payments, and both revenues and primary spending are little changed. Buoyant economic conditions provide the opportunity to take bolder action. A larger reduction in the deficit would be preferable in order to continue an appropriately countercyclical fiscal stance and to make further progress toward a medium-term budget surplus. We welcome the decision in the budget to end the recourse to temporary measures, which will improve the quality of fiscal adjustment. We strongly recommend that durable spending measures, rather than temporary ones (including tax amnesties), be used to meet deficit-reduction goals.

The further reduction of the corporate tax rate is welcome, as it should improve the business climate. Although the details are not yet available, personal income taxes are also to be reformed beginning next year. Apart from rate reductions, significant benefits would be achieved by broadening the tax base by phasing out the long list of distortionary exemptions. In any case, these measures should not be allowed to jeopardize progress on fiscal consolidation.

Substantial reforms to expenditure management will be critical to sustain fiscal consolidation and strengthen the operations of the state more generally. The recent initiative to develop program-based budgeting is therefore welcome, but the benefits will be reaped only when this approach is fully integrated into budget preparation and execution. The creation of the new directorate of fiscal audit is also welcome, and it should focus on evaluating programs against objectives and ensuring value for money. The development of a medium-term budget framework would help to guide fiscal strategy and prioritize policy objectives, including during the further consolidation needed in the years ahead.

Strengthened tax administration is needed for durable fiscal consolidation, and would also improve economic efficiency and the business climate. Progress is being made on this front, including by focusing tax audits on larger cases, clarifying corporate deduction rules, improving VAT collection, and reforming regional tax offices and the tax appeals process. Nevertheless, reform efforts need to continue. Tax evasion remains a particular problem, undermining revenues and imposing a high burden on those in the formal economy. The authorities' initiatives of last year to tackle this problem, which appear to have succeeded in raising tax revenues, are therefore welcome and should be redoubled.

Unless the social security system is fundamentally reformed, the long-term costs of population aging are expected to threaten the sustainability of the public finances. The necessary task of estimating aging costs has proceeded slowly, and therefore the National Actuarial Authority should quickly be brought up to full strength and data provision by social security funds speeded up. All social partners should step up efforts to build momentum for reform, including by supporting the work of the Analytis Committee, which will be crucial for an early adoption of concrete measures. Reforms have been taken in the health-care sector, but the key challenge remains providing quality medical services while containing costs.

The commercial banking system enjoys high capital and liquidity ratios, and profitability remains robust, driven by rising lending volumes in Greece and Southeastern Europe. However, households may become overextended and asset quality degraded as credit continues to grow at very high rates. Also, high NPL ratios persist despite very strong domestic lending, indicating that banks may need to refine their risk management practices further. And increasing reliance on non-retail and potentially more volatile funding sources may raise costs and undermine profitability.

The attention paid to these issues by the Bank of Greece (BoG) is commendable. The BoG has stepped up its monitoring of banks' lending standards, strengthened provisioning requirements, increased the risk weighting on high loan-to-value residential mortgages, and introduced new liquidity requirements. Looking forward, the BoG should continue to carefully supervise banks' risk management practices and maintain close cooperation with its counterparts in Southeastern Europe. Regarding the insurance sector, the new supervisor needs to be made fully operational and the authorities should ensure a smooth transition as it takes up its duties.

Strengthening international competitiveness will require further reforms to product and labor markets, including by improving public administration. Greece still lags on many indicators of competitiveness and dynamism, as indicated by the chronic weakness of FDI inflows (notwithstanding a pickup this year). The authorities have embarked on a commendable program of product market reform to improve the business climate. Simplified business licensing procedures have been introduced for industrial firms but should be extended to the much larger commercial sector. The overhaul of bankruptcy legislation, which appears to be nearing fruition, is welcome. Network industries are being liberalized, but convergence to EU requirements should be accelerated.

Some welcome initiatives have also been taken in the labor market, notably the easing of overtime restrictions and reforms to integrate immigrants into the formal economy, but progress has otherwise been relatively limited. Labor markets perform poorly by international standards and, despite recent restraint in the public sector, wage increases have been too large to preserve international cost competitiveness. Measures that should be considered include relaxation of strong employment protection legislation, and decentralization of the bargaining system, including opt-outs.

Measures to strengthen the performance of state-owned enterprises (SOEs) are welcome. The introduction of private-sector terms of employment (though for new employees only), improved governance, and the submission of annual business plans should, over time, increase productivity and reduce the dependence of SOEs on the state budget. Further moves toward privatization, most recently the sale of stakes in the telephone operator OTE and three banks, are also welcome. This policy should be continued, including by privatizing those SOEs that have been put on a commercial footing.

Public-private partnerships (PPP) are beginning to be put in place under the new law. Although it is too early to judge success, we welcome the intention to subject projects considered for PPP financing to cost-benefit tests and to integrate them into the wider public investment strategy. A full accounting for the costs, including future budgetary obligations, should be presented in a transparent way with the budget.

Economic statistics have improved substantially in recent years, but need to be strengthened appreciably. Improvements to the quarterly national accounts, which are in train, and the publication of full financing-side fiscal data are two urgent priorities. The recently announced revisions to the national accounts points to the need for a policy of timely updates, since the long lag since the last major revision contributed to the large size of the update and thus to a distorted picture of the macroeconomy in the interim. Also, the initial skeptical reaction in many quarters to the announcement of the revisions suggests the need to strengthen the credibility of the national statistical office, particularly by granting it independent status.
Athens, October 20, 2006



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