PUBLIC FINANCE IN THE EUROZONE: STATUS QUO – IN 2018 THE FISCAL DEFICIT STOOD AT 0.5%, ITS LOWEST LEVEL SINCE THE YEAR 2000

Tailwind from economic recovery and low interest rates

The development of public finances in the Eurozone has been seeing some improvement in recent years. In 2018, the average government budget deficit stood at 0.5% of economic output – its lowest level since 2000 and down from 6.2% as recently as 2012. However, this cannot be attributed to a stringent consolidation policy but rather to the positive economic developments in the Eurozone. Even though government spending as a percentage of GDP has fallen for the fifth year in a row (to 46.8% in 2018 after 48.5% in 2015), in absolute terms it has risen continuously since 2012. In 2018, it registered about 20% above pre-crisis levels. Another key driver of the declining budget deficit is the European Central Bank’s ultra-loose monetary policy. Since the ECB announced that, within its mandate, it would do whatever it takes to save the euro, the overall interest burden in the Eurozone has fallen sharply – from 3.0% in 2012 to 1.8% in 2018. However, not all governments have used the additional fiscal space resulting from a shrinking interest burden to consolidate their finances.

The reduction of the debt mountain has only just begun

Despite the headway made in reining in public-sector deficits in the Eurozone, the consolidation of government debt has barely begun. Although the government debt ratio fell for the fourth year running in 2018, the debt burden at 85.1% of GDP is still almost 20 percentage points higher than it was before the crisis. In 2017, only eight Eurozone countries met the 60% Maastricht debt criterion. In five member states, the government debt ratio was still above 100% in 2018.

PUBLIC FINANCE IN THE EUROZONE: QUO VADIS? OVER THE NEXT 15 YEARS, ONLY GERMANY AND IRELAND WILL MEET THE 60% DEBT CRITERION

Each year we forecast the development of government debt (D) in selected Eurozone countries over a 15-year horizon using long-term assumptions for nominal GDP growth (g), the primary balance (PB) and the average interest rate on government debt (r). Our calculations for the development of government debt in the Eurozone Big Three (Germany, France and Italy), and in the four former crisis countries (Spain, Portugal, Ireland and Greece), show that a sustained reduction in the respective debt mountains even under rather favorable conditions is likely to be a slow and drawn-out process.

Over the next 15 years, only Germany and Ireland will manage to meet the 60% debt criterion laid out in the Stability and Growth Pact. Germany will probably succeed as early as 2019. Spain and Portugal continue to make good progress and the trend is also moving in the right direction in France. Meanwhile Greece, as well as Italy, stand out for still featuring government debt ratios of 100% and higher - even at the end of the forecast horizon. While Greece, with a debt level of 181% in 2018, has the worst starting point, in Italy it is the very unfavorable growth prospects compared to the interest burden that will hinder progress in consolidation. 

The breakdown of the change in the public debt ratio into its key drivers – economic growth, primary balance and average interest rate on government debt – shows which factor, compared to its 2019 value, makes the main contribution to reducing the debt ratio by 2033. The results vary greatly from country to country. In Italy, for example, a lasting recovery of growth prospects and the primary surplus – both of which are currently at very low levels due to the government’s expansive fiscal course -– are a prerequisite for reducing the debt burden. 

By way of comparison, should Italy maintain its current fiscal stance in an unchanged economic environment, government debt would rise to 163% of economic output by 2033 rather than decline to 121% as envisoned in our baseline scenario. Like Italy, most countries considered here will have to display more fiscal discipline to achieve the calculated consolidation results, with the prevailing low interest rate environment only partially compensating for slowing economic growth and/or lower primary balances. In the long-term, this is hardly a sustainable strategy to reduce government debt in the Eurozone. In contrast, in Germany we expect a slowing debt reduction momentum – thanks in particular to lower primary surpluses – over the forecast period.                        

If Germany were to maintain the primary surplus of around 2% expected for 2019, government debt would not fall to 34% but to around 20% of economic output by 2033, assuming an unchanged economic backdrop. Meanwhile, the moderate expected increase in the average interest rate on government debt over the forecast period will have only a minor impact on the government debt dynamics in Italy and Germany.

Our interactive Debt Tool allows you to simulate the development of the debt ratios of selected Eurozone economies by applying alternative assumptions, and to compare the figures with our forecasts.

HOW HAVE OUR RESULTS FOR THE LONG-TERM DEBT SUSTAINABILITY IN THE EUROZONE CHANGED OVER THE PAST YEAR?

Even minor changes in fiscal and economic policy are reflected in a change in long-term debt sustainability. Over the past 12 months, the following changes have occurred in the individual variables we forecast:

• Economic growth: Our current forecasts for long-term nominal GDP growth in Germany, France, Italy and the four former EMU crisis countries Spain, Portugal, Ireland and Greece are slightly lower on average compared to one year ago. In addition to the gloomy medium-term outlook for world trade, the impact of lingering populist tendencies is also reflected here. These will hamper the implementation of growth-promoting structural reforms. Measured against last year's already very cautious growth forecast, the correction in Italy's GDP forecast is particularly marked: from +1.1% to +0.8%.
• Primary balance: In almost all the countries considered here, we now expect a slightly lower primary balance in the long term. In addition to weaker economic growth, which is likely to weigh on government revenues, the decisive factor is the rising pressure on government spending as a result of populism.
• Average interest rate on government debt: We now assume that the ECB will not begin normalizing its monetary policy before 2021. This means that the current low interest rate environment will be maintained for much longer than expected, which will have a positive effect on the average interest rate on government debt.  

In conclusion, for all countries considered here, government debt at the end of the forecast period is now estimated to be somewhat higher, with the exception of Spain and Portugal, where there will be slight improvements. For Italy, we see a significant deterioration in the dynamics of debt reduction. Our forecast for government debt as a percentage of economic output rises from 112% to 121% for 2033.