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Positive changes since the Global Financial Crisis include
fewer excesses and imbalances, the ECB's asset purchase programs,
and the creation of the ESM and RRF.
However, following the COVID-19 shock, six eurozone member
states will have public debt to GDP ratios well in excess of 100%
and achieving sustained reductions will be difficult.
Given low nominal GDP growth rates, lasting improvements in
primary budget balances will be required even if interest rates
remain relatively low.
This will not be easy, given political constraints. Persistent,
elevated debt ratios imply a high risk of more turbulent market
conditions once the ECB starts to lessen its support.
Shaky foundations have been reinforced…
Long-standing concerns about the stability of the eurozone and
its member states' public finances stem from a combination of
structural challenges at national level and an inadequate
infrastructure for the currency union. While the former remains a
concern (discussed below), some welcome progress has been made on
the latter.
Various institutional improvements and support mechanisms have
been introduced since the Global Financial Crisis. These include
2012's creation of the European Stability Mechanism (ESM), with a
total lending capacity of EUR 500bn, plus 2020's agreement on the
Recovery and Resilience Facility (RRF), providing financial support
to vulnerable member states, including via grants.
The ECB has also demonstrated its willingness to do whatever it
takes to preserve eurozone financial stability via the creation of
the Outright Monetary Transactions (OMT) framework in 2012 and its
subsequent large-scale asset purchases under various programs,
including the current Pandemic Emergency Purchase Program (PEPP).
After a surge in the initial wave of COVID-19 in spring 2020,
intra-eurozone yield spreads have remained relatively low and
stable since.
…but high debt ratios will remain a source of
vulnerability
While the chances of another full-blown crisis engulfing the
eurozone have reduced given the changes above, there is still cause
for concern. In particular, the vulnerabilities associated with
persistently high public debt to GDP ratios in the aftermath of the
COVID-19 shock. Six eurozone member states have ratios well in
excess of 100%.
The debt to GDP ratio is not the sole metric determining
sustainability. As long as interest expenditure remains low,
elevated debt to GDP ratios can be sustained for some time.
However, a sudden loss of investor confidence and a jump in
financing costs can quickly destabilize the situation, with
far-reaching consequences for economic and financial stability.
While the eurozone now has various support mechanisms in place
to try to contain these effects, both the ECB's OMT and assistance
from the ESM would require acceptance of formal macroeconomic
adjustment programs. Governments will be extremely reluctant to
sign up for such programs, absent sustained market pressure.
Uncomfortable fiscal arithmetic…
The evolution of public debt to GDP ratios typically depends on
the interaction of three key factors: the nominal interest rate
paid on the debt, nominal GDP growth and the primary budget balance
(excluding debt interest). While debt service costs are
exceptionally low at present, the longer-term prospects for nominal
growth and primary budget balances in many of the most highly
indebted eurozone member states are not favorable.
Debt ratios are unlikely to fall substantially, therefore, in
the absence of prolonged fiscal adjustments. But such adjustments
will be difficult to achieve and sustain. Forming a stable
government is difficult in many member states and austerity is
unpopular. Government revenues already account for very high shares
of GDP in many member states, while sustained reductions in
expenditure will run into strong opposition.
…including in Italy
Italy's situation illustrates the precarious nature of the
fiscal metrics in highly indebted, low growth economies. Italy's
public debt to GDP ratio is forecast to have peaked at just under
160% in 2020, up from 105% back in 2007. The long-standing upward
trend in the debt ratio occurred despite Italy achieving sustained
primary budget surpluses from 2008 to 2019 (with the exception of
2009). Having plunged into deficit in 2020, we forecast that the
primary balance will return to return to surplus from 2023 onwards,
remaining between 1-2% of GDP.
As GDP growth picks up in the immediate aftermath of COVID-19
but the ECB's asset purchases lean down on yields, the "snowball
effect" on Italian public debt is favorable initially. But it soon
fades, as real GDP growth returns to its meagre potential rate and
inflation remains subdued. Italy's public debt to GDP ratio barely
declines over the forecast horizon as a consequence, ending up at
around 150% by 2050.
This is despite persistent positive real GDP growth rates,
sustained primary budget surpluses and a very limited increase in
interest rates throughout the forecast - highlighting Italy's
vulnerability to adverse shocks. Alternatively, if we assume
somewhat lower nominal GDP growth rates through the forecast
period, along with a gradual upward trajectory for interest rates,
the path for the debt to GDP ratio in Italy looks very disturbing,
exceeding 200% by 2050.
ECB's support critical, but what if it steps
back?
The good news is that the ECB is committed to providing
extensive policy support for some time to come, prolonging the
favorable combination of low interest rates and rebounding growth.
Its asset purchases under the PEPP are being stepped up near-term
and will continue until at least the end of March 2022 according to
ECB forward guidance. Reinvestment of principal payments from
maturing assets under the PEPP will continue until at least the end
of 2023.
But thereafter, assuming the ECB wants to start scaling back its
huge balance sheet, the situation will become much more unstable,
necessitating credible fiscal consolidation strategies across the
most highly indebted member states. If governments do not seem able
or willing to deliver those adjustments, and the ECB will not step
back in (absent agreements in favor of formal macroeconomic reform
programs), the resulting stand-off would risk another eurozone
crisis.
Posted 19 March 2021 by Ken Wattret, Vice President, Economics, IHS Markit
