Shock therapy may smother Greek economy, extend crisis

ATHENS (Reuters) - Greece's drastic belt-tightening to secure emergency aid risks plunging the economy into a deeper recession, threatening delivery of key fiscal targets and prolonging the debt crisis.

Wary markets are focused on implementation risks associated with the EU/IMF-led austerity plan and whether the price for a 110 billion euro bailout -- tax increases and big cuts in wages and pensions -- may be too high for the economy and government to bear.

"If it turns out that the economy is not able to withstand the measures, if growth falls much more than forecast there could be social unrest, forcing the government to consider alternative moves in its asset-liability management," said RBS economist Silvio Beruzzo.

"This may include restructuring."

Greece's economy, which represents just 2.5 percent of the euro zone, has relied heavily on consumer spending to drive growth since the country adopted the euro in 2001.

Households took advantage of low euro-wide interest rates to buy cars, homes and goods to fill them up. Private consumption accounted for more than 70 percent of economic output, swelling Greece's current account gap in the process.

It is this consumer-reliant model that is now at serious risk from government austerity plans which call for 30 billion euros in new savings from wage and pension cuts, and a rise in value added tax (VAT) to 23 percent -- highest in the euro zone.

"No one can tell what the impact of these measures alone will be on Greek consumers: increasing VAT from 19 to 23 percent in a few months is a huge increase," said Chris Pryce of Fitch Ratings.

Under the three-year plan agreed by Prime Minister George Papandreou's government in exchange for aid, economic forecasts for the country have been revised down significantly.

Gross domestic product (GDP), which slumped 2.0 percent in 2009, is now projected to contract by 4.0 percent this year and by 2.6 percent in 2011.

But even these more pessimistic estimates look overly rosy to some economists given the size of the fiscal adjustment facing Greece -- 11 percent of GDP in total through 2013.

FEW AND FAR BETWEEN

"Governments that have pulled this off in the past are few and far between," said Ben May, an economist at Capital Economics.

"What's more, those that have done so have tended to benefit from a loosening in monetary policy, a large devaluation of the exchange rate and strong global demand, something that Greece cannot rely upon."

RBS's Beruzzo estimates tax hikes could add 200 basis points to Greek inflation, bringing it close to 6 percent, its highest level since EMU began, and further eroding purchasing power.

While he considers the government's GDP forecast for 2010 "realistic", he said the significant compression of consumption and low investment could easily push output down 5 or 6 percent this year.

Economist Yannis Stournaras, who headed the council of economic advisers under the government that led Greece into the euro zone, now expects unemployment to shoot up to 13 percent and consumer spending to fall between 7 and 8 percent.

"The EU/IMF deal has priced in a large probability of slippage. There is a big cushion for deficit and debt targets," he said.

He said success in meeting the economic targets would depend on the government's ability to deliver on pledges to open up restricted professions in legal, pharmacy, notary, engineering an haulage sectors, among others.

BANK RISKS

Another risk to the economy is the Greek banking sector, which made it through the first wave of the global financial crisis without too much damage because it had virtually no exposure to toxic U.S. mortgage-related assets.

The sector got a shot in the arm when the European Central Bank agreed earlier this week to accept junk-rated Greek debt as collateral, cutting the risks of a liquidity crunch.

But a combination of sharply lower loan volumes and a strong rise in non-performing loans on the back of an expected increase in unemployment remains a threat to the sector and the broader economy. Reflecting these worries, Greek bank stocks have suffered a sharp selloff this week.

Greece's main opposition party voted against the austerity bill in parliament on Thursday on growth concerns.

"The dose of the medicine you are administering risks killing the patient," its leader Antonis Samaras told parliament.

(Reporting by George Georgiopoulos; editing by Noah Barkin and Toby Chopra)