EMU strategy: lessons from Greece

The author draws the main conclusions from the convergence experiences of the eurozone countries in general and Greece in particular.

Several useful lessons may be learned from the convergence experience of those Member States which adopted the euro, and in particular that of Greece in January 2001, which was the first successful attempt by a country to join the euro area after the first wave of 11 founding members.

The importance of credibility in achieving convergence…

• The Greek drachma entered the ERM once substantial progress had been made towards nominal convergence. Entry into the ERM in March 1998 was made at a central rate involving a 12.3% devaluation in the drachma against the ECU, a development which made it possible to recover losses of competitiveness caused by the hard drachma policy*, but which was accompanied by an agreement with the Greek government, the aim of which was to reorganise the public finance system and undertake the requisite structural reforms in order to improve the economy and contain the inflationary impact of devaluation. The devaluation was, subsequently, partly reversed as the drachma strengthened on the foreign exchange markets.
• One crucial aspect of Greece’s convergence effort was the fact that the rate of economic activity remained relatively high, supported to a significant extent by Community funds, thus enabling the authorities to maintain their “hard drachma” policy and high interest rates, with no serious adverse effects upon the economy. This situation, which relied upon the credibility of the policies implemented, enabled nominal and real interest rates to drop.
• The credibility of the convergence objective was reflected in wage moderation in the public and private sectors, a phenomenon also observed in other EU countries in their drive towards EMU. This can be attributed to the desire of social partners to preserve competitiveness and employment, realising that devaluation would no longer be an option.
• The broad political support for the EMU project by the majority of the Greek political parties and public opinion was an important positive factor in stabilising expectations and deterring speculation in difficult times.

…and a careful management of capital flows

• The risks of destabilising capital movements can be reduced considerably by the implementation of sound and sustainable economic policies**. In the case of Greece the following steps have helped to avoid undesirable capital flows :
• Although not explicitly stated, a careful policy was followed of maintaining a safety margin when reducing interest rates, in order to keep the yield of drachma denominated assets attractive to domestic and international investors and ensure orderly convergence to euro area interest rates. Such a policy was also compatible with the disinflation strategy.
• The appropriate sequence of capital movement liberalisation was followed beginning with long-term and trade-related capital movements and ending with purely financial operations***. This approach, combined with the safety margin maintained in reducing interest rates, contributed to avoiding reversals in capital movement liberalisation. Elsewhere, such reversals proved to be very damaging to the credibility of economic policies.
• In parallel, the country set in place a strengthening of the financial system and the supervision of banking and capital markets, notably by adapting the legislation to the Community framework.
• There was no significant uncovered foreign currency exposure of the corporate sector, although borrowing in foreign currency has increased significantly since 1995, as foreign currency borrowing was, to a large extent, covered through “natural hedging” i.e. by receipts in foreign currency, mainly by companies engaged in tourism, shipping and export-orientated activities.

* In 1995, when a new thrust was given by the Greek authorities to the convergence effort, it was decided that a rapid disinflation of the economy was central to the convergence effort. Inflation was high, at around 11% in 1994, and its steady fall conditioned progress in meeting the rest of the convergence criteria, notably the exchange rate stability criterion and the government deficit criterion, given the high government debt ratio and, therefore, the high interest payments. The “hard drachma policy”, whereby the exchange rate was used as a nominal anchor, was at the centre of the disinflation operation, from the double digit figure of 1994 to the euro qualification inflation levels of 1999, and was an essential element of the whole macroeconomic and budgetary adjustment effort as specified in Greece’s convergence programmes.

** However, capital movements may in some cases provide useful information about inconsistent policies, enabling timely corrective action. If massive short-term capital movements occur, the monetary authorities have at their disposal ways to deal effectively with the undesirable effects of massive capital movements (in particular, interest rate changes and sterilisation operations).

*** The liberalisation of capital movements was completed in May 1994 with the removal of the last remaining restrictions on short-term capital movements.

This is a synopsis of amore detailed paperpresented at the Hellenic Observatory, European Institute, London School of Economics, on 20th January 2004. The views expressed in this paper are those of the author and do not necessarily reflect those of the Bank of Greece.

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