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Stabilization of the debt-to-GDP ratio in the Eurozone: where do we stand today?

The essential

Eurozone countries saw their debt-to-GDP ratios soar during the “Great Recession” of 2008-2009 and this spiraling of public debt was the catalyst for what came to be known as the “eurozone crisis”. We analyze in this text the underlying factors of the change of the debt-to-GDP ratio for the eurozone’s four biggest countries. 

It seems obvious that a very accommodative monetary policy from the ECB is necessary during several years to stop the “snowballing effect” and to ensure the stabilization of the debt-to-GDP ratio in the medium run in the case of Spain and Italy.

Eurozone countries saw their debt-to-GDP ratios soar during the “Great Recession” of 2008-2009. This spiralling of public debt was the catalyst for what came to be known as the “eurozone crisis”(the root causes of this crisis are complex and related to the way the eurozone was structured; numerous articles on the topic have appeared in this publication, and the issue will not be addressed here). Bailout mechanisms were put in place to reschedule and relieve Greek, Portuguese and Irish government debt in hopes that this would avert an explosive situation. In the case of Greece, government debt was also massively restructured in February of 2012. Here, we propose an analysis of the sustainability of government debt in the eurozone, several years since the peak of the crisis.

The evolution of the debt-to-GDP ratio essentially depends on three factors: the nominal interest rate paid on the existing debt, nominal GDP growth and the primary deficit/surplus* (the difference between government revenues and spending, excluding the debt burden). The evolution of government debt is generally expressed using a simple equation1.

1-formule

In this equation, dt represents the debt-to-GDP ratio at t, r stands for the nominal interest rate on existing debt, g represents the nominal GDP growth rate, pt is the primary deficit/surplus and ddat the “debt-deficit adjustment” (financing needs are not always exactly equivalent to government deficits because they include, among others, financial investments made by the government, it is also often called “stock-flow adjustment”). One key point with respect to the sustainability of debt is whether the nominal interest rate is higher than nominal GDP growth; or in other words, whether the real interest rate exceeds real GDP growth. One talks of “snowball effect” when the real interest rate is above real GDP growth.

We have broken down the changes to the eurozone’s debt-to-GDP ratio into several components as of Q1 20142: (i) the contribution of the differential between r and g, (ii) the primary balance and (iii) the debt/deficit adjustment. It is striking to note that over the last two to three years, most of the rise in the debt-to-GDP ratio results from the difference between the nominal interest rate and nominal GDP growth. Meanwhile, the primary deficit of the eurozone taken as a whole has sharply fallen, with the primary balance now close to zero.

Here it becomes clearly apparent how deflation could negatively impact government finances. In addition to an anaemic level of real growth, weak or negative inflation would push up real interest rates—potentially above real GDP growth, contributing to the rise in the debt-to-GDP ratio. Deflation would seriously undermine the solvency of Eurozone countries since, all other things remaining equal, government debt would continue to climb.

Thus, looking at the eurozone as a whole, the difference between nominal interest rates and nominal GDP growth continued to contribute to the rise in the debt-to-GDP ratio until at least Q1 2014. Since the beginning of Q2 2014, nominal interest rates have fallen sharply, especially in the peripheral countries. This is positive for the sustainability of government debt, but growth and inflation have also declined… On top of that, the decline of nominal interest rates that has taken place only concerns the bonds to be issued and it will take a long time before it is transmitted to the entire stock of public debt. This illustrates just how difficult it will be to stabilise the debt-to-GDP ratio. We cannot expect much in terms of falling nominal interest rates. Due to announcements and measures taken by the ECB in recent years (OMT programme, LTRO, zero interest rate policy, announcements of TLTROs, etc.), the nominal interest rates applied to borrowings by eurozone governments are at all-time lows; they now stand at zero or near-zero levels for five-year maturities—quite close to the average maturity of debt for the majority of eurozone countries. For example, on 17 July, France issued €4 bn at an average yield of 0.55%, and on 30 July, Italy issued €3 bn with a five-year maturity at 1.20%. In other words, even if the ECB were to try to improve the solvency of Eurozone countries by making nominal interest rates go down, it would no longer be able to achieve spectacular results, as bond yields can no longer decline. At most—and this would already be very significant—the ECB could help maintain interest rates at current levels for a long period, through quantitative easing (QE).

Globally, the above analysis reveals that only larger primary surpluses and/or more solid economic growth can help to stabilize the debt-to-GDP ratio. To take the analysis further—and applying a lesson from recent history—it is worth looking into debt dynamics on the level of individual countries.

First of all, with respect to the primary balance, the aggregate data for the entire eurozone hides a very mixed picture. Indeed, the eurozone’s primary balance is near zero because the significant primary surpluses of Germany and Italy (approx. €45 bn and €35 bn, respectively, in 2013) almost completely offset the large primary deficits of France and Spain (both approx. €45 bn in 2013). As a percentage of GDP, the largest primary deficits in the eurozone are those of Spain (approx. 4%), France and Ireland (approx. 2%). The Netherlands and Portugal have slightly smaller primary deficits. Germany and Italy are the only countries with substantial primary surpluses (around 2% of GDP). 

We will now compare the evolution of nominal interest rates and nominal GDP growth. We have calculated the “implicit” average interest rate on the debt burden by dividing the interest paid on the debt by total government debt. This interest rate stands at approximately 2.5% in Germany and France and 3.75% in Italy and Spain. This means that nominal GDP growth falling below this rate would imply, all other things being equal, a “snowball effect”, whereby nominal debt grows more quickly than the economy, while nominal growth above this rate would imply a reduction in nominal debt in relation to the size of the economy. Currently, among the four largest eurozone countries, only Germany has nominal GDP growth above the nominal interest rate. That being said, the gap between interest rates and growth remains too smallto make a substantial contribution to reducing  German government debt. In Spain and Italy, meanwhile, interest rates are much higher than nominal GDP growth. However, the gap between nominal interest rates and nominal GDP growth is considerably magnified in Italy by the scale of government debt, such that the contribution of the “interest-growth differential” to the increase in the debt-to-GDP ratio is higher in Italy than in Spain (around 5 percentage point of GDP per year in Italy versus 4 percent per year in Spain). In France, the interest-growth differential also contributes to the rise in the debt-to-GDP ratio, although much less so than in Italy or Spain (currently at around 1 percentage point of GDP per year).

Ultimately, the sustainability of Spanish government debt raises the most questions, as the country still has a very high primary deficit and its interest growth differential remains far too large. Despite its significant primarysurpluses, the evolution of the debt-to-GDP ratio is not much more encouraging in Italy, as its GDP growth is too weak to hold back the “snowball effect”. In the case of France, the increase in government debt is largely attributable to recurring primary deficits. The stabilisation of France’s debt-to-GDP ratio  hould be achieved through the scaling back of government spending, a task being undertaken by the French government. In Germany, primary surpluses already ensure a decrease in the debt-to-GDP ratio; as such, the country enjoys a unique standing within the eurozone.

Future prospects

Although we can expect a decrease in the primary deficit and an increase in primary surpluses in Italy in the coming years (barring a major shock), the “snowball effect” remains a concern for these countries. Under the strong assumption that bond yields remain at the levels seen in late-August 2014 (thanks to the ECB) and that the countries renew 10% of their debt stock per year, the average interest rate on debt should be approximately 2.5% in Italy and Spain at the end of 2019. In its April 2014 World Economic Outlook, the IMF’s projections for 2019 were 0.9% real growth and 1.6% inflation for Italy and 1.3% real growth and 1.1% inflation for Spain—just enough to hold back the “snowball effect”. Under this scenario, the debt-to-GDP ratio would decline in Italy before Spain due to the differences in their primary balances. The major risk, however, is that inflation may prove much lower than anticipated: with inflation of 0.5% or 0%, for example, or in a “Japanese” type scenario, the “snowball effect” would continue to exert a major influence on the rise in government debt.

Conclusion

Debt-to-GDP ratios in Italy and Spain can still be stabilised in the medium term, but only if a series of strict conditions is met: bond yields must remain at their current (extremely low) levels, inflation must rise gradually over time (thus averting a “Japanese” type scenario) and real growth will have to align with potential growth (for this to happen, no major negative shock of external origin may occur). This means that the ECB will have a major role to play on the issue, and monetary policy will remain highly accommodating for many years to come.

 

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1 For example, see the IMF’s 2010 “Practical Guide to Public Debt Dynamics, Fiscal Sustainability, and Cyclical Adjustment of Budgetary Aggregates.
2 The ECB does the same work on a regular basis in its monthly bulletin.

 

Deflation would seriously undermine the solvency of European governments

 

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Bastien DRUT, Strategy and Economic Research at Amundi
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