Fiscal credibility – the revenge of the South?
The shape of European debt has undergone swift and surprising transformation. For the fourth year in a row, that paragon of virtue – Germany – intends to suspend its cast-iron constitutional debt brake drastically restricting any budget deficit to 0.35%. Meanwhile, several countries in southern Europe – often criticized in the past – are on a deleveraging path to make the most orthodox green with envy. A lesson in realism for the big boys?
This needs qualification. Germany still fulfils its role as gatekeeper. Despite its budget deficits in recent years, its particularly acute energy crisis, and its 2023 recession (a price-adjusted contraction of 0.8% year-on-year in the third quarter), its public debt to GDP ratio remains the best of the major economies in the eurozone at 66% in 2022. And the economic consensus is for this to remain more or less stable – or even to decline slightly – in the coming years.
However, the country finds itself in a budget crisis following a surprise decision of the German constitutional court. The court annulled the decision to allocate the unused EUR 60 billion initially earmarked to cushion the fallout from the Covid pandemic to special funds for the energy transition, which will now require alternative funding. At the very least, expenditure will have to be slashed – if not quite with the “chainsaw” evoked by the future Argentinian president for his country – whilst Germany’s climate commitments are being reaffirmed, especially in the run-up to COP 28. An additional burden for an already disoriented economy.
Germany is not the only major economy in the eurozone with fiscal difficulties. France, whose debt to GDP ratio is close to double that of Germany (110%), figures on the recently published list from the European Commission that identifies countries whose budgetary plans “risk not being in line” with European recommendations in 2024, due to excessive public spending. Forecasters estimate its budget deficit at 4–5% in the coming years, a far cry from the 3% which is still the European red line.
As a mirror image of this picture, parts of southern Europe are presenting a perfect picture of recovery rather than indebtedness. Greece has just seen its borrowing rating upgraded and now sits on the cusp – depending on which agency we are talking about – of investment grade and higher risk. Its debt ratio was over 200% in 2020 and is forecast to fall to around 150% in 2024. The debt ratio of Portugal – in serious difficulty during the crisis in the 2010s – has just fallen below that of France. It is the same story for Spain. Italy is seeing a clear improvement, moving towards 140% versus 155% in 2020, with the help of inflation.
What lessons can we draw from this? In economic terms, Europe’s debt rules require urgent revision as they are no longer credible. Suspended between 2020 and 2023 due to the Covid and energy crises, the restrictions defined in the 1990s are, in principle, due to apply again in 2024. But at a time when the eurozone as a whole has a debt to GDP ratio of over 90%, reintroducing the old rules is inconceivable. The Europeans have agreed to review these by the end of 2024, but negotiations are stalling, particularly between Germany and France, to everyone’s cost. A reset is thus required for the role of all participants. From this perspective, both Germany and France emerge relatively weakened from their recent errors, giving the countries in southern Europe more credibility. Tomorrow’s rules are thus likely to be less dominated by German orthodoxy.
From a market perspective, the benchmark status of the bonds of countries in northern Europe could be partly rebalanced in favour of peripheral countries. Some of these countries are already seeing their risk premiums fall sharply versus Germany, a sign of overall convergence within the zone.
Lastly, on a more general note, the encouraging trajectory of the smaller countries in southern Europe could serve as inspiration for other countries with budget problems across the world. Their example shows that a turnaround is a real possibility – of course it comes at the cost of a heavy sacrifice, but one which pays dividends in the future in the form of a lighter debt burden.
Final version of 24 November 2023 – Alexis Bienvenu, Fund Manager