Recent market volatility seems to reflect severe doubts that the Greek rescue package can work and, by extension, that serious contagion to other larger European debtors can be avoided. Yet a close look at the numbers in the IMF program for Greece suggests that although the fiscal adjustment needed to secure debt sustainability is daunting, it is feasible. The prospects might be further enhanced by a more ambitious contribution to debt reduction from the proceeds of privatization. Ultimately, in view of the past history of debt crisis resolution, the determining factor for success or failure of the program will likely be political will.
The algebra of debt sustainability provides a useful framework for identifying the principal components of the recent IMF-eurozone-Greek program to achieve debt stabilization. Let r = the interest rate, g = nominal growth rate, and π = primary surplus as a fraction of GDP, and λ = the ratio of public debt to GDP. Then it can be shown that the proportionate annual change in the ratio of debt to GDP will be:1
Correspondingly, for debt sustainability defined as a condition in which the debt to GDP ratio is not rising, the primary surplus as a percent of GDP needs to equal the difference between the interest rate and the nominal growth rate, multiplied by the debt to GDP ratio (higher required surplus for higher initial debt). Thus, setting the left-hand side of equation 1) to zero and solving for π* as the critical threshold for the primary surplus yields:
where λ is the constant ratio of debt to GDP.
It turns out that even seemingly high debt ratios can be stabilized if the interest rate is moderate, growth is reasonable and the primary balance is adequate. For example, a debt to GDP ratio of 120 percent can be kept constant if the interest rate is 6 percent, the nominal growth rate is 4 percent, and the primary surplus is 2.4 percent of GDP (2.4 = 1.2[6-4]). Indeed, Greece itself maintained the debt to GDP ratio at a plateau of about 105 to 110 percent in 1997–2008 without the present panic.2 Japan is an even better-known case of an economy that has managed a high ratio of debt to GDP on a sustainable basis thanks to a low interest rate.
Two other influences affect the path of debt. First there is “discovered debt” (realization of contingent liabilities that occur outside the budgetary process). Second, working in the opposite direction, there is privatization, which provides cash receipts that can be used to retire debt. Setting these respectively at δ and φ (as fractions of GDP), then the proportionate change in the debt ratio becomes:
The debt ratio will then either decline or increase depending on whether the primary surplus, privatization, and economic growth are high enough to more than offset interest obligations on old debt and the addition of new “discovered” debt.
Table 1 reports the structure of the IMF and Eurozone supported adjustment program adopted by Greece. The table indicates the adjustment plan’s expected levels for each of the variables in equation 3). (The table also reports real growth, g*.) The last three rows of the table report, respectively, the IMF projection of the debt to GDP ratio; the proportionate change in the ratio from the previous year calculated from equation 3; and the estimated debt to GDP ratio based on the cumulative predictions of equation 3. The resulted “estimated” ratios are extremely close to those reported in the IMF program document.
The debt to GDP ratio rises from 115 percent of GDP in 2009 to nearly 150 percent by 2013 before it declines to 139 percent in 2015 and (not shown) 120 percent by 2020. The biggest surge occurs in 2010, from 115 percent of GDP to 133 percent. A large amount of discovered debt (6.7 of GDP) associated with recognition of the swaps that had disguised debt (as well as recognition of some military purchases and health liabilities) contributes to the surge, as does a decline in nominal GDP as well as a still substantial primary deficit.
The key to debt stabilization is the reversal from a primary deficit of 8.6 percent of GDP in 2009 to a primary surplus of 6 percent of GDP by 2015. The large primary deficit in 2009 was mainly cyclical. In contrast, the primary deficit was only 0.7 percent of GDP in 2008. The size of the primary balance adjustment looks much more feasible if it is calculated against a more normal 2008 base than against the 2009 base, amounting to an improvement of about 7 percent of GDP by 2015 instead of almost 15 percent. Although the primary surplus target of 6 percent of GDP by 2015 is ambitious, it is not implausible. Brazil has achieved primary surpluses close to 5 percent of GDP in recent years, and Turkey has reached levels of close to 7 percent.
|Table 1 IMF Program for Greece (percent of GDP and percent)|
|% chg λ||15.5||8.7||2.6||0.5||-3.1||-3.7|
|Source: IMF, Greece: Staff Report on Request for Stand-By Arrangement, IMF Country Report No. 10/110, May 2010|
Also crucial to the program is the maintenance of moderate interest rates. The average interest rate is slightly below 5 percent in 2010-11, before rising to only moderately above 5 percent in 2012 and after, as official support is replaced by market sources. The interest rate will depend crucially on the credibility of the program, because if markets do not consider that enough progress is being made, then by 2012 and after when the special official support is replaced by private finance the interest rate would be considerably higher than the program assumes. The projections place the spread above the German Bund rate at 250 basis points in 2010, falling to 200 bp in 2011, 150 bp in 2012, and 100 bp thereafter. If instead interest rates on the private funding replacing official support by 2015 and after are an additional 200 basis points higher, then by 2020 the debt to GDP ratio stands at 130 percent rather than 120 percent (IMF, Greece …, p. 36).3
The program acknowledges that real growth (g*) will be seriously negative this year and next before becoming weakly positive in 2012 and then more normal by 2013-15. If growth is higher by one percentage point per year, the debt ratio would stand at 120 percent of GDP by 2015 (instead of 139 percent) and 80 percent by 2020 (instead of 120 percent). The average rate of real growth achieved by Greece in the period 1994-2007 following the 1992-93 recession was 3.6 percent annually.4 In contrast, the average real growth assumed in the adjustment program for the post-recession years beginning 2012 is only 2 percent for 2012-15 and 2.7 percent for 2016-20, so the IMF baseline may well be too conservative.
A fair question is whether even the growth path assumed in the program can be achieved without devaluation as a means to boost competitiveness. As a Eurozone member Greece cannot devalue on its own. However, the program envisions at least some modest relative deflation against eurozone partners, with a cumulative GDP deflator increase of 3.3 percent from 2010 to 2015 versus 7.6 percent for partners. In addition, if the euro remains at its low level of mid-May, which is about 15 percent below the level in late 2009, Greece would enjoy considerably increased competitiveness against the rest of the world. If instead the euro recovers, the return to growth in Greece without greater relative price reduction could still occur through the channel of lower wages and higher profit incentives to firms at nearly unchanged prices.
One source of additional adjustment might be privatization. State enterprises have an estimated capital value of €44 billion, or about 20 percent of GDP. It would seem reasonable that a more accelerated privatization program could contribute more than the baseline 0.4 percent of GDP (about €1 billion) annually to debt reduction.
Overall, the decomposition framework in equation 3 and the levels of its components assumed in the adjustment program suggest that it should be possible for Greece to carry out debt stabilization in technical terms. However, as in most cases of sovereign debt distress, the ultimate outcome will depend on political will. A good illustration of the centrality of political commitment to honoring the debt is provided by the contrast between Chile and Venezuela in the 1980s debt crisis. Chile began with a much higher debt to GDP ratio but managed to avoid debt restructuring forcing principal or interest reduction, whereas Venezuela sought and received such restructuring in a Brady Plan arrangement.
1. See William R. Cline, “A Note on Debt Dynamics.” (Peterson Institute for International Economics, May 2010).
3. Note, however, that even in this case with the spread at 350 basis points in 2012 the reduction in progress in comparison with the program’s baseline is too small to be consistent with the judgment by Kirkegaard (2010) that Greece in 2012 will be inevitably insolvent and forced to default. Jacob Funk Kirkegaard, “A Default by Greece: Why and When?” Peterson Institute for International Economics, Realtime Economic Issues Watch, May 16, 2010. The spread has already fallen to 470 bp since the announcement of the support program (Lukanyo Mnyanda, “Greek Bonds Rise after European Union Transfer of $18 billion,” Bloomberg.Com, May 18, 2010). A further decline by at least 120 bp is surely likely by 2012 if Greece sticks by the fiscal adjustment plan.
4. IMF, World Economic Outlook, April 2010.