On May 9, Standard & Poors downgraded the Greek debt by reducing its ratings from BB-to B, for the long term, and from B to C, for the short term. The downgrade reflects a) the fact that the fiscal target (a reduction of the fiscal deficit to 9.6% of GDP) was not met (the deficit was 10.5%) and b) the opinion that the Greek debt is unsustainable. S&P says estimates that a 50% “haircut” in the value of the debt may be required to restore solvency. In fact, there seems to be a wide agreement among economic commentators that a restructuring of the Greek sovereign debt is inevitable, so it is no coincidence that the rumors of a new loan (60 billion) to Greece, circulated a few days back by the Wall Street Journal, turned out to be void of content. A new loan may perhaps buy some extra time for Greece, but would hardly change the substance of things. At present, the only alternative to debt restructuring, ruling out an inflation bout which would require leaving the Euro, seems to be a strong, albeit unlikely, rebound in growth. Here’s why.
The preliminary data for 2011 are discouraging: a primary deficit (d) of about 5% of GDP, an average interest rate on debt (i) that the Greek Economic Minister Papacostantinou (optimistically) estimates around 4.5%, a rate of Inflation (π) at 2.6%, a negative growth rate of about 3 points and a debt ratio (b) at 150%. These numbers imply that in order to stabilize the debt/output ratio at the current level, it would be necessary to achieve and maintain a primary surplus (-d *) of 7.5 points of GDP. Thus the required cuts would top 12.5% of GDP (see first row in Table 1). Of course, such a consolidation could not be achieved in a single year, and for a time the debt will continue to grow (assuming that Greece may access the capital market).
A new 60 billion loan from the EU-IMF would be of little help (second row of the table). This figure represents about one-fifth of the outstanding debt, so even if Greece could access the new money at subsidized rates (say two points below the actual average cost), this would have only a tiny effect on the average cost of debt, about 40 basis points (= 200 bp / 5). Consequently, the budget surplus needed to stabilize the debt ratio would be reduced only marginally, from 7.5 to 6.9%.
In contrast, a partial default would considerably reduce the required adjustment: a “hair cut” of 40% of the debt’s face value, in addition to the reduction in rates, would imply a sharp reduction in the stabilizing primary surplus, to little over 4 per cent of GDP. The only realistic option to avoid a default would be a resumption of growth: if growth could be revamped into positive territory and stabilized there e (say at 1%) a meager 1.3% primary surplus (see last line) would do to stabilize the debt. But markets do not seem to believe it.
Note: d = primary surplus / GDP ratio, i = average cost of debt, Π = growth rate of consumer prices, r = real interest rate, b = ratio of gross public sector debt to GDP ratio, d * = ratio of primary deficit GDP ratio required to stabilize the debt, d = d *- maneuver necessary in relation to GDP
Sources: EIU, statements by the Minister Greek Papacostantinou, author’s calculations.