Euro Area: Rising Trends in Structural Public Spending to Test Fiscal Space for Post-Pandemic Agenda

Euro-area governments have announced spending strategies for post-pandemic recoveries that reverse some of the adverse public expenditure trends of recent years. However, there appears to be limited room for potential savings on other expenditure items that could provide the requisite fiscal space.

Plans to raise public investment and strengthen healthcare systems, reversing some of the cost containment of the past, coincide with the prospect of further rises in social-welfare payments due to ageing populations and labour markets strained by the severity of the Covid-19 crisis. Some governments cannot rely on substantive additional future savings on interest payments to make up much of the difference when interest rates are already near zero, if not negative.

Pension, labour-market reform, public investment could limit damage to public finances

We see two possible avenues to reconcile governments’ policy agendas with adverse structural expenditure risks.

Reforms of pensions and labour markets can help contain increases in social-welfare payments. Together with well-targeted public investment facilitated by fund inflows from the EU, they could boost growth, resulting in extra budgetary room over the medium term.

The alternatives are less attractive: higher taxes and social contributions or persistent budget deficits becoming a ‘new normal’ long term.

In our latest study on the composition of public expenditure across euro area countries, we note that in the 15 years pre-crisis, average annual government expenditure as a share of GDP increased in the period 2010-14 compared with 2005-2009, before declining in the period over 2015-19, when public expenditures grew more slowly than nominal GDP. This resulted in an overall zero net increase in average annual public expenditure as a share of GDP between 2005-09 and 2015-19.

Governments held overall spending in check, but social welfare costs on the rise

However, looking at the individual expenditure components, we see a more heterogenous picture. Structural increases in social payments were in the past being offset by lowered interest payments and personnel costs as well as cuts in public investment as a share of GDP.

The share of social payments in total expenditure rose over time from 44% on average in 2005-09 to 47.5% in 2015-19. Other expenditure areas have declined in relative significance, notably the share for interest payments, down to 4% in 2015-19, from 6% in 2005-09, investment (5.7% vs 7%) and personnel costs (21% vs 21.8%). Even though governments held overall expenditures in check pre-crisis, this was not true of all components of spending even then.

Looking at expenditure projections for forthcoming years, governments’ proposals to raise public investment and strengthen healthcare systems would reverse some past underinvestment in these areas; however, without proposing counterbalancing savings, this could set debt on an unsustainable trajectory.

Spending pressures vary across the euro area’s largest economies

The extent to which euro area governments will be affected by expenditure hikes varies across countries, as the examples of the four biggest economies show:

  • Germany may need to temporarily abandon strict expenditure controls to enhance public investment.
  • France may benefit from less significant demographic pressures than peers. Pressures on expenditure items outside of ageing-related costs appear more rigid for France, however. For instance, the share of employee compensation in GDP is much higher than that of peers.
  • Italy will be a major beneficiary of EU recovery funds over 2021-26 to enhance public investment and could benefit from further declines in interest payments as well as debt is rolled over at much-lower market rates than in the past. At the same time, high and rigid expenditures for pensions at 16% of GDP (12% is the average for the euro area) strain public finances while employment and labour-participation rates remain low.
  • Spain could significantly benefit from EU recovery funds to reverse recent underinvestment in capital spending. A key pressure-point in reforming Spain’s rising social expenditures relates to its weak labour market, with Spain having even before the corona crisis displayed the highest structural unemployment in the euro area (of about 14% in 2019).

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Giulia Branz is Associate Analyst in Sovereign and Public Sector ratings at Scope Ratings GmbH.

Germany, France, Italy, Spain: Sustained Growth Required to Heal Public Finances as EMU-4 Debt Soars

Countering the Covid-19 pandemic has required European governments to loosen fiscal policy and borrow heavily in 2020, raising concerns about how sovereign debt will evolve after the shock.

Scope Ratings’ analysis of fiscal targets under the Economic and Monetary Union (EMU)-4’s 2021 budgetary plans leads to two main conclusions.

First, the proposed budgets mirror the EU’s shifting paradigm towards counting on growth rather than austerity for achieving fiscal consolidation.

Secondly, official forecasts assume an effective and long-lasting fiscal impulse from stimulus packages despite challenges such as ageing populations and environment-related adjustment costs. However, we believe less buoyant growth even with expansionary fiscal policies will prevent the EMU-4’s governments from bringing down public debt ratios to pre-crisis levels over the foreseeable future.

Government debt to rise to record highs

Government debt is set to rise to record highs this year in the EMU-4 due to the Covid-19 crisis. Scope expects public debt to increase by between 9pp and 23pp in the four economies, adding up to a weighted aggregate 107% in 2020 from 90% of GDP at end-2019.

Budget deficits in the EMU-4 have widened by similar degrees amid fallout from the 2020 pandemic, but why they have increased differs markedly. The dominant role here of discretionary fiscal support in Germany contrasts with the impact of automatic stabilisers, such as lower tax revenues and increased spending on short-time work schemes, in France, Italy and Spain, induced by more severe recessions in the latter economies.

The substantial increase in public debt ratios in France, Italy and Spain, by more than 20 percentage points this year, reflects the double impact of a severe growth contraction and an automatic decline in the primary balance, being a lot more significant than the debt-creating effects of discretionary fiscal measures.

Governments to rely on growth, rather than austerity, to achieve future fiscal consolidation

The stabilisation and then reduction of debt ratios of the four governments under IMF forecasts hinge upon governments making swift budgetary adjustments despite less generous IMF estimates for future growth compared with national government forecasts. Governments themselves are counting on growth, rather than fast budget adjustments, for achieving fiscal consolidation, relying on optimistic scenarios for their economies’ longer-term growth potential, driven by assumed permanent growth impacts of fiscal stimulus.

The focus on fiscal stimulus is a landmark moment in euro area economic policymaking with a shift from the previous paradigm of fiscal restraint towards a more durable dependence on pro-growth policies. Seizing the opportunity to raise growth potential has to be weighed against risks that growth forecasts prove too optimistic, however.

Optimistic official forecasts in 2021 budgetary plans

The four governments expect a significant growth boost over the next years. Italian officials project an average growth rate of 2.7% in 2022-24 compared to 0.9% in three years before the crisis and the Spanish government has raised its growth forecast to above 4% by 2023 compared with 2% growth in 2019. Scope’s forecasts remain more conservative, with expected growth converging more rapidly to pre-crisis potential rates.

Spanish officials expect a doubling and Italian authorities even a tripling of growth over the next three years compared with pre-crisis growth rates. Uncertainties about fiscal multipliers, project implementation risks and structural challenges such as declining productivity growth and ageing societies present risks to official forecasts.

The EU’s massive stimulus package of EUR 750bn over 2021-26 will spur investment. At the same time, the fruits of infrastructure investments or higher spending on education will only be felt over the more distant future.

EU funds will support a faster green transition but achieving important long-term social objectives such as a more educated and skilled workforce will require a lot of staying power in terms of reform progress if it is to sustainably elevate growth.

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Giulia Branz is Associate Analyst in Sovereign and Public Sector ratings at Scope Ratings GmbH.

Hungary Faces Tougher Public Finance Challenges in the Era of Covid-19

Scope Ratings says improvements in Hungary’s debt structure and the expected timely return of the economy to pre-Trisis growth mitigate an increased vulnerability of the country’s public finances to future shocks.

“An important absorption measure would be the further extension of public debt maturities,” says Giulia Branz, analyst at Scope. “Doing so could reinforce Hungary’s fiscal resilience by reducing high gross annual financing needs, although a critical issue remains the capacity of domestic investors to absorb higher volumes of government bonds issued by the Hungarian State Treasury – especially at longer durations.”

Scope draws five main conclusions from its latest analysis of Hungary, illustrated by five charts in a new report, available here.

Upward revisions to public deficit and debt, but significant improvements in debt profile

“We have made an upward revision in our deficit forecast to 10% of GDP in 2020 after higher spending in response to the pandemic, expected further extension of fiscal support, and a deep recession,” says Branz.

Nevertheless, a robust recovery in nominal output is foreseen in the years ahead, which should ensure the gradual decrease of debt back toward 75% of GDP by 2024.

A significant improvement in Hungary’s debt profile over the past decade, including a substantially lowered share of foreign-currency denominated debt, has reduced external sector risks and helped to advance Hungary’s domestic capital market liquidity, especially via the issuance of retail bonds.

Constraints from low average debt maturity and domestic sector’s limited debt absorption capacity

At the same time, Hungary still faces a relatively low average public debt maturity – only 4.4 years for HUF-denominated debt – resulting in high yearly gross financing needs relative to other countries’ in Central and Eastern Europe.

“The fact that domestic debt holders have a limited capacity to absorb longer-dated government bond issuance compared to the tolerance of international investors may pose a constraint on the government’s objective of extending debt maturities,” says Branz.

The benefits of fairly benign market conditions

Hungary benefits from fairly stable market conditions over recent months, with current 10-year yields around 70bps above pre-crisis levels. Hungary’s international capital market access was also successfully tested through the placement of a EUR 500m bond denominated in Japanese Yen (Samurai Bond) this month.

“The mix of lower interest rates and the quantitative easing of the Magyar Nemzeti Bank (MNB) have provided robust support for Hungary’s debt management agency, ÁKK, to complete a large share of its funding needs for 2020, including 100% of the planned foreign-currency debt issuance,” she says.

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Giulia Branz is Associate Analyst in Sovereign and Public Sector ratings at Scope Ratings GmbH.

Demographics Squeeze Advanced Economies’ Long-Term Growth Potential; Big Test for Italy & Japan

Scope Ratings has examined the impact of demographic trends on long-term economic growth in major economies, assuming productivity growth and employment rates remain constant.

“We show that GDP growth rates are likely to decrease in all countries in the coming decades, but large differences exist between advanced economies. Comparing the best and worst performers – the US on the one side and Italy and Japan on the other – over time highlights the magnitude of the problem: by 2050, US GDP could be significantly higher compared to its 2020 level in real terms, while, in the absence of significant productivity and employment gains, Japan and Italy would likely have lower real GDP levels than potential GDP today,” says Giulia Branz, analyst at Scope Ratings.

At the same time, countries can enhance productivity to maintain positive long-term growth and implement policies to address adverse demographic trends and employment trends – two key variables that are captured in the ESG-risk pillar in Scope’s forthcoming update to its sovereign rating methodology.

Demographics explain a large part of structural downward trends in growth

Demographic factors explain a large part of the downward trend in advanced economies’ recent economic growth rates and are likely to remain important over the coming decades according to Scope’s study of the 1960-2050 period, focusing on working-age populations, productivity, and employment rates.

“Our model holds productivity and employment rates constant at 2014-19 levels – which we recognize is a bold assumption as these can change significantly as a result of government policies – but this allows us to estimate a country’s growth prospects based only on its demographic trends that are less likely to fluctuate as significantly,” says Branz.

Significant differences in growth prospects between countries

Growth prospects are structurally declining in all advanced economies, but significant differences exist across selected countries:

  • The US, UK, and France are likely to continue to grow over the long term thanks to relatively favorable demographic trends.
  • Germany and Spain are likely to see GDP stagnate over the coming decades. Adverse demographic trends are likely to offset some of the expected gains in productivity and employment (assuming the latter are sustained over the coming period).
  • Japan and especially Italy would likely experience a marked decline in GDP levels over the next decades based only on adverse demographic trends were such trends not offset with productivity and employment gains that have been distinctly lacking over recent years.

“Our findings have important implications for public debt dynamics and, as a result, sovereign ratings,” says Branz. “Policies that improve countries’ productivity levels, demographic trends, and employment rates are critical to ensuring the long-term sustainability of public debt.”

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Giulia Branz is Associate Analyst in Sovereign and Public Sector ratings at Scope Ratings GmbH.

Euro Area’s Fiscal Plans Face Financing Challenges Following Covid-19

Understanding gross financing needs (GFNs) is essential to assessing the sustainability of sovereign borrowing by providing an aggregate figure of the maturing debt volume, primary fiscal deficits and interest payments in a fiscal or calendar year.

In 2020, Scope Ratings expects euro area gross financing needs of around 18% of it’s GDP, assuming an aggregate primary deficit of 6% of the GDP and interest payments of 1.8%. By comparison, in 2019, GFNs amounted to 12% of GDP.

“We expect for 2020 a similar overall size for euro area gross financing needs compared with that in 2009, at the peak of the Global Financial Crisis, but this time the focus around the composition will be different,” says Giulia Branz, an analyst at Scope and co-author of the Euro Area Gross Financing Needs in 2020:
rise mitigated by favourable composition . “Hefty fiscal stimulus is the main driver of the rise in GFNs in 2020 while interest payments and the amount of maturing debt remain lower than in 2009,” she says. “Governments are issuing debt to counter-cyclically address the crisis, rather than to service past borrowing. This may support faster economic recovery and thus strengthen debt sustainability over the medium term.”

The euro area’s total GFNs this year might remain comparable to those during the Global Financial Crisis in 2009 if the economic contraction from the Covid-19 remains close to Scope’s baseline estimate of around 6.5% of the GDP. At the same time, euro area governments have varying degrees of fiscal space, with projected GFNs in 2020 ranging from 8% in the case of Estonia to over 30% of GDP in Italy’s case.

The Italian exception

“Italy is among the few countries facing very similar amounts of amortisations and interest expenditures this year compared to 2009, despite recurrent primary surpluses in the aftermath of the financial crisis and the extraordinary interventions of the ECB,” says Branz.

Italy’s gross financing needs in 2020 nonetheless remain far below those projected for other reserve currency sovereigns such as the United States (38.5% of GDP) or Japan (45.6% of GDP). In addition, the European Central Bank’s enhanced role as a lender of last resort and will support fiscal sustainability despite the one-time surge in fiscal deficits. ECB support is expected to keep interest costs low to mitigate spreads in risk premia across countries and absorb part of the additional gross financing needs resulting from higher primary deficits.

An elevated 2020 euro area deficit but a more homogenous fiscal response

“In absolute terms, we currently estimate the euro area’s fiscal deficit for 2020 at around EUR 890bn. This compares with the ECB’s additional purchase programmes totalling around EUR 1trn, of which we can assume around 70% relate to euro area government securities purchases.”

Scope’s forecast of an aggregate euro area fiscal deficit of around 8% of GDP can be broken down into the pre-shock primary balance, shock-related discretionary spending, the cyclical component including higher unemployment benefits and lower tax revenues, in addition to interest payments. While the projection for the cyclical component deterioration is comparable to that seen in 2009, interest payments are significantly lower this time – thus creating the space for greater stimulus.

“We see greater use of fiscal spending in 2020 and more homogeneous fiscal responses across euro area countries, as the discrepancies in their fiscal balances, are set to be much lower than in 2009,” says Branz. Counter-cyclical and coordinated fiscal policy are what countries have to do to mitigate the impact of the economic shock. Still, this will inevitably translate into an increase in the stock of public debt.

A rise in regional debt, but via growth-enhancing spending rather than higher interest cost

“We project the euro area’s debt-to-GDP ratio will increase to a record high of around 98% in 2020, up from 84% in 2019. However, thanks to prudent fiscal policies over the past ten years, much of the increase in public debt results from higher primary spending rather than from higher interest payments.”

Euro-area governments have several ways to offset the impact of higher GFNs on future economic performance, including:

  1. Lengthening debt maturities to lower annual refinancing needs.
  2. Improving the euro area’s long-term fiscal capacity (such as creating a recovery fund, new forms of emergency lending, region-wide unemployment insurance).
  3. Monetary policy support during times of market volatility.
  4. Common endeavours to raise the euro area’s growth potential.

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Giulia Branz is an Associate Analyst in Public Finance at Scope Ratings GmbH.