Eurozone public debt: The interest rates reality check
Allianz SE | Munich | Sept 30, 2022
How the end of zeronomics changes public debt dynamics in Europe.
In recent years, Eurozone governments borrowing more and more seemed to matter less and less as falling interest rates made high and rising debt levels less burdensome. However, sovereign debt dynamics are bound to significantly deteriorate as the ECB raises interest rates to fight rampant inflation. Now all eyes are on new budget announcements by several Eurozone governments. With monetary policy becoming increasingly restrictive, finance ministers need to strike a delicate balance between extending targeted fiscal support and potentially exhausting available fiscal space at a time when growth is slipping and refinancing costs are rising. So far, announced budgets suggest strong crisis support until next year at the risk of delaying fiscal adjustment. We expect budget deficits to decline in all large Eurozone economies, except for France (at 5.5% of GDP). The French government just published its draft budget bill for 2023, which extends support measures to households and firms but implies an overall reduction in real spending.
In this paper, we assess the consequences of the new debt reality in the four largest Eurozone countries by projecting the expected debt path over a 15-year horizon. Our key takeaways are:
The largest economies will struggle to reduce elevated government debt. In fact, the government-debt-to-GDP ratios in France, Italy and Spain are set to increase. On the other hand, Germany will cement its position as a fiscal policy outlier by pushing its debt ratio below the 60% mark by 2028.
Rising refinancing costs will add pressure to debt sustainability. Assuming both government debt ratios and the average maturity of government debt are kept constant over the next 15 years, a lasting increase in the interest rate level by 200bps means that interest expenses in relation to GDP will tally up to 1.4% in Germany, 2.3% in France, 2.4% in Spain and a whopping 3% in Italy by 2030. To put these figures into perspective, for Italy and Spain, the additional budget burden exceeds the total public investment in relation to GDP in 2019.
To avoid the interest hangover ahead, and protect fiscal space for spending on the green and digital transitions, governments require much greater fiscal discipline and/or higher nominal growth. However, current debt-to-GDP ratios in France (113%), Italy (151%) and Spain (118%) imply a Herculean fiscal consolidation effort, i.e. a notable reduction in the primary deficit. Relative to its fiscal stance in 2023, the largest adjustment would be needed in France. Conversely, vulnerable countries, such as Italy, would need to almost double potential growth to lower debt levels if fiscal adjustment is not feasible.
New government budgets prioritize crisis support and delay necessary fiscal adjustment.
As fiscal policy takes center stage in mitigating the economic cost of the current energy crisis, all eyes are on the upcoming budget announcement by several Eurozone governments. With monetary policy becoming increasingly restrictive, finance ministers need to strike a delicate balance between extending targeted fiscal support and potentially exhausting available fiscal space. The planned budgets will significantly influence debt sustainability at a time when growth is slipping and refinancing costs are rising.
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What would it take to stabilize debt at current levels, or even return to the 60% debt ratio outlined in the Maastricht Treaty? With the help of our interactive debt tool, we assess the consequences of this changed debt reality in the four largest Eurozone countries by projecting the likely debt path over a 15-year horizon
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