Sovereign Debt - Still the Elephant in the Room? (Reuters)

It has been my view that debt is and will be the major hurdle to overcome to find resolution to the global financial crisis.  As with most financial transactions, its all about the math.  The math has been on the sides of those that have tested the waters of (un)realistic and (un)sustainable debt for some time now.  No primary deficit, low interest rates combined with continued growth in GDP has kept their heads above water.  But times might be changing.  Growth is less certain.  Rising interests rates are more likely.  And what if Primary deficits emerge?  How much of a change with any one or combination of these three will matter?  and what change will bring what consequences?  

When all three factors — economic contraction, higher rates and rising deficits — come at once, they easily start fuelling one another in a vicious cycle. If the profligate country has to pay a 6 percent interest rate instead of 4 percent and recession and belt-tightening have cut nominal GDP by 2 percent, a primary surplus of just over 8 percent is required just to keep the ratio of debt to GDP stable.

Watch and learn.  Time will tell.

Sovereign debt maths show risk of vicious circle

APR 9, 2010 10:07 EDT

GDP | SOVEREIGN DEBT

How can a country support debt of over 100 percent of GDP for many years and then suddenly start spiralling towards insolvency? That question of sovereign debt maths is not merely academic. It is highly relevant to the likes of Greece and Italy.

The answer is that size of the sovereign debt burden is not everything when it comes to keeping up with interest payments. No matter how high the ratio of debt to GDP may be, it does not need to increase as long as the government has two factors going its way: the “primary” budget balance — the balance before interest payments — and the growth rate of nominal GDP.

To see how these play out, consider two countries. One has a moderate debt load, 50 percent of GDP, which carries a 4 percent average interest rate. If the budget is in primary balance, the government will still run a deficit of 2 percent of GDP, which is 4 percent (the interest rate) of 50 percent (the debt). As long as nominal GDP grows by 4 percent, the ratio of debt to GDP stays the same.

The other country is highly indebted, with a debt/GDP ratio of 100 percent. Assume it also pays an interest rate of 4 percent. With a primary budget balance, its fiscal deficit is 4 percent of GDP. However, as long as nominal GDP keeps growing at 4 percent a year, the ratio of debt to GDP stays the same — 100 percent.

In effect, the highly-indebted government doesn’t pay a penalty for its profligacy, as long as growth keeps up and interest rates stay low. Greece and other heavily indebted countries benefited from such a happy environment for years.

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