Greek PM Unveils Further Fiscal Measures Aimed at Calming Markets

In a highly anticipated speech yesterday, Greek prime minister George Papandreou tried to assure the markets that his government is serious about solving the country's increasing fiscal problems. Indeed, he pledged to bring the fiscal shortfall to below 3% of GDP by the end of his premiership in 2013. However, the speech was thin on details and may not be enough to calm the markets.

Despite the lack of detail, Papandreou did propose several measures. In an attempt to please the markets, he announced that public sector wages above 2,000 euro (US$3,000) per month will be frozen in 2010. Although this is actually a significant measure by Greek standards, those who had called for pay cuts in the public sector—similar to those in Ireland, for example—will have been left disappointed. The recruitment of new permanent staff in the public sector next year will also be frozen, while retiring employees will only be replaced at a rate of five to one from 2011 onwards. Moreover, Papandreou announced that spending on social security will be cut by 10% next year, although he did not specify how this will be achieved.

On the tax side, Papandreou proposed a new income tax and the reintroduction of inheritance tax. Moreover, several tax exceptions will be abolished, while the government also proposed the introduction of a capital gains tax. In a move more likely to please voters than bring down the fiscal deficit, Papandreou announced that officials at public banks will not receive bonuses at all, while bonuses at private banks will be taxed at 90%.

Outlook and Implications

It is undeniable that Greece's fiscal problems are very serious. In mid-October, Finance Minister George Papaconstantinou announced that the fiscal deficit for 2008, which had originally been put at 3.7% of GDP, was now estimated to have been 7.7% of GDP. As a consequence, the fiscal shortfall is now expected to stand at a huge 12.5% of GDP in 2009, while government debt is likely to exceed 110% of GDP. Apart from reinforcing the lack of credibility of the government figures—built up by years of misreporting public finance data—the new, markedly revised fiscal data pose serious concerns about the future path of Greece's public finances.

These revised figures have resulted in a series of downgrades by credit agencies. The last, and most significant, revision was by Fitch, which downgraded Greece's rating from A- to BBB+. Under normal circumstances, the European Central Bank (ECB) would only accept bonds rated A- or above to use as collateral in its liquidity operations. This rule was relaxed as a result of the financial crisis, and now the limit has been lowered to bonds rated BBB-. However, in principle these emergency rules will only be in place until the end of 2010, raising questions as to whether Greek bonds will be eligible for use as collateral after that date should the situation deteriorate further.

The strongly negative market reaction to the downgrade by Fitch earlier this month put the government under intense pressure. It was clear that the markets did not consider the budget for 2010 tough enough, given the dire condition of the public finances, and the government needed to do something, and quickly.

Although yesterday's measures will not solve Greece's problems, they should give the government more time to build the political consensus necessary to implement the deep reforms the economy so urgently needs—not only to bring down the deficit, but also to make it more competitive. However, by failing to present a more detailed picture of how the exorbitant levels of public spending will be brought down, the government has risked upsetting the markets even further. Indeed, the initial market reaction has not been encouraging. The Athens Stock Exchange today opened more than 1% lower than yesterday's level, while the spread between Greek and German 10-year government bonds reached 252 basis points at midday—up from 226 at the start of the day. This suggests that these latest new measures may not be the last aimed at tackling the deteriorating public finances. However, the seriousness of the situation means that the government does not have any time to lose. Given its huge credibility problems and the strongly negative sentiment currently prevailing in the markets, failure to act soon will have dire consequences for the Greek economy.