(Corrects lead to say economy will shrink two percent 'this year', not 'next year')
* Greek c.bank chief sees 2 pct contraction in 2010
* Fiscal steps to bring upgrades once results visible
* Greek bond yield spreads to tighten on policy action
* More consolidation in Greek banking inevitable
By George Georgiopoulos and Sakari Suoninen
ATHENS, March 12 (Reuters) - Greece's economy will shrink another two percent this year, much more than currently forecast by the government, though its debt servicing costs will fall, central bank Governor George Provopoulos told Reuters.
Grappling with a ballooning deficit and a 300 billion euro ($411 billion) debt pile, Athens aims to reduce its fiscal gap by four percentage points of gross domestic product this year through a combination of cuts and higher taxes. [ID:nLDE621162]
That will still leave it with a deficit of 8.7 percent of GDP and economists say the plan's success will hinge on strict implementation and social peace.
But the plan has eased financial markets' nerves around the country's ability to finance its debt and cut the premium Greek pays to borrow after a surge this year.
"All bold fiscal consolidation packages initially have some contractionary effects. It is one reason we expect economic activity to contract by 2.0 percent this year," Provopoulos, also a member of the European Central Bank's Governing Council, told Reuters in an interview conducted on Thursday, but cleared for publication on Friday.
"However, the fiscal consolidation package will also create conditions for sustainable growth in the future, something that would not occur in the absence of a credible consolidation programme," said.
Greece's economy contracted 2.0 percent in 2009, its first recession since 1993. Belt tightening to cut the government's wage bill and higher taxes to boost revenues will mean the 240 billion euro economy will be in recession for a second year.
Provopoulos' prediction compared with a 0.3 percent contraction forecast by the government and less growth will also hurt budget revenues.
But he said the fiscal austerity -- which has prompted popular protests in Greece -- would have positive longer term effects and would improve its credit ratings.
"I am optimistic and believe that as the government pursues its programme, while enriching it with structural policies, we will transform a vicious circle into a virtuous one. This will create positive momentum for sustainable growth," he said.
The central bank has not made forecasts but given the expected downturn in economic activity, demand for loans and credit expansion will be weak this year, Provopoulos said.
The latest data on credit growth in December last year showed business and household credit grew at a slower 5.1 percent annual pace to 253 billion euros. Private sector debt is low in Greece by European standards. [ID:nLDE610125]
BANKING CONSOLIDATION
Provopoulos said a changing landscape at home and the Balkans, where Greek lenders have expanded for growth, will form conditions for more consolidation in banking.
"Consolidation of the Greek banking system over a medium to longer-term horizon is inevitable. In the coming years the economic landscape in Greece and in neighbouring countries will differ somewhat from the landscape of the past 10-15 years," Provopoulos said. "I am referring to the next few years, not the next months," he added.
He said recent policy action by the socialist government will help tighten bond yield spreads as results become visible.
"Given that Greece has undertaken bold and credible economic policies, I am not concerned that rating agencies might downgrade. In fact, upgrading is just a matter of time," Provopoulos said.
"As the government's new measures start producing positive results, there will be rating upgrades. It is a matter of quarters or possibly months," he said.
Greece's fiscal woes and deteriorating debt metrics prompted consecutive rating downgrades in December, widening bond yield spreads sharply. [ID:nLDE5BH149]
Greece, which borrows as Hellenic Republic, is currently rated BBB+ by Fitch and Standard & Poor's and A2 by Moody's.
With 53.2 billion euros in borrowing needs this year, the country has been paying a high premium over benchmark European bonds to raise funds. The yield spread of 10-year Greek government paper over bunds topped 400 basis points in January.
"It is obvious we have had an overshooting of Greek sovereign bond spreads," Provopoulos said. "However, in previous pre-crisis years the spreads were unrealistically narrow. Therefore, in previous years we had one extreme but now we are experiencing the opposite extreme."
"It is a matter of time (before they come down). It is certain that they (spreads) will move downward. I cannot predict the pace at which this will happen," he said.
The central banker expressed confidence that the package of measures announced by the government last week, including cuts in public sector pay, a freeze in pensions and a rise in VAT tax, will restore credibility and help achieve fiscal targets.
"I don't believe that the issue of the future (beyond this year) acceptance of Greek government bonds as collateral will be relevant for very much longer," Provopoulos said. "Once measures start showing their effects I would expect to see upgrades in Greek sovereign ratings."
For Provopoulos's views on changes in collateral rules click on [ID:nLDE62B0KE] (Writing by George Georgiopoulos; editing by Patrick Graham)