Untitled Document

Speech by Mr. Panayotis A. Thomopoulos,
Deputy Governor of the Bank of Greece

At the Economist Conference on
"GREECE AT THE THRESHOLD OF EMU

At the Brewery - London on 21.2.2000

1. I would like to speak about the role of the Bank of Greece in establishing stability oriented policies. President Clinton, recently, in Athens, addressing the Prime Minister, stated that Greece should be awarded the gold medal for the economy, and Mr. Papantoniou explained to you the reasons for this (inflation, budget deficit and growth).

2. The Bank of Greece followed the "3 Cs policy" and merits a smaller medal, that of consistency, continuity and confidence. Contrary to the past, when policies were pulling in different directions, the macroeconomic policy framework has been consistent since 1994. The Bank of Greece's monetary and exchange rate policies, on the one hand, and the government's fiscal, incomes and structural policies on the other, were interactive and reinforcing each other. On the continuity front, the Bank of Greece operated a stability oriented monetary and exchange rate policies without interruption. The Bank of Greece has not deviated, even during the 1997 - 1998 S.E Asia crisis, from the course it established in 1994. The Bank of Greece's handling of the latter and the smaller Russian crisis, and our perseverance established our credibility and the drachma's entry into the ERM in March 1998 boosted confidence.

3. I still remember at the end of 1997, I gave here a speech trying to explain that Greece is a high yielding, high profit economy, but not a high risk economy, and, therefore, we should be taken out of the emerging markets list. And when I was voicing concern about rumours that there was a need for a substantial devaluation, I tried to convince you that the macro and micro adjustments under way in Greece were guaranteeing a lasting improvement in competitiveness, and exchange rate adjustments were at best of marginal importance. In effect, the effective devaluation has been 2% on average between 1955 and 1999, less than that of many industrial countries, and down from 7% on average over the previous five years. The market-oriented recent revaluation of the drachma's ERM Central rate further underlines our belief in the crucial role of fiscal consolidation and product and labour market reforms as well as of privatisation in ameliorating competitiveness, which according to the more recent indicators (ULC, export penetration and balance of payment situation) has further improved in recent years.

4. The strong drachma policy, combined with a high real interest rate policy, which continues into 2000, have been our two main operating tools. What Greece lacked most in the previous twenty years was financial discipline. Government agencies and businessmen had to stop thinking that exchange rate changes would compensate for excessive wage and price rises, low quality products or neglect of cost - cutting investment.

To-day businessmen have shelved their old complacent attitudes, recognising that the road towards lasting competitiveness passes through: moderate wage rises, modern management techniques, high productivity growth, new investment to upgrade capacity and the quality of products. Private business investment in real terms was in 1998 some 64% above the average of the period 1990 - 1994 and in 2000 it is estimated to be 100% higher. The strong drachma dampened the wage - price spiral. In effect by curbing the increase in prices of imported goods and by forcing home producers to align their prices to those of imported goods it triggered the disinflation process. We considered then that a temporary loss of competitiveness was a small sacrifice for setting in motion a downward wage-price spiral and we have proven right as the widespread competitiveness benefits from disinflation have considerably more than compensated for the initial small loss of price competitiveness. The exchange rate policy went hand-in-hand with the high real interest rate policy, which is an essential ingredient of all anti-inflation strategies in high inflation countries. ?igh real interest rates, which by itself moderated domestic demand related inflationary pressures, also signalled to the market of the Bank of Greece's commitment to its strong anti-inflation stance, thereby weakening inflationary expectations, as well. It has to be noted that contrary to popular belief the high real interest rate policy supported the faster rate of GDP growth (3½% on average) over the last 3-4 years. This apparent paradox is due to the fact that during a phase of disinflation continuing high real interest rates are consistent with falling nominal interest rates.

5. Last year real interest rates on loans were 13% on average, roughly the same as in 1993. But in 1993 nominal interest rates were over 30% whereas last year they were 16% and next year they will be some 6 -7% for the business sector. The gain in cash flow has been phenomenal: for a loan of Euro 1 million a company paid 320.000 Euro interest in 1993, only half (Euro 160.000) in 1998, and one-quarter ($ 70.000) in 2001. This has been reflected in a marked reduction in financial costs, from some 30% of total company costs on average prior to 1994 to 13% in 1998, and probably less than 10% in 2001, when we enter the Eurozone and adopt the common interest rate structure. This marked reduction in financial costs has been a major factor for the restoration of healthy profits. They are among the highest in Europe. As in addition substantial capital has been raised through the Stock Exchange in 1999 (Euro 10 billion compared with only Euro 2 billion on average in 1997/98) augurs well for a further substantial growth of profitability over the medium to long-term. This is even more valid after taking into account that the sizeable private investment and infrastructure investments under way should start maturing as from 2001. Besides the surge in private investment, public investment also rose considerably: in 1992 there were in total - built since 1960 - just over 200 km of highways, at the end of this year there will be 800 km and from 2001 there will be additional 100 km every year. There are numerous examples of productivity gains in the pipeline; the introduction of new fast and environmentally friendly ships is worth mentioning for a country with many islands and the fact that our land route to Europe is practically cut off since the Yugo crisis. Travel time between Patras and Ancona, the main sea route to Europe, has been reduced by almost one half, from over 33 hours in the early 1990's to just over 20 hours last year and to 19 hours this year. Between Piraeus and Crete it will be reduced from 12 hours to 5-6 hours this summer, etc.

In short I want to say that tight antinflationary monetary and exchange rate policies have been accompanied by a revival of investment-led fast growth, because policies were consistent, continuous and restored business confidence. Boom and bust cycles have disappeared - steady course, erring on the side of caution has been our motto.

The transition to the single monetary policy is expected to be smooth. The Bank of Greece has already adopted the whole set of instruments employed by the ECB, standing facilities, open market operations and minimum reserves. We shall have to refine them further, and harmonize the relevant ratios to those of the ECB but we have been operating these instruments successfully over the last few years. The deposit facility operates with two tranches: in the first the interest rate is 9.5% and each bank is allocated a quota share and in the second tranche the interest rate is 8.5% and banks may deposit any surplus amount. These two tranches will be unified to fully harmonise them with the ECB. In addition open Market operations include weekly and monthly tenders for deposits or Repos with a maturity of 14 days and 3 months respectively. The Bank of Greece has also conducted fine-tuning operations, swap operations as well as limited outright sales and purchases of government securities. Greece participates in the TARGET and HERMES-Euro, which was activated with 30 banks, by processing domestic and cross-border payments in Euro. Hermes Euro owned and operated by the Bank of Greece offers real-time settlement in Central bank money, i.e. ensures immediate finality of the payments and allowing the re-use of funds within the day.

6. In the last few years the Bank of Greece also focused its policies on improving the operation and soundness of the banking system by reinforcing supervision and issuing directives, regulations and guidelines for improving internal control systems, risk management system and forcing the banks to write off quickly bad loans, or make corresponding provisions. Banks' accounts are now purified and transparent: dividends are paid out of realised profits and are no longer based on accrued interest of bad loans. The Bank of Greece supervising framework and regulations have been transposed from the E.C., but when necessary they were made even more stringent.

Banks have on average a capital adequacy ratio well in excess of 11%, comfortably above the 8% requirement and are rapidly introducing up to the state of the art management techniques.

7. The financial system will undergo an important change after entry into the Eurozone. Contrary to the Eurozone structural shortage of liquidity, covered by cash injections by the ECB to the tune of Euro 200 billion at the end of 1999, there is a structural liquidity surplus in Greece, which the Bank of Greece has been absorbing in order to contain inflationary pressures. The average daily absorption in 1999 amounted to Euro 12 billion: 8 billion under the compulsory reserve requirement (12% of bank assets) and Euro 4 billion the surplus liquidity freely deposited at the Bank of Greece. The later is now about Euro 2 ½ billion. In 2001, the compulsory requirement will be reduced to 2%, and the Bank of Greece once member of the ESCB will stop absorbing liquidity on its own initiative, so that in total almost Euro 10 billion of liquidity would be released. The basic reasons for the structural liquidity surplus are: first interest rates on short-term deposits were and still are high (8% in 1999, i.e. a real interest rate of 5,4%) and, second, because of high and fluctuating inflation up to recently Greeks were reluctant to invest in fixed interest rate bonds.

8. The bias in favour of short-term deposits and correspondingly the high degree of liquidity of bank assets is also reflected in an outflow to abroad of short-term capital, more than Euro 7 billion has been placed in the last few years. On the other hand, considerably larger amounts of long-term capital inflows from abroad have been recorded for purchases of Greek government bonds (in excess of $12 billion in the last few years). We suspect that, as in the case of Germany and Luxembourg, part of these "foreign" purchases of bonds have been financed by Greek capital flown abroad. The Bank of Greece will issue short-term certificates of deposit to mop up the released liquidity as the reserve requirement ratio is reduced to the 2% of the Eurozone. But in 2001 and thereafter Monetary policy operations in Greece will be conducted by the ECB, therefore, Bank of Greece's ability to absorb surplus liquidity on its own initiative will be nil. However, it should be noted that the total liquidity of the greek economy is expected to be much smaller once we enter the Eurozone, because: First, interest rates will fall to the low Eurozone levels and this fall will spur a rise in demand for loans, second foreign banks will stop placing short term assets in Greece once the interest rate will be at the Eurozone level, third, banks will place a substantial part of their remaining liquidity in other countries in Europe so that Greece will finance part of the Eurozone's structural deficit.

However, the main question is: can the Greek economy afford to deposit abroad its liquid assets at a rate of interest 3 ½ % and pay some 6% to foreign investors who buy greek bonds. The answer is no, and for this not to happen banks and other financial intermediaries should provide facilities and persuade investors to invest in Greek high yielding bonds.

9. At present financial institutions have not developed the required services and products to attract individuals to buy and hold bonds. But they will have to do so urgently if they don't want to hold considerable sums in low-yielding liquid assets.

10. The Bank of Greece, has one of the most technically advanced electronic trading system for bonds - HDAT - the electronic secondary security market - and this system can easily be developed further to handle retail transactions on behalf of individual banks. The Bank of Greece's immediate goal is, in collaboration with the banks, to promote retail bond transactions. In the last five months the Bank of Greece introduced the electronic trading of repurchase agreements in HDAT and an electronic credit management system, so that market participants can control their exposure to risks. Moreover, non-resident financial institutions will soon participate in HDAT. Their treasurers from their screens in London will trade Greek bonds through HDAT. This remote access system will be further enhanced in 2000 when, as we plan, HDAT will apply to be connected to the European MTS system and hence participants of HDAT will be able to trade directly in other European markets. Transactions in HDAT were just less than $ 10 billion per month over the last twelve months and $ 14 million per month the last two months, but more importantly, HDAT prices are the official and undisputed reference prices. These are used for direct trading between financial institutions and between the latter and their clients, so that the total volume of bond trading registered by the Bank of Greece Security Settlement System in a book-entry reached Euro 45 billion per month in the last twelve months, and 65 billion per month in the last 2 months. HDAT is a fully integrated market, inter-linked with the settlement system of the Bank of Greece. Settlement amounts are processed automatically and clearing is effected without any involvement of trading counter-parties.

Without HDAT it would have been impossible for the interest rate spread between bid and offer to have narrowed to less than 25 b. points from more than 300 basis points prior to HDAT. Likewise the interest rate spread over the 10 years bund from more than 300 basis points has been reduced to some 90 basis points. The related budget saving of interest payments is estimated at least Euro 250 million per annum and probably more. The development of HDAT will continue so that it can meet at any moment the highest technical and safety international standards, and in this way Greek bonds can be at par with other paper used for monetary policy operations by the ECB. In this connection, the Bank of Greece will soon introduce a fully automated valuation system enabling the Bank to apply haircuts on the market value of securities on a daily basis (i.e. the present 20% haircut will cease); the lowering of haircuts will remove a competitive disadvantage faced by Greek banks holding securities, thus further enhance their attractiveness. Using rigorous quantitative assessments of price behaviour of government bonds the bank will utilise soon market-oriented risk control methods in its collaterilised lending to domestic banks in contrast to methods based on face values. A corporate bond market is also expected to develop as gradually the tax treatment of corporate bonds is aligned to that of government bonds. A mature corporate bond market will also help to relocate (back to Greece) part of loans now raised through other European financial centres, often loans granted by greek banks operating abroad.

In a low-yield environment investors are increasingly seeking for return enhancement, and corporate bonds offer better return than government bonds. Likewise, more and more banks prefer to manage and issue bonds on behalf of their clients rather than to provide outright loans which affect their balance sheet and, their liquidity. Moreover, fees for issuing and managing a bond combined with the fact that a bond does not carry a credit risk often provides higher profits to the banks than loans. We think that there is still big potential for the development of the greek government and corporate bond market after Eurozone entry and this , despite the narrowing of the spread over the 10 year bond yield, which will encourage some investors to move to higher yielding emerging markets. We expect that his will be considerably more than compensated by investors who prime security (particularly pension funds and insurance companies) and the 30-40 basis points higher yield of the greek 10 year bonds will attract them. Indeed, there is a sizeable untapped market. Pension funds of larger countries which now focus on their home market, will gradually diversify their investments into other Eurozone countries and in Greece in particular as the currency risk is eliminated and credit risk gradually becomes nil as the government debt/GDP ratio moves to below the 100% and towards 60% mark. Other things being equal (i.e. risk premium), investors will be more aggressive and look for higher yields and for pension funds a yield difference (premium) of 0,40% per annum over the Bund cumulated over 10, 20, 30 years will weight heavily in financial investors choice.