G-r test for Greece

March 4, 2010

Greece announced a 4.8 bln euros extra austerity programme on Wednesday in a bid to secure European aid to tackle its cripling debt problem.


But few people think this is the end of the story. Two German MPS have said Greece should consider selling some of its islands as one option to reduce debt. Fancy turning Santorini into a luxurious private resort, anyone?

On a serious note however, Stephen Jen, head of macroeconomics at London-based hedge fund BlueGold, says Greece needs a “Thatcher-like” wholesale restructuring of the economy to fully exterminate default risks and deep fiscal cuts alone might not be sufficient to calm bond markets in the long term.

“Fiscal austerity would only be a ‘kicking-the-can-down-the-road’ strategy for a country like Greece,” he says.

Jen says economic growth is the single most important factor in discussing debt sustainability.

He says that sustainable debt service is often defined as whether the debt-to-GDP ratio can remain at least stable over time, assuming zero primary balance. This in turn is determined by the real interest cost of debt — r — and the real economic growth rate — g.

If, over time, the real cost of borrowing persistently exceeds the economic growth rate (r > g), the debt-to-GDP ratio would grow without bounds. Greece and other debt-laden euro zone peripherals have reaped significant benefits from the much-reduced interest rates from the euro zone.

“Assuming inflation in these countries remains below the euro zone average… the real cost of capital (r) will likely remain significantly higher than the expected growth rate (g) in Greece or other PIIGS economies. It is, thus, far from clear that debt sustainability can be achieved without wholesale economic reforms, in addition to austerity measures,” he says.

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