EurozoneEY Eurozone Forecast September 2014

AustriaBelgiumCyprusEstoniaFinlandFrance

GermanyGreeceIreland

ItalyLatvia

LuxembourgMalta

NetherlandsPortugalSlovakiaSlovenia

Spain

Spain

Portugal

France

Ireland

Finland

Estonia

Latvia

Belgium

Slovakia

Austria

Slovenia

Italy

Greece

Malta Cyprus

Netherlands

Luxembourg

Germany

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Outlook for Greece

A return to growth, but fiscal risks remain

Spain

Portugal

France

Ireland

Finland

Estonia

Latvia

Belgium

Slovakia

Austria

Slovenia

Italy

Greece

Malta Cyprus

Netherlands

Luxembourg

Germany

1EY Eurozone Forecast September 2014 | Greece

Highlights

• After six years of recession, which saw the Greek economy contract by 25%, monthly indicators suggest activity has stabilized and the economy is no longer contracting. Indeed, the latest European Commission (EC) economic sentiment data suggests there will be growth in Q3.

• Retail sales and industrial production have both recently shown positive annual expansion, while the unemployment rate has plateaued at 27%. We now forecast GDP growth of 1.4% in 2015, after an outturn close to zero this year. However, Greece continues to face many challenges in translating this progress into a sustained recovery.

• Progress on the fiscal front has been little short of heroic. A fiscal deficit of more than 15% of GDP in 2009 has been transformed into a significant primary fiscal surplus in 2013. This was ahead of schedule and above the program target. Greece now has the highest cyclically adjusted primary surplus in the Eurozone.

• Nevertheless, although the pace of fiscal tightening should ease, more needs to be done in order to achieve a primary surplus of 3% of GDP in 2016. Currently, the International Monetary Fund (IMF) estimates a fiscal gap for 2015 of around 1% of GDP.

• The Government has been slow to implement structural reforms, which means the economy still lacks international competitiveness. Despite private sector nominal wages falling by 16% since 2009, the IMF estimates that the real exchange rate is some 10% overvalued and the anticipated contribution of net trade to positive growth has failed to materialize.

• The depth of the recession has also taken its toll on private sector balance sheets. Non-performing loans (NPLs) reached almost 40% at the end of 2013, while the coverage ratio (provisions over NPL) was only 49%.

GDP growth

2014

0.1% GDP growth

2015

1.4%

Unemployment

2014

27.1%

Consumer prices

2014

–1.0%

2 EY Eurozone Forecast September 2014 | Greece

A return to growth, but fiscal risks remain

The long recession is almost over …

After six years of recession, the Greek economy is on the verge of returning to growth. During the recession, the economy has seen a very significant rebalancing in the face of sizeable imbalances and high levels of indebtedness. Unfortunately, structural reforms aimed at boosting productivity have been slow. As a result, the adjustment has largely been through recessionary channels. This has seen GDP contract by 25%, income per capita fall by nearly 33% and over a quarter of the labor force out of work.

Few countries in peacetime have seen an adjustment on this scale and it is hard to do justice to the extent of the hardship imposed on the Greek people. The share of the population at risk of poverty increased from 20% to 23% between 2009 and 2012

and inequality has risen. As the IMF readily acknowledges, adjustment fatigue has set in and there is a desire to see light at the end of the tunnel.

Certainly, activity appears close to bottoming out. The declines in GDP have been getting smaller, with GDP down just 0.9% on the year in Q1. Moreover, the latest EC economic sentiment data points to growth turning positive in Q3. This is consistent with some of the other monthly indicators moving into positive territory; for example, retail sales were up nearly 4% on the year in April and industrial production was up 1.8% in May. As a result, we expect GDP growth of 1.4% in 2015, after an outturn close to zero this year.

The sense of bottoming out is also reflected in the labor market, where the unemployment rate has stabilized at about

27%. Bond yields have also fallen over the last 12 months, with 10-year interest rates at around 6%, down from 9% a year ago. Improving confidence across the whole of the Eurozone, combined with the improving growth prospects in Greece itself, has also enabled both the Government and banks to successfully fund themselves in the capital markets for the first time since the crisis started.

… but debt levels remain high

However, the crisis has undoubtedly left Greece with a significant hangover. For example, government debt remains extraordinarily high, at 175% of GDP. Servicing this debt will weigh heavily on Greece for many years to come, even if about two thirds of this is now owed to official creditors.

Table 1

Greece (annual percentage changes unless specified)

2013 2014 2015 2016 2017 2018

GDP –3.9 0.1 1.4 1.9 2.1 2.4

Private consumption –5.9 –1.2 0.8 1.2 1.4 1.6

Fixed investment –12.7 –1.8 3.4 5.0 5.0 4.8

Stockbuilding (% of GDP) 1.6 2.4 2.7 2.1 1.8 1.8

Government consumption –4.2 –3.3 –1.8 1.6 1.8 1.6

Exports of goods and services 1.3 5.0 5.0 4.9 4.8 4.9

Imports of goods and services –5.4 3.5 1.6 2.3 3.3 3.9

Consumer prices –0.9 –1.0 0.3 1.0 1.6 1.8

Unemployment rate (level) 27.5 27.1 25.7 24.0 22.1 20.3

Current account balance (% of GDP) 0.8 1.5 1.4 1.4 1.4 1.4

Government budget (% of GDP) –12.7 –2.8 –1.6 –1.3 –1.1 –0.8

Government debt (% of GDP) 175.1 179.9 177.2 172.1 166.2 159.7

ECB main refinancing rate (%) 0.5 0.1 0.1 0.1 0.2 0.8

Euro effective exchange rate (1995 = 100) 120.8 123.6 119.9 118.8 118.8 118.4

Exchange rate (US$ per € ) 1.33 1.34 1.27 1.24 1.24 1.23

Source: Oxford Economics.

3EY Eurozone Forecast September 2014 | Greece

Table 2

Forecast for Greece by sector (annual percentage changes in gross added value) 2013 2014 2015 2016 2017 2018

GDP –3.9 0.1 1.4 1.9 2.1 2.4

Manufacturing –4.4 –1.4 1.0 1.5 1.9 2.2

Agriculture 0.1 1.8 2.2 1.5 1.5 1.8

Construction –18.2 2.9 3.6 3.9 3.0 2.8

Utilities –2.4 1.2 2.6 2.5 2.7 3.1

Trade –6.8 –1.1 1.3 1.9 2.3 2.6

Financial and business services –2.8 0.5 1.4 1.6 1.7 2.0

Communications –8.9 0.9 3.3 3.2 3.3 3.6

Non-market services –0.4 –5.3 –0.7 2.0 2.0 1.9

Source: Oxford Economics.

The risk is that by constraining the Government’s capacity to finance new investment in either human or physical capital, Greece’s long-term potential growth rate is undermined. Official creditors are very much aware of this risk and are currently negotiating with the Greek Government to secure a further debt restructuring in return for a commitment to undertake structural reforms to enhance productivity.

It remains an official target of the IMF program to reduce Greek debt to 122% by 2020, although it remains to be seen whether this is wishful thinking. Certainly there is still considerable disagreement between official creditors on the extent of possible debt restructuring — it is too easy to bury these differences under overly optimistic forecasts.

In the short term, the biggest challenge facing Greece is the threat of deflation. Consumer price inflation has been falling consistently for the past 18 months, and in June was down 1.5% on the year on the harmonized basis. Although stable, unemployment remains exceptionally elevated, especially for young people, among whom it is over 50%.

There is clearly a risk that high unemployment and a large negative output gap will continue to weigh on earnings growth and undermine the prospects for consumption. Private sector nominal wages have fallen by about 16% since 2009. Unfortunately, the latest earnings data is only available with a considerable lag and currently still refers to Q3 2013. This shows the annual decline in hourly labor costs moderating to 2%, which is a significant slowdown in the pace of decline from Q1 2013, when hourly labor costs fell by 9%.

High unemployment likely to compress wages for a long time

With the economy beginning to stabilize, our forecast is conditioned on the view that deflationary pressures will begin to abate. Hence we expect consumer prices to fall by 1% on average this year, before posting a modest rise of 0.3% in 2015. In practice, this means inflation moving back into positive territory later this year and earnings stabilizing in line with unemployment.

Figure 1Contributions to GDP growth

Source: Oxford Economics.

% year

–12

–10

–8

–6

–4

–2

0

2

4

6

8

2000 2003 2006 2009 2012 2015 2018

GDP

Net exports

Domestic demand Forecast

Figure 2Unemployment

Source: Oxford Economics.

%

0

5

10

15

20

25

30

2002 2004 2006 2008 2010 2012 2014 2016 2018

Forecast

4 EY Eurozone Forecast September 2014 | Greece

A return to growth, but fiscal risks remain

Figure 3Prices and wages

Source: Oxford Economics.

% year

–9

–6

–3

0

3

6

9

12

15

18

21

1995 1998 2001 2004 2007 2010 2013 2016

Wages

Consumer prices

Forecast

Figure 4Government deficit and debt

Source: Oxford Economics.

% of GDP% of GDP

0

20

40

60

80

100

120

140

160

180

200

1995 1998 2001 2004 2007 2010 2013 2016–18

–16

–14

–12

–10

–8

–6

–4

–2

0

Government debt(right-hand side)

Government deficit(left-hand side)

Forecast

However, getting the domestic economy growing again is going to be hard. With both employment and earnings looking as if they will remain subdued, income growth will probably be weak. In the short term, this is likely to weigh on the prospects for consumption, which we continue to expect will contract again in 2014, before returning to weak positive growth in 2015. Nevertheless, it will take many years to reabsorb the under-utilized labor resources, during which time there remains a risk that the significant amount of slack in the labor market will continue to weigh on earnings growth.

Prospects for investment, however, look more positive and may represent an upside risk to growth, albeit from a very low base. For instance, construction activity has been decimated in the recession, having fallen by more than 95% from its pre-crisis peak. Although not yet reflected in the production indices, confidence in the construction sector has recently started to rise. Given the extraordinarily low level to which construction activity has fallen, there is scope for a recovery to make a significant contribution to growth and for the construction sector to absorb some of the unemployed.

Although still four percentage points below its long-run average, capacity utilization has also recovered strongly in Q3, which bodes well for business investment. Overall, after another fall (of about 2%) this year, we expect fixed investment to grow by 3.4% in 2015, rising to 5% in 2016.

Move to export-led growth disappointing, but tourism is strong

Despite the decline in earnings, exports have only very recently begun to show signs of responding to the implicit improvement in competitiveness and Greek export performance has generally

been weak. By far the biggest adjustment on the trade side has come from a collapse in imports, which reflects the weakness of domestic demand.

More positively, tourism receipts remain very strong and have contributed to the current account moving back into surplus. The structural reforms Greece has undertaken under the adjustment program have so far contributed to a 23% decline in relative unit labor costs, underscoring the improvement in competitiveness. This should help exports to be a significant driver of the recovery, in addition to the potential for the recovery in investment.

Few countries have undertaken a fiscal adjustment of the scale that has been imposed on Greece. Between 2010 and 2013, the structural budget adjustment has been of the order of 11% of GDP. And the European Central Bank, EC and IMF continue to press for further fiscal tightening. This year, Greece’s adjustment program targets an overall budget deficit of 2.7% of GDP and a primary surplus of 1.5%. Current targets for 2016 are for the country to reduce the overall deficit to 0.6% of GDP and run a primary surplus of 4.5%. The additional fiscal tightening this will require is currently put at 1.75% of GDP in 2015–16.

Greece’s long-term fiscal position therefore remains delicately balanced. After peaking at close to 180% of GDP this year, the IMF currently expects the debt-to-GDP ratio to decline to 128% in 2020 and 117% in 2022, before additional contingent relief measures from Greece’s European partners. However, this rapid decline is predicated on primary surpluses of over 4% of GDP being achieved and relatively high nominal GDP growth being sustained for several years. This outlook remains vulnerable to further fiscal slippage, delayed structural reforms that slow competitiveness gains, and lower-than-expected inflation.

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About Oxford EconomicsOxford Economics was founded in 1981 to provide independent forecasting and analysis tailored to the needs of economists and planners in government and business. It is now one of the world’s leading providers of economic analysis, advice and models, with over 700 clients including international organizations, government departments and central banks around the world, and a large number of multinational blue-chip companies across the whole industrial spectrum.

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