Almost a month ago favorable news on Greece spread around. Also at this column I wrote a commentary with the title 'Greece will take a deep breath, but will not be in peace'.  Nonetheless, intrigues did not end preventing Greece to take a deep breath. The point we arrived is quite worrisome.

On Tuesday Standard and Poors drooped the credit rating of Greece from BBB+ to BB+. At the same time it warned the investors that hold Greece bills that they might have to agree to get the half of the value. In the meanwhile, Eurostat declared that the 2009 budget deficit of Greece was even worse than the estimations; 13.6 percent as a ratio to the gross domestic product (GDP).

These declarations widened the difference of return between the bills issued by Greece Treasury and Germany Treasury to 682 basis points. As a result, interest on Greece Treasury bills exceeded 9 percent leading to steep drops in European stock exchanges on Tuesday.

The biggest problem of Greece is the opinion that high public debts are not sustainable. The warning I mentioned above is an evidence for this. Regular readers of this column will immediately recall how these expectations for non-sustainability feed itself further increasing the risk and making things more complicated: If I believe that a significant value loss in Treasury bills I hold is a heartbeat away, I will try to sell them immediately. If others also think alike, a small number of buyers will be willing to pay low amounts on these bills. To put it differently, they ask for higher risk premium to buy the bills putting an upwards pressure on the interest rate on them. This is exactly what we witnessed on Tuesday.

Even if the issuer country decides to implement a serious fiscal policy and start to reduce the budget deficit, this is a process and requires time to fulfill the target. During this process, the country has to make new borrowing to finance the budget deficit. However, market interest rates have already gone up and the interest on the bills to be issued will also increase. This implies that interest payments and thus budget deficit will increase further. As a result, borrowing requirement will increase further. What was the reason for the initial increase in risk premium and interest rate? The reason was the high domestic debt of the country. What happened as a consequence? Domestic debt increased further. What will happen after? Risk premium will rise and interest rates will climb further. In consequence, this is a vicious circle by all means.

To put it simply, there are two factors determining the movements of the debt of Greece as a ratio to the GDP:  the difference between growth rate and real interest rate of Treasury bills, and primary budget surplus. As the level of these two increases, ratio of debts decreases.  Eurostat estimates that Greece will contract by 0.3 percent in 2010. Let us do a favor and assume that the growth rate will be 0. In that case, if we assume that the real interest rate of Greece Treasury bills stands at zero, debt ratio of Greece will be constant only if primary budget is in balance. Two months ago nominal interest rate for treasury bills was around 7 percent and real interest rate was around 5 percent. So, Greece should have had a 5 percent primary surplus in order to keep debt ratio constant.

Risk perception against Greece already increased as a result of EU's procrastinating attitude, the concerns as to whether a deal with the IMF will be signed and as to whether Greece can achieve such a high budget surplus or not along with the talks on the street protests against the economic program planned to be implemented. Thus, on Tuesday nominal and real interest rate roughly reached 9 and 7 percent, respectively. Now Greece has to achieve 7 percent primary surplus as a ratio to GDP in order to keep debt ratio at a constant level.

Of course these are rough calculations; but these are good examples for reflecting how the rises in risk perception drag the country into trouble. I want to remind that these calculations show the level of primary surplus required to keep debt ratio constant. The problem is that Greece has to reduce the debt ratio. In that case, the fiscal policy measures needed to be taken will be harsh as long as Greece has to make borrowing at market interest rates. This is why Greece should have had borrowed a significant amount at a lower interest rate than the market rate and with advance payment. And the primary candidate to lend this fund is IMF. However so far there is no deal signed with the IMF and thus Greece is gets closer to the edge of the cliff day by day.

This commentary was published in Radikal daily on 29.04.2010