The latest IMF staff report on the Greek economy contains a detailed analysis of the fund’s view on the economic situation in Greece and its future prospects. Key elements of the report include:

  • The economy is expected to contract by 5% in 2012, with the debt ratio leveling at 167% of GDP in 2013.
  • Bank recapitalization due to the PSI and NPLs is projected to approach 50 billion €, lowering gains from the PSI deal (actually government debt will increase since new funding for the period 2012 – 14 will be close to 173 billion €).
  • Budget adjustments of 2.75% of GDP are required for 2013 and 2014, in order to achieve a sustained primary balance of 4.5% of GDP (2012 balance projection is close to 1%).
  • Potential growth is calculated around 2%, while long-term growth is lowered to 1-1.5%, making long-term debt sustainability challenging.
  • ULC competitiveness deficit stands at 15% and is required to be eliminated within the next 3 years, mainly through real wage adjustments.

Overall, the task of stabilizing the Greek depression, without destroying the social fabric seems challenging (to say the least). Debt sustainability is based on almost impossible terms, which include strong continued fiscal consolidation of more than 5.5% of GDP,  closing of the competitiveness gap and a sustained rebound in economic activity within the following year.

What is very interesting is the fund’s own view on the capacity of internal devaluation schemes to produce working results, especially compared to the route of currency devaluation. In general, it seems that even the IMF is not sure about its own medicine having positive effects, while projected cumulative output loss is comparable to those of Argentina and Latvia.

IMF Internal Devaluation View

Internal devaluations are almost inevitably associated with deep and drawn-out recessions, because fixed exchange rate regimes put the brunt of the adjustment burden on growth, income, and employment. Depending on the size of the imbalances, the strength of adjustment measures, and the responsiveness of key macroeconomic variables, the duration of the initial adjustment period has ranged from 5 quarters (Hong Kong) to  15 quarters or more (Argentina before abandoning convertibility), while the depth of the downturn has varied from shallow growth recessions (Germany, Netherlands) to deep economic collapse accompanied by devastatingly high unemployment and emigration (Latvia).

Restoring competitiveness by way of internal devaluation has proved to be a difficult undertaking with very few successes. Countries with outright exchange rate devaluations usually recover faster.

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Country experience suggests several factors are needed for internal devaluation to work. The most important preconditions are an open economy with high factor mobility and a high degree of wage and price flexibility.

Despite deep nominal declines in wages and pensions, real effective exchange rate depreciations have been regularly only modest due to only limited pass-through to prices (Baltic states, Argentina, Greece). Furthermore, private sector corporations are more likely to cut employment than to fully adjust wages, even in fairly flexible labor markets (Latvia). It also takes a long time for resources to shift from the non-tradable to the tradable sector, and both persistent skill mismatches and lack of increased investments in the tradable sector preclude full factor reallocation (former East Germany, Latvia). External adjustment therefore works predominantly through import compression rather than an expansion of exports—and oftentimes imports contract long before any real depreciation of the exchange rate. Finally, the often observed deterioration in asset quality and large increases in non-performing loans suggest that balance sheet effects are not limited to outright exchange rate devaluation—they only materialize more slowly in the process of internal devaluation as incomes fall but debt service does not.

The experience of Argentina in 1998–2002 shows that an economy can get trapped in a downward spiral in which adjustment through internal devaluation eventually proves impossible, and the only way to an eventual recovery remains default and the abandoning of the exchange rate peg.

Argentina ended convertibility in January 2002, almost four years into a deep recession that saw a 20 percent cumulative loss in output, culminating in sharp increases in interest rates, bankruptcies, unemployment, and poverty; deep cuts in wages and pensions; deteriorating asset quality, and deposit runs. The banking system collapsed and economic activity came to a virtual standstill in the first quarter of 2002. Nevertheless, only one quarter later the economy embarked on a rapid and sustained recovery, achieving 8.5 percent average real GDP growth over the following six years. The pre-recession output peak was exceeded after three years. Interestingly, despite a large and permanent real depreciation of more than 50 percent and a significant price boom in Argentina’s agricultural export products during this period, net exports contributed positively to GDP growth only in 2002, before turning negative again in the following years.