An Empirical Evaluation of Greece’s Public Debt Sustainability

Bachelor Thesis 2011 44 Pages

Economics - Finance










1. Introduction

The collapse of Lehman Brothers in 2008 sparked the vicious cycle of the financial crisis that drove banks and companies of all sizes to the brink of bankruptcy. Channelled through international contagion effects the liquidity and credit crunches spread quickly from the originating U.S. economy to the European Union and into the rest of the world. As a consequence, not only recessional but also systematic problems in the EU were revealed that led to insolvencies of entire governments. The precedential case of sovereign debt crises in the EMU caused many controversial debates concentrating on countries that are mostly suffering from debt difficulties such as Portugal, Ireland, Greece, Spain (sometimes provocatively referred to as PIGS), Italy or Iceland. However, the focus of these debates rested on the particular severe situation of Greece and its solvency problems.

The repeated downgrading of Greek government bonds by leading rating agencies resulted in a strong increased yield for risk compensation. Ultimately this was manifested in a ten-percentage point surge in the yield spread of long-term government bonds during the crisis compared with the benchmark Germany (OECD, 2011b). Accordingly the Greek government is facing even more costs to finance its debt, which in turn decreases credibility of debt repayment and thus additionally increases the yield. To combat this vicious cycle and the difficulties to roll over its debt, the EU in combination with the ECB and IMF (sometimes referred to as “Troika”) offered a loan package to Greece that was accepted shortly after, however under the conditionality of severe austerity measures. The reforms in the public sector in order to realign the revenues with the expenditures seem indispensible for mastering the crisis.

Indeed, the unsustainable conduct of Greece’s fiscal policy is usually blamed as underlying reason to its sovereign debt crisis. But are these claims underpinned by theoretical considerations? And moreover, is Greece adjusting its public balance bearing the current crisis in mind? This paper aims at assessing these two questions by examining the theoretical sustainability of Greece’s public finances and subsequently evaluating its fiscal adjustment process. For the theoretical sustainability analysis two empirical tests are used that rest on two slightly different definitions of sustainability.

The sustainability analysis of debt is usually applied to a country’s public or external debt. While both examinations yield different valuable insights, in the case of Greece the public finances are the primary concern in view of the sovereign debt crisis. The first method used for evaluating the sustainability of Greece’s fiscal policy is the framework of co-integration. Starting in the 1980s this technique found many applications to debt sustainability, in particular examining sovereign debt. The second method is an estimation of a fiscal response function, in order to directly analyse if the government is taking corrective action when the debt-to-GDP ratio rises. The examination of the fiscal response approach found several implementations, however only to evaluate the public finances rather than the external balance. The conclusions of both empirical assessments suggest that Greece’s public finances are indeed on an unsustainable path.

The fiscal adjustment part deals with the logically arising question whether the government of Greece is adjusting its behaviour in the light of the sovereign debt crisis and its unsustainable prior policies. In addition, this paper reviews the discussion of the success and macroeconomic implications of such an adjustment process and proposes some considerations that relate to the special case of Greece’s integration into the EMU.

The remainder of the paper starts with an identification of different sustainability concepts and an overview of Greece’s public debt ratios in section two. Thereafter, section three examines Greece’s public debt sustainability on the basis of the co-integration approach. Subsequently, section four assesses debt sustainability on the grounds of the government’s reactions to debt accumulation by estimating a fiscal response function. Section five identifies the current fiscal adjustment process and surveys the academic discussion surrounding its success and impact on economic growth. Some considerations of the special case of Greece from the aspect of European integration are pointed out in section six and finally, section seven concludes.

2. What is sustainability?

In order to examine the sustainability of the public finances in Greece, it is essential to define the concept of sustainability. Subsequently a preliminary analysis of Greece’s public debt ratios follows.

2.1. Liquidity, solvency and sustainability

When analysing the circumstances of debt repayments, three different, but central concepts should not be confused: liquidity, solvency and sustainability. The former two have a rather tight interpretation, whereas the latter concept, sustainability, is fairly broad and can adopt various definitions. In order to distinguish different definitions of sustainability the abbreviation (Si) will be used for the ith definition1. Furthermore, some definitions of sustainability explicitly involve the concept of solvency, like the co-integration approach applied in section three, while others do not, as the fiscal response approach in section four. In the following the two concepts of solvency and liquidity are examined with their relations to different notions of debt sustainability:


In theory, strict solvency is a fairly straightforward concept. A government can be characterized as solvent if it is able to repay all interest on its debt out of its income (IMF, 2003). That is, if the present value of real future net interest payments is not greater than the present value of real future primary surpluses:

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where is the real interest rate in period t, the real debt in period t-1 and the real primary surplus. The repayment of the debt principal does not need to be taken into account, as for a strictly positive real interest rate, the discounted principal reduces towards zero in the long run assuming that the debt can be rolled over (IMF, 2003)2. One could argue that sustainability of debt is satisfied if condition (1) holds and thereby using the term sustainability (S1) interchangeably with solvency.

Yet in reality, the sole ability to pay its interest payments is a non- binding concept, because (1) is easy to fulfil. Even in extreme cases of high future payments, the borrowing government would “just” have to accept severe cuts in its future net spending behaviour in order to meet the solvency condition (1) through high primary surpluses. With this reasoning in mind (S1) appears to be practically always satisfied. However, (S1) only seems non- binding, because future primary balances are allowed to change on an arbitrary basis. One might argue that fiscal policy is solely sustainable if its continuation does not violate (1), or in other words, if condition (1) holds based on realistic expectations of. Accordingly, another concept of debt sustainability (S2) can be used, with a fiscal policy being sustainable if (1) is fulfilled conditional on a continuation of current fiscal policy under the projected macroeconomic environment. That is, (S2) is violated if some severe fiscal adjustment processes are necessary in some future period in order to restore condition (1).

In a scenario with a large initial debt and therefore high necessary future primary surpluses, the required future behaviour of the government is costly, as it would imply a slowdown in the economy due to typical Keynesian effects. The government is thus facing a trade-off between continuing paying its debt with costly fiscal adjustment on one hand and the adverse affects of a default with decreased access to international capital markets on the other hand (Manasse & Roubini, 2005). If the relative costs of defaulting are low, the government might not be willing to repay its debt and decide to default even though it has the theoretical ability to pay3. This gives rise to a third concept of sustainability (S3), predicting sustainability of a country’s debt if its willingness to pay is positive. Note that if (S2) is satisfied, i.e. no adjustments need to be taken, then under normal circumstances (S3) should also be fulfilled as the relative costs of default are high. However, this reasoning does neither hold for a violation of (S2) nor goes the other way.

According to Milesi-Ferretti & Razin (1996), the borrower’s willingness to pay is a more powerful concept for understanding historical defaults than his ability to pay derived from condition (1). They apply this concept to external debt in a qualitative manner, since they argue that the nature of the willingness to pay makes quantitative predictions of defaults based on this concept rather difficult. Thus (S3) appears to have a rather limited feasibility and will therefore not be applied to the case of Greece in this paper.

The analysis above suggests that the ability to pay based on (S1) should not be used to measure sustainability, because taken by itself it is a weak theoretical concept. Since the concept (S2) alleviates these concerns by testing actually conducted and expected fiscal policy in the long run, it seems to be a reasonable theoretical foundation for testing debt sustainability. A co- integration relationship can be estimated in order to test for such long-run behaviour and possible violation of condition (1) (Corsetti and Roubini, 1991). The co-integration method is indeed a frequently used approach4 to evaluate sustainability and will be more thoroughly assessed in section three, prior to applying this concept to the case of Greece.


In contrast to the long-term notion of solvency, liquidity is the short-term capability to fulfil current payment obligations. According to the IMF (2003) it almost exclusively occurs during a solvency crisis. This seems quite logical, as a borrowing country faces more difficulties and costs to issue new debt when the market considers the country to be on a path leading to insolvency.

Hence a solvency crisis could ultimately culminate in a liquidity crisis with the government unable to meet its payment obligations.

However, insolvency is not a necessary condition for illiquidity. Even when a government is solvent, i.e. (1) is satisfied, other factors like an adverse macroeconomic environment5 could give rise to liquidity crisis. Sustainability concepts are long-term concepts and thus not directly related to the concept of liquidity, yet the two concepts might be highly correlated through the effects of a solvency crisis based on an unsustainable fiscal policy.

2.2. Debt ratios of Greece

Arguably the most frequently used tools of evaluating indebtness are debt ratios. The scaling of debt makes comparisons with other countries more interpretable. Prior to the analyses of the public debt ratios, a short discussion that stresses the important difference between public and external debt follows.

Net external debt is the aggregate of the net liabilities of the domestic government and the private sector against foreign creditors. Importantly, external debt is not simply accumulated deficits in the current account. One can think of the current account as being mirrored in the financial and capital account of a country through the balance of payments, assuming no change in currency reserves (Gärtner, 2009). Since the elements of the financial and capital account include all capital transfers in the form of debt instruments, one might conclude that the capital and financial account ( = current account) constitute the external deficit. However, as Rossini and Zanghieri (2009) argue, a country could have sustained current account deficits without running an external deficit. This would be the case if they are financed with FDI, which are incorporated in the financial account but do not add to external debt, as they are no debt instruments. Hence the net international investment position, which usually includes FDI (IMF, 2009), is only an approximation of external debt. On the other hand, net public debt is the net liabilities of the government against both, domestic and international creditors6.

A common sloppiness is a misuse of terms when it comes to debt concepts. In particular, the terms of external debt and public debt are sometimes used interchangeably. In the recent sovereign debt crisis of Greece, sovereign debt is sometimes described as “Greece’s debt” and thus misleading. In fact this would suggest that the debt of Greece as a country is at stake and therefore its external debt, while the primary concern is the public debt. Note that the common component of both debt measures is the net external public debt, the net liabilities of the government to foreign creditors. In the current context of Greece’s public debt crisis, international creditors should care mostly about this component. A possible debt relief or bankruptcy of the government and according cut in its external debt affects international creditors with a reduced position directly only through this channel.

Public debt-to-GDP ratio

In order to take the resource base of a country into consideration, a commonly used ratio is government debt divided by GDP7. Most of the time the ratio is provided as gross debt-to-GDP, which seems intuitive, because the gross liabilities are the amount that has to be paid off. However, from a long-term perspective, the measure of net debt appears more attractive, as it also accounts for assets hold by the government, e.g. deposits or securities. Figure 1 depicts the path of Greece’s annual gross and net government debt ratios from the 1980 until 2012, whereas from 2011 forecasts of the OECD (2010) are used. Both ratios have an increasing trend, i.e. debt is generally growing faster than GDP, to about 700% its size in 2010 compared to the beginning of the period. After the Maastricht treaty there was a typical slowdown in the growth of the debt-ratios due to the convergence criteria. From 2006 to 2008 the diverging gross and net debt ratios suggest that Greece’s government managed to significantly increase its asset position. However, the decrease in the net debt ratio was not prolonged, as with the beginning of the financial crisis in 2008 the ratio grew sharply again. The reason for the strong increase in the ratio is not just a considerable increase in liabilities, but due to the nature of a ratio, also a decline in Greek GDP in 2009 and 2010 (OECD, 2010).

In spite of the debt-to-GDP ratio being the most popular expression of a government’s debt, the net debt-to-GDP ratio appears more representative in the context of solvency. In the short run gross debt is a powerful indicator, since assets calculated into net debt might be illiquid. However, since solvency is a long run concept, the net debt ratio seems appropriate. If the ratio increases forever, then condition (1) cannot be satisfied and the government can be characterized as insolvent. Hence, in a dynamic setting a

Figure 1: Gross and net government debt as percentage of nominal GDP 160%

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Note: For the years 2011 and 2012, forecasts of the OECD (2010) are used. Data Source: IMF (2011) and OECD (2010)

stable ratio provides a sufficient condition for the solvency criterion8 (Roubini, 2001). The path analysis of the debt-to-GDP ratio therefore gives rise to another sustainability concept (S4), predicting sustainability if the ratio is stable or converges to a certain value over time (e.g. Ziesemer, 2009). In fact, (S4) is theoretically similar to (S2) as a stable debt ratio implies that condition (1) holds.

3. Stationarity and sustainability of public debt

For the purpose of a sustainability analysis of Greece’s public finances, this section test (S2) for Greece for the time period of 1980 to 2010. The framework of co-integration is used to evaluate if condition (1) holds on the basis of actual conduct and expectations of fiscal policy.

3.1 Methodology

In principle condition (1) is the same as the intertemporal budget constraint (IBC), which is more commonly illustrated than (1). In order to note the relationship, the paper first reproduces the IBC. As debt ratios are important to incorporate the scaling effect, a dynamic representation of public debt as a share of GDP can be written as:

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where is the real interest rate adjusted for GDP growth9 in period t, the real net debt-to-GDP ratio andthe real primary-surplus-to-GDP ratio. If equation (2) covers a relatively long time period, it can give rise to an evaluation of the IBC. From equation (2), Bohn (2008) derives a representation for the debt-to-GDP ratio at the start t of period. Bohn uses conditional expectations of future debt ratios and future primary surplus ratios. Taking the limit of and assuming that the discounted sum converges this representation is

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That is, the initial debt-to-GDP ratio equals the discounted expected primary surpluses as a fraction of GDP plus the discounted expected debt as a fraction of GDP at time n, where n approaches infinity. The definition of the IBC that Bohn gives is that the discounted expected primary surplus ratios equal the initial debt ratio:

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Equation (3) shows that the IBC (4) is satisfied if and only if the second term on the right hand side, the discounted expected debt ratio at time n equals zero:

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which is often referred to as the transversality condition (TC). That means in order to achieve sustainability concept (S2), condition (4), the IBC or equivalently condition (5), the TC has to hold. Hamilton and Flavin (1986) were the first to explicitly spell out condition (4) and (5) in the setting of government solvency. They emphasize that the two conditions do not imply a decreasing debt ratio10, but on the contrary are compatible with a growing ratio, as long as the growth rate is less than !!.


1 Table A2 in the appendix gives an overview of the identified sustainability concepts.

2 Note that for simplicity the interest rate on the debt is assumed to equal the discount rate (risk-free rate).

2 Note that for simplicity the interest rate on the debt is assumed to equal the discount rate (risk-free rate).

3 If a large fraction of the debt is to be repaid to international creditors and governments. care more about domestic residents, it could additionally decrease its willingness to pay.

4 Section three analyses this approach and mentions several studies based on this approach.

5 For example the liquidity crunch in the recent financial crisis following the collapse of Lehman Brothers.

6 Furthermore, it has been proposed that both, the public and external deficit might move together in the so called twin deficit hypothesis (e.g. Miller and Russek, 1989).

7 The use of nominal debt divided by nominal GDP produces a ratio that accounts for inflation, just as dividing real debt by real GDP.

8 A stable ratio implies an ever increasing debt assuming a positive GDP growth. This seems to contradict the analysis given for condition (1). However, as the reasoning in section three shows, a stable ratio is sufficient for (1) when the variables are replaced by ratios.

9 This interest rate accounts for GDP growth and inflation, as it is equal to the nominal interest rate minus the nominal GDP growth rate. This is the case, because a change in the debt-to-GDP ratio is not simply the deficit-to-GDP ratio (as would be the case when using nominal terms), but differs from it by a nominal growth term (Bohn, 2008).

10 Actually they make this point for real debt and not a debt ratio and therefore with interest rate r rather than r*.


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Title: An Empirical Evaluation of Greece’s Public Debt Sustainability