While the Greek economy is expected to grow in 2017, the Bank of Greece has underlined that a series of challenges and threats must be addressed and warns that the reform efforts must carry on. As the Bank of Greece argues in its interim report, it is critical to complete negotiations on the second bailout review as soon as possible.

Progress with the implementation of the programme and with economic recovery must not be halted

The present Interim Report on Monetary Policy is submitted at a time when negotiations with the institutions on the second review of the European Stability Mechanism (ESM) programme are at a crucial stage. Progress with the implementation of the programme so far has had beneficial effects on liquidity and confidence and is reflected in the encouraging GDP growth data for the third quarter of 2016, the positive fiscal developments, as well as improved bank results. These outcomes enhance the prospect of an economic recovery and a definitive exit from the crisis, as the Bank of Greece already pointed out last June in its Report on Monetary Policy 2015-2016. This is not merely useful, but also imperative at a time of significant external shocks and potential risks. Under no circumstances should this progress be halted.

This emerging positive momentum in the economy needs to be supported and consolidated through adherence to the programme targets and an accelerated implementation of the reforms and privatisations agreed on. Any differences must be worked out at the negotiations table, in a genuine spirit of cooperation with the institutions and our partners.

The consistent and persistent implementation of the programme would enable the adoption of decisions on medium- and long-term measures to ensure the sustainability of Greek public debt and on the inclusion of Greek government bonds in the ECB’s quantitative easing programme. Such a development would pave the way to the full return of the Greek government and Greek businesses to international financial markets.

A strengthening of growth is projected for 2017

In the first part of 2016, the economy continued to be weighed down by the capital controls and the uncertain economic climate caused by the protracted negotiations. Against this background, GDP contracted in the first half of 2016, dragged down mainly by a decline in consumption (private and public) and a negative contribution from the external sector, in contrast with investment which trended upward. The completion of the first review, however, laid the basis for an easing in financing conditions and a pick-up in economic activity. Meanwhile, the resolution of pending issues under the first and the second review – such as the completion of the privatisation of regional airports and of the old Athens airport at Hellinikon – gradually turned the economic climate around.

Although short-term activity indicators and soft data present a mixed picture, ELSTAT data for the third quarter of 2016 suggest a significant rise in GDP by 0.8% quarter-on-quarter and by 1.8% year-on-year, signalling a return of the economy to an upward path, with GDP growing by 0.2% year-on-year in the nine-month period from January to September 2016. This performance was mainly driven by a rise in gross investment and a rebound in consumption, whereas the contribution of net exports to GDP growth was negative.

The forecasts of the Bank of Greece for the Greek economy point to a recovery of activity starting in the second half of 2016 and gathering pace in 2017, 2018 and 2019. Specifically, the Bank of Greece expects GDP to grow by a marginal 0.1% in 2016, before picking up to 2.5% in 2017 and further to 3% in 2018 and 2019, supported by investment, consumption and exports.

On track to a new, extrovert growth model

Looking at the course of the economy from a longer-term perspective, Greece has since the start of the crisis clearly made remarkable progress in correcting the fiscal and external imbalances that led to the crisis in the first place. More specifically:

•An unprecedented fiscal consolidation was achieved, with an improvement in the “structural” primary budget balance by 17 percentage points of potential GDP over the period 2009-2015, twice as much as the adjustment in other Member States that were in EU-IMF programmes;

• The cumulativeloss in labour cost competitiveness vis-à-vis our trading partnersrecorded between 2000 and 2009has been fully recouped;

•The external deficit has been eliminated, with a cumulative improvement of more than 15 percentage points of GDP over the period 2008-2015;

•Recapitalisation and restructuring have taken place in the banking system, enabling it to withstand the crisis and the flight of deposits;

• Substantialstructural reformshave been implemented in the labour and product markets, as well as in public administration.

The above improvements are expected in the long term to raise the growth potential of the Greek economy by fostering faster labour productivity growth and job creation.

The reforms implemented so far have contributed to an emerging restructuring of the economy towards a new, extrovert growth model, based on tradables and a higher share of exports in GDP. The available evidence is already strong and points to this restructuring gaining momentum, provided that all of the reforms still pending are implemented.

Challenges that need to be addressed for a successful restructuring of the economy

Despite the significant progress in the last few years and the recouping of international competitiveness in labour cost terms, restoring price competitiveness still lags behind. Furthermore, despite the improved cost competitiveness, goods exports still fall short of the level expected on the basis of historical correlations between the variables. This can in part be explained by the lack of sufficient financing, comparatively higher long-term borrowing costs, heightened uncertainty, as well as by the fact that progress with product market reforms and the removal of the various barriers to investment has been slow, compared with labour market reforms.

An acceleration of reforms can be expected to speed up the recovery and the restructuring of the economy towards tradables and increased exports. However, this shift to an export-led growth model also requires improvements in the financing and liquidity of the economy and the removal of disincentives to boost investment, broaden the export base and upgrade the (currently low) technology content of Greek exports. This in turn presupposes a well-functioning banking system, giving priority to the effective management of the high stock of non-performing loans (NPLs). Progress on this front would impact favourably on economic activity and productivity through a higher supply of bank credit and lower borrowing costs for businesses and households. Meanwhile, the resolution of NPLs would not only further improve banks’ capital adequacy ratios but would also free up funds which, if channelled into productive businesses and sectors, would in the long term contribute to restructuring the economy and raising total productivity.

Signs of an improvement in liquidity

On the basis of the latest data available, bank deposits of non-financial corporations, households and non-residents recorded a cumulative net inflow in 2016. In terms of annual rates of change, overnight deposits rose significantly. Substantial amounts of banknotes were redeposited with banks, while there were also cases of repatriation of funds.

Improved bank results

In the first nine months of 2016, Greek commercial banks and their groups reported marginal pre-tax profits, after years of loss-making. In all three quarters so far, net income exceeded provisions for credit risk.

Also, for the first time since the start of the crisis, non-performing exposures (NPEs), as defined by the European Banking Authority (EBA), decreased in absolute terms. Meanwhile, the coverage ratio remains at roughly 50%; this ratio comes close to 100%, when the value of collateral is added. Another positive development was the decline in the Texas index (i.e. the ratio of NPEs to the sum of tangible common equity capital and loan loss reserves) by 15 percentage points to 126%, which however still remains high at twice the EU average.

In terms of capital adequacy, the Common Equity Tier 1 (CET1) ratio on a consolidated basis in September 2016 rose to 18.1% (December 2015: 16.3%) and the Capital Adequacy Ratio to 18.2% (December 2015: 16.5%).

In response to these favourable outcomes, Moody’s recently revised its outlook on the Greek banking system to “stable” from “negative” amid funding and profitability improvements.

Improvements in the legislative and regulatory framework in order to address the problem of non-performing loans

Key to the recovery of Greek banks’ lending activity will be their effectiveness in tackling the high stock of NPEs, which represents the major challenge for the Greek banking system. The NPE ratio for domestic banks on a solo basis stabilised at 45.2% in the first nine months of 2016. Particularly high NPE ratios were recorded for loans to SMEs and professionals, especially in the food services, textiles, paper and wood manufacturing, as well as in the sectors of construction and trade.

On a positive note, some progress has been made in addressing this most crucial of challenges for the domestic banking system. Specifically, in the first nine months of 2016, the banks increased NPE restructuring by 11.3%, in most cases through recourse to long-term forbearance options, which now account for some 44% of all forbearance and resolution and closure solutions.

Furthermore, banks are now required to comply with concrete operational targets (both results- and action-oriented) for the management of non-performing exposures in their portfolios. These targets were agreed upon in June 2016, after the Bank of Greece and the ECB held consultation with Greece’s four core banks, and concern the period from the second quarter of 2016 through 2019. According to the first “Report on Operational Targets for Non-Performing Exposures” recently released by the Bank of Greece, the core banks have committed to reduce their non-performing exposures by about 38% (or roughly €40 billion) by 2019. This reduction will be achieved through long-term forbearance measures and resolution and closure solutions, selective loan write-offs, collateral realisation and loan sales.

Meanwhile, important legislation has also been adopted to speed up court proceedings in general and to simplify the resolution and special liquidation of businesses, to protect vulnerable borrowers and at the same time take measures against strategic defaulters and, finally, to allow banks to assign the management of and/or transfer of non-performing exposures to specialist companies authorised by the Bank of Greece on the basis of strict criteria.

In this connection, the Bank of Greece, by Executive Committee Acts No. 82/2016 and No. 95/2016, established the regulatory framework for the authorisation and supervision of credit servicing and credit acquiring companies. It should be recalled that all companies that choose to operate in this market will be subject to strict rules on the protection of borrowers (households and businesses) and will be required to comply with the provisions of the Code of Conduct.

Risks to the recovery

Despite the current positive indications and the progress achieved, the outlook for the Greek economy remains subject to risks.

The most significant and immediate risk relates to a failure to reach a timely completion of the second review of the programme, especially in the light of upcoming national elections in a number of euro area countries.

Furthermore, the achievement of the fiscal outcome in 2016 is subject to downside risks, related to measures announced by the Greek government on 8 December 2016 corresponding to a fiscal loosening of roughly 0.4% of GDP. These measures, which were announced after the present Report went to print, reduce significantly the estimated safety margin beyond the target for 2016. Besides, the execution of the 2016 Budget has not yet been completed and the general government performance for 2016 has not been finalised.

Also, any postponement of decisions on the part of our partners on concrete measures aimed to ensure the long-term sustainability of public debt, would hamper the improvement of Greece’s economic and investment outlook and weaken the prospect of a return of the Greek government and Greek businesses to international financial markets and, thereby, the prospect of a definitive exit from the crisis.

On the domestic front, a number of obstacles continue to weigh on the business environment and investment. Some of these obstacles have to do with excessive red tape, but others stem from minor or major vested interests and opposition from local stakeholders. As a result, significant investment projects have stalled. Failure to address these practical deterrents to investment could even jeopardise the prospect of economic recovery, considering that one of the key growth pillars in the years ahead is the anticipated growth of investment.

Given that fiscal consolidation has for the most part relied on revenue-side measures, there is a risk that higher taxation could have a greater-than-expected dampening effect on economic activity. Thus, an improvement in the fiscal policy mix would be desirable.

Despite notable progress and the upgrading of the relevant legislative and regulatory framework, there are still some gaps in the legislative framework that impede the drastic reduction in the volume of non-performing loans, with possible negative repercussions on the capacity of credit institutions to finance new investment.

Finally, there are significant risks regarding the course of the global economy and the recovery of world trade, relating, among other things, to the rise in populism and anti-European rhetoric, the rise in political uncertainty in several advanced economies, a surge of protectionism worldwide and a possible worsening of the refugee crisis. These risks could slow down the recovery of the Greek economy, through negative impacts on tourism and trade flows and through a slower than anticipated decline in Greek bond yields on account of risk aversion from international investors.

Prerequisites for speeding up the restructuring of the economy and bolstering the recovery

In order to address the above risks, correct any previous slippages and confirm the positive outlook for the Greek economy in 2017, specific coordinated actions are required, along the following lines:

1.Pragmatism and flexibility both from our partners and the institutions and from the Greek side, with a view to the timely completion of the second review of the programme.

2.An acceleration of the pace of implementation of reforms and privatisations. The government must remain committed to the timely implementation of the structural reforms and privatisations agreed on with our partners. This entails lifting the remaining obstacles that stall even privatisations already approved.

3.Addressing the problem of non-performing exposures. 2016 saw the adoption of several amendments to the institutional framework, and practices have been initiated that should contribute decisively in the immediate future to addressing the problem of non-performing exposures on bank balance sheets. Still, the size of the problem has not allowed a significant strengthening of the Greek banking system’s intermediation activity and ability to inject sufficient financing into the real economy.

Therefore, apart from the efforts made so far by banks and the relevant legislative and regulatory reforms already enacted, there is still need for the following:

• The introduction of a framework for out-of-court workouts, so as to ensure a rapid, effective and transparent resolution of arrears owed to the private but also to the public sector.

• Amendments to legislation on matters related to:

‒ the tax treatment of impairment losses and loan write-offs;

‒ the rights of creditors against non-cooperating shareholders during the restructuring of ailing businesses;

‒ the legal protection of bank and public entity staff during the restructuring of businesses; and

‒ the development of a sound and effective framework for promoting NPL workouts for common borrowers.

A more active NPL management policy on the part of banks, in tandem with a full implementation of the reforms already legislated and a removal of the legal impediments identified, would improve the asset quality, profitability and liquidity of the banking system. This would translate into more credit for the real economy, thereby supporting investment and contributing to the creation of new businesses and jobs and, more generally, to economic growth.

4.Addressing the public debt overhang problem and achieving a realistic adjustment of fiscal targets. The implementation of specific measures that ensure long-term public debt sustainability would enhance the credibility and acceptance of the policies pursued, thereby helping to consolidate confidence and strengthen economic recovery and facilitating a sustainable return to the financial markets once the programme is completed.

At the same time, according to estimates from the Bank of Greece, a lowering of the fiscal target from 2018 onwards to a primary surplus of 2.0% of GDP (from 3.5%) would be feasible, if combined with mild debt relief measures. The easing of the primary surplus targets, together with the implementation of the agreed structural reforms, would put the necessary conditions in place for a gradual lowering of taxation, with positive multiplier effects on economic growth.

5.Changes to the fiscal policy mix to make it more friendly to entrepreneurship and growth. This could be achieved by placing greater emphasis on cutting non-productive expenditure, increasing efficient utilisation of public real estate and boosting the efficiency of public administration, in particular the tax collection mechanism, while at the same time reducing tax rates.

6.Tackling the problem of long-term unemployment. Active employment policies and training programmes can serve to reduce unemployment, especially among the social groups most affected. Meanwhile, a consistent implementation of the action plan against undeclared work would bolster formal employment, with a favourable impact on social security contributions, and reduce the ensuing distortions to competition among businesses.

7.Easing and ultimately lifting the remaining capital controls. The gradual relaxation and ultimately the lifting of capital controls, as confidence and liquidity improve, are expected to contribute to a normalisation of economic conditions by facilitating both enterprises and individuals with their transactions.

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The Eurogroup decision of 5 December 2016 is a small positive step towards the completion of the ESM programme. With this decision, our partners deliver on their commitment to provide partial debt relief in the form of ‘short-term’ measures, as agreed on. These measures are expected in the long run to reduce public debt by some 20 percentage points of GDP, as well as the annual gross borrowing needs of the Greek government.

On the downside, however, an agreement has yet to be reached on the completion of the second review. And there is not much time left, in the light of upcoming national elections in a number of euro area countries. In order to preserve the positive momentum emerging in the economy, the Bank of Greece calls on the partners and the institutions as well as on the Greek government to display pragmatism and flexibility, to set aside any matters that hamper the execution of the programme and to re-assess them once the differences have been worked out, and to focus on what has been agreed on, so that the review can be completed as soon as possible.