Finland: Strong Pension System Mitigates Fiscal Risks From Ageing Population

The Finnish economy has proven remarkably resilient to the Covid-19 pandemic. Still, the three simultaneous shocks of energy, geopolitical risks and rising interest rates will materially affect the country’s economic and fiscal outlooks in the near term.

Scope Ratings expects flat economic growth next year of just 0.2%, following a robust 2.3% this year and a deterioration of the fiscal deficit to 2% of GDP in 2023, from 1.6% expected this year. Interest expenditure will gradually increase from about 0.5% of GDP last year to over 1% by 2025, reflecting the shifting monetary-policy and interest-rate environments.

Debt Ratio Expectations to Resume Upward Trajectory Medium Term

Robust nominal growth and a contained fiscal deficit should result in a moderate decline in the debt-to-GDP ratio this year to 71%, from 72.3% in 2021. But we expect Finland’s debt ratio to resume an upward trajectory in the medium term, increasing towards 75% of GDP by 2027, given a moderate growth outlook and persistent fiscal deficits driven by the ageing population, on top of gradually higher debt-servicing costs.

Finland has the second highest old-age dependency ratio in the euro area after Italy’s. The share of people over 65 increased to 37% of the working-age population last year from 22% in 2000. Age-related fiscal pressures are set to further increase in the next few years: the old-age dependency ratio is projected to reach 45% by 2040 (see Figure 1), driven by a 3% decline in the working-age population.

By that time, the number of Finnish people above 85 years of age will be more than twice the number today. This will have an exponential impact on health and long-term care spending.

According to Finland’s Ministry of Finance, the consolidation effort needed to ensure balanced government finances over the long term accounting for population ageing is around 3% of GDP.

Figure 1. Finland’s demographic developments

Population structure, people thousands (lhs); Old-age dependency ratio*, % (rhs)

*Old-age dependency ratio: the ratio of the number of people aged 65+ to the number of people of working age (15-64) Source: United Nations population projections, Macrobond, Scope Ratings

Sound Pension System and Progress on Welfare-sustainability Reform Important Mitigating Factors

The Finnish pension system performs well in terms of social and financial sustainability. The system is mostly based on earnings-related pension schemes, complemented by national and guarantee pensions that secure a basic livelihood for people with limited income.

Earnings-related pensions in Finland are part of statutory social security and include, in addition to the pay-as-you-go scheme, partial funding in both private and public-sector schemes. This is relatively rare in European social security pensions, which are usually funded as pure pay-as-you-go systems.

The pre-funding element supports the resilience of the system for the future, especially given the significant accumulation of pension schemes’ assets over recent decades (see Figure 2). These assets increased from about EUR 40bn in 1995 to above EUR 250bn last year, or to over 100% of GDP, and remain elevated at EUR 245bn despite the weak performance of global financial markets in the first half of 2022.

Figure 2. Employment pension schemes assets

EUR bn (lhs); % of GDP (rhs)

Source: Statistics Finland, Macrobond, Scope Ratings

The investment return of pension assets plays a key role in the Finnish earnings-related pension system, by supporting the financing of annual pension payments. This allows a reduction in contributions collected both at present and in the future, thereby limiting distortions in the labour market. Earnings-related pensions today are already in part covered by returns on investment funds. Annual investment returns are generally higher than the contributions required to cover pension costs, allowing a further increase in asset positions of the schemes.

Adverse Demographic Trends Will Challenge Sustainability of the Pension System

Despite this favourable position, adverse demographic trends will challenge the financial sustainability of the pension system over the long run as the latest projections from the Finnish Centre for Pensions show.

That said, Finland is better prepared than many other European countries, because it set up a forward-looking system, together with proactive reform and high social acceptance. This is demonstrated by the strong link between retirement age and life expectancy introduced with the major pension reform of 2017.

The government has also been proactive in addressing health and long-term-care spending. The IMF estimates the net present value of the cumulative change in healthcare spending between 2021 and 2050 for Finland amounts to 36% of GDP. Next year, the landmark healthcare reform (SOTE) will take effect, providing for the shift of social and healthcare services from the highly-fragmented municipal sector to newly-created county governments.

If corroborated by solid fiscal targets, the rationalisation in service provision could contain costs in an area driving structural imbalances in Finland’s government finances.

References: Finnish Centre for Pensions, The Finnish Pension Alliance TELA

For a look at all of today’s economic events, check out our economic calendar.

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

Baltics: Small, Open Economies Face Highest European Inflation; Underlying Credit Resilience Intact

Soaring inflation is a widespread challenge for many economies. However, for the Baltics, the challenge is especially acute. Inflation in August was running above 20% YoY, more than 10 times the ECB inflation target.

Specifically, inflation stood at 24.8% for Estonia (rated AA-/Stable), 22.4% in Lithuania (A/Positive) and 21.6% in Latvia (A-/Positive), in all three cases more than double the euro-area average of slightly above 9%.

Inflation is set to average 17-20% for the year (Figure 1) across the three economies, before dropping by around a half by next year, as base effects improve, to still unusually elevated levels.

Figure 1. Inflation among euro area countries

% YoY, August 2022 (or most recent month available)

Source: Macrobond, Scope Ratings

High Vulnerability to Inflation Results in Sharp Economic Slowdown

The Baltic economies are especially vulnerable to current inflationary pressure in view of comparatively higher shares of energy and food items in their respective consumption baskets, which reflects, among other factors, the Baltics’ still relatively lower income levels vis-à-vis that of euro-area peer economies. As prices for energy and food have soared since escalation of the Russia-Ukraine war, inflationary pressure has risen significantly.

Such high inflation holds adverse consequences particularly for small economies such as those of the Baltic region, notably for social stability via eroding purchasing power and savings, creating regressive redistribution among different income groups as well as between creditors and borrowers. Inflation also creates uncertainty for businesses around future costs and prices, which deters investment.

The economic impact of soaring prices on businesses and households is visible in the region’s slowing economic growth. Output contracted in the second quarter across the Baltic region, between -0.5% and -1.3% quarter-on-quarter. We expect annual growth to remain moderate this year – between positive 1% and 2% for Estonia and Lithuania and around 2.5% for Latvia.

The headline annual growth figures are deceptive as they reflect a carry-over from the robust economic growth at the beginning of the year. The economies face a sharp slowdown during the second half of 2022. Next year, growth will slow further but we do not expect full-year contraction. However, fuller recovery will be delayed to 2024.

Limited Solutions to High Price Pressures Ahead, but Solid Fundamentals Cushion Ratings

The ability of the ECB to curtail high inflation appears especially limited in the case of the Baltics despite the 75bp rate hike last week, and this is not only due to a dominant role of supply-side factors in current inflation.

Although inflation in the Baltic region is far higher than euro-area averages, the ECB focuses its monetary policy on average inflation of the single currency area, inherently skewing policy toward its largest member states. As such, ECB policies remain overly accommodative for inflation conditions in smaller Baltic economies.

Also, demand-driven inflation is stronger than in other euro-area member states, after comparably modest economic contractions in the Baltic region during 2020 Covid-19 crisis peaks, which were swiftly followed by robust recoveries. Tight labour markets are likely to favour longer-lasting inflation risk, as vacancies remain high and unemployment rates low even after recent inflows of Ukrainian refugees.

Moreover, Baltic governments are under growing pressure to step up budgetary support to alleviate price pressures on businesses and households, although such support – depending on its overall volume and target – might further contribute to underlying inflation dynamics.

However, the three countries as well share common credit strengths. These include access to significant EU funding over coming years via the Cohesion Policy and Next Generation EU programme, solid economic fundamentals, profitable banking systems, and robust institutions, helping the region cope with the energy crisis and supporting their respective credit ratings.

In addition, Estonia, Latvia and Lithuania benefit from comparatively low public debt ratios. Relatively robust growth in nominal terms should help stabilise debt-to-GDP despite widening budget deficits and rising financing costs within the euro area.

Scope Ratings’ next sovereign calendar review dates of the region are:

  • Lithuania: 18 November 2022
  • Estonia: 25 November 2022
  • Latvia: 2 December 2022

For a look at all of today’s economic events, check out our economic calendar.

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

Finland, Sweden: Covid-19 Resilience Creates Buffers Against War Costs and Geopolitical Risks

The economies of Finland and Sweden proved resilient during the Covid-19 pandemic crisis. Economic contraction in 2020 of 2.3% and 2.8% of GDP respectively was approximately half the average for EU countries. This was followed by rapid recoveries, with real GDP already reaching pre-pandemic levels in both countries during the first half of 2021 (see Figure 1).

Figure 1: Economic recovery from Covid-19

Real GDP level, 2019=100

Source: IMF, Scope Ratings

The strong economic rebound also allowed for quick recovery in the countries’ government budgets last year, with a rapid reduction of headline fiscal deficits to levels well below those of European peers and already in compliance with the EU’s 3% Maastricht reference deficit limit.

Resilience during Covid-19 crisis leave Finland, Sweden well positioned to contend with Russia-Ukraine war costs

The short-lived effects of Covid-19 leave the countries well positioned to face adverse economic ramifications of the Russia-Ukraine war. We expect the war to affect both countries’ economies via several channels, including trade links and commodity price shocks.

We have thus revised down our economic forecasts for this year by about 1pp in the case of Finland to 1.7%, and by 0.7pp in the case of Sweden to 2.6%. Next year, we expect Finland to grow by 1.5% and Sweden by 2.3%.

The growth revision for Finland reflects its geographic proximity to Russia resulting in strong economic links between Finland and Russia. Russia was Finland’s fifth most important export market in 2021, accounting for about 5% of total exports and more than 1% of value added. Sweden’s trade relations with Russia are less significant, accounting for just above 1% of aggregate exports.

In addition, Finland has higher energy dependence on Russia than Sweden does. However, when compared with the EU average, Finland’s energy mix benefits from wider diversification of sources and lower reliance on natural gas. Inflationary pressures are visible in both economies, with Finland’s March inflation rate at 5.8% and Sweden’s at 6% YoY.

Implications of Russia-Ukraine war are primarily political

The implications of the Russia-Ukraine war are primarily political, with geopolitical concerns a tail risk for the countries’ respective credit outlooks.

This is reflected in fiscal- and foreign-policy shifts. Defence spending is set to increase in both nations; however, approved measures do not, as yet, indicate a reversal of the gradual improvement of headline fiscal deficits expected over the next several years.

More fundamentally, official debates concerning a decision to join NATO have intensified over the recent weeks. Many political forces have already expressed public support for such membership. This reflects a shift in public opinion since the war in Ukraine escalated. There is now a solid majority in both countries in favour of joining the military alliance (see Figure 2). Both countries are likely to present a joint membership application in the coming weeks.

Figure 2: Public support for NATO membership

Public opinion survey results, %

Source: 2014: YLE, Taloustutkimus, Novus; April 2022: MTV Uutiset, Aftonbladet, Demoskop

Finland is especially exposed to the conflict given geographical proximity to Russia

Finland is particularly exposed given its geographical proximity to Russia: this shared border stretches over 1,300km. This explains why Finland has taken the lead among the two countries around next steps in applying for NATO membership.

At this stage, we consider an escalation of geopolitical risks to the point of threatening either country’s macro-economic stability as very unlikely. This is also due to the very strong international ties of Sweden and Finland to European and other Western allies, which in our view create a fundamental deterrent to a direct attack from Russia.

For a look at all of today’s economic events, check out our economic calendar.

Giulia Branz is an Analyst in Sovereign and Public Sector ratings at Scope Ratings GmbH. Eiko Sievert, Director at Scope Ratings, contributed to writing this commentary.

Spain’s Surging Inflation Sets Back Economic, Fiscal Recovery; Growth to Slow in 2022

We have preliminarily revised down real growth forecasts for this year and next. Spain’s output will grow 4.0-4.5% in 2022, below our December forecast of 6% for this year, and under the 5.1% growth of last year. Growth will then further slow to 2-3% in 2023.

Across Europe, the repercussions of the war and the imposition of international sanctions on Russia are aggravating price pressures and supply disruptions predating February’s invasion of Ukraine.

Very elevated inflation in Spain and across the euro area

In the case of Spain, there were significant price shocks in January and February, confirmed by most recent data releases in March, with the headline rate of inflation jumping to 9.8%, the highest in 37 years, mostly driven by energy and food prices, as core inflation remains relatively contained, averaging below 3% in the first quarter.

Very elevated inflation rates have been recorded this month also in the other large euro-area economies, although to a somewhat lesser extent. In Germany, inflation stood at 7.3%, in line with Italy’s rate at 6.7%, while price pressures were more modest in France with inflation of 4.5%.

In the current quarter, the interplay of raw materials shortages and rising prices is likely to maintain upward pressure on inflation. Ultimately, the short-term path of inflation will depend on the duration of the war and on the extent and persistence of sanctions on Russia.

For the whole year, the inflation rate in Spain would average above 5% even under an unlikely scenario of convergence towards the ECB’s inflation target of 2% by the end of this year. If pressures should persist in line with the first three months of the year, annual inflation would average at 8%.

Inflation outlook for Spain

HICP inflation rate, %

Source: Eurostat, Scope Ratings GmbH

High-flation presents a challenge for the ECB

Spain’s and the euro area’s inflation surge presents a challenge for the ECB. Price stability is the core mandate of the central bank. However, the ECB is confronting a very specific situation, in which inflation is mostly driven by supply-side shocks, together with a slowdown in economic growth. In other words, rate hikes by the ECB in the current situation cannot directly address the inflationary effects related to the spike in energy prices from the war in Ukraine.

We expect flexibility to remain the cornerstone of the ECB response, with the central bank taking steps towards normalisation of monetary policy through a gradual ceasing of net asset purchases while adapting to economic circumstances as they evolve.

Spanish government measures to alleviate the impact of high inflation for the private sector

The Spanish government’s measures to alleviate the impact of elevated inflation on Spanish businesses and households include a reduction in the prices of fuel, caps on rent increases, increased income support for poorer households as well as provision of state-guaranteed loans. These support packages come at a budgetary cost of around 1-2% of GDP and therefore are also likely to affect Spain’s funding programme for 2022.

Though the Russia-Ukraine war and its economic ramifications have changed the global economic outlook, fiscal policy at the European level will likely remain supportive in the near term, helping national governments tackle some of the additional costs from high energy prices and refugee inflows. Still, it is unclear at this stage to which extent fiscal support will continue in 2023 and beyond, when the suspension of the Stability and Growth Pact is scheduled to end.

Discussions on possible modifications to the current rules as well as around additional EU-wide fiscal measures to address the energy, security and migration consequences of this crisis – including a new EU resilience fund, along the lines of the Covid-19 EU Recovery and Resilience Facility – are ongoing.

While we expect the policy response by the EU to entail some burden-sharing, additional flexibility of fiscal rules is likely. Spain’s own efforts to consolidate its public finances will be delayed due to the conflict as the government faces complex policy trade-offs as the economy recovers from the pandemic.

For a look at all of today’s economic events, check out our economic calendar.

Giulia Branz is Analyst in Sovereign and Public Sector ratings at Scope Ratings GmbH. Jakob Suwalski, Director at Scope Ratings, contributed to writing this commentary.

 

Stronger EU Architecture and Debt Profiles Shield Euro Area Periphery From Wider Financial Fragmentation

Yields on euro area peripheral countries’ government bonds have sharply increased from very low levels in February, reflecting a wider rise in euro area bond yields and largely discounting a rate hike before the end of the year. However, the risk of severe financial fragmentation in the euro area remains low.

Risk premia in southern European countries – Greece (rated BB+/Stable), Italy (BBB+/Stable), Portugal (BBB+/Stable), Spain (A-/Stable) – are discounting tighter future monetary policy, particularly after ECB February decisions confirmed the halt of net asset purchases under the Pandemic Emergency Purchase Programme (PEPP) by March 2022. The central bank has also shifted its guidance towards the possibility of a rate hike before the end of this year.

Highly indebted euro area governments are comparatively more reliant on central bank support

We recognise that highly indebted euro area governments are comparatively more reliant on central bank asset purchases to retain favourable market conditions and are more sensitive to rising financing costs, given in general the need to refinance large volumes of debt and their history of restricted market access during the euro area sovereign crisis.

The impact of higher yields on debt sustainability needs to be seen in the context of improved debt structures, however, for these four southern euro-area countries. The countries have extended their average debt maturity over the past decade, which means that the cost of new debt only rolls in over a longer period.

The average cost of issuance remains moderate under historical standards and, for most countries, below the cost of outstanding debt, thereby supporting a continued reduction in the interest burden on the back of robust economic growth over coming years. With higher inflation, real yields remain negative despite the recent rise in risk premia.

Flexibility has also become a core element of ECB monetary policy

Flexibility has also become a core element of ECB monetary policy. In December, the PEPP reinvestment phase was extended until at least 2024, including a temporary increase in net purchases under the Public Sector Purchase Programme to smooth the exit from the PEPP. Also, the ECB can re-start the latter programme in cases of emergencies after communicating readiness to adjust flexibly PEPP reinvestment under renewed market fragmentation.

The EUR 800m in Next Generation EU recovery funds also asymmetrically favour the countries with weaker economies, underpinning an encouraging medium-term economic outlook.

All factors point to stronger commitment and a clearer path towards long-run financial integration in the euro area.

Other challenges confront southern European sovereigns’ debt sustainability

Over the long run, however, other challenges emerge in terms of the ability of government in Greece, Italy, Portugal and Spain to sustain high levels of public debt, including the possibility of future political instability, which could hamper government efforts to implement required reforms to make effective use of EU recovery funding and address countries’ challenges such as adverse demographic trends and moderate-to-weak growth potential, which place structural pressure on their budgetary performance.

Without the implementation of important reforms, structural factors impede any substantial reduction in debt, which in a context of future rate increases and normalisation of monetary policies, will increase these countries’ vulnerabilities to financial shocks.

Read Scope’s report.

For a look at all of today’s economic events, check out our economic calendar.

Giulia Branz is Analyst in Sovereign and Public Sector ratings at Scope Ratings GmbH. Jakob Suwalski, Director in Sovereign and Public Sector ratings at Scope Ratings, contributed to writing this commentary.

Portugal: growth, fiscal momentum at risk as snap elections end six years of political stability

Snap elections come at a sensitive time and a delayed budget will likely hold some adverse repercussions as concerns the country’s post-pandemic recovery plans on top of the impact from increased political uncertainty.

The time needed to form a new government could impede Lisbon’s efforts in implementation of reform and deployment of crucial investment outlined in the country’s recovery plan, despite the government’s strong record as regards improving Portugal’s long-run growth and government finances.

Recent opinion polls suggest the Socialist Party could come out on top in an early election but again fall short of a parliamentary majority, indicating any new government is expected to be tricky to form. Strained relations with left-wing parties, which have so far granted external support to Prime Minister Antonio Costa’s minority government, may increase risk of permanent political instability.

Complex coalition politics could ultimately dent Portugal’s record of fiscal prudence

Portugal’s dependence upon more complex coalition politics in formation of governments, while increasingly common in European capitals, might ultimately dent authorities’ records as concerns prudent fiscal policy and commitment to fiscal consolidation, and hinder gradual unwinding of structural economic imbalances, including reduction of elevated structural unemployment.

Economic stagnation is a key risk for Portugal given modest growth potential, which we estimate at only 1.5%.

The proposed budget from the Socialist-led minority government, voted down by two left-wing allies, would have trimmed the budget deficit to 3.2% of GDP in 2022 from 4.3% in 2021, confirming commitment to fiscal stabilisation.

Fiscal discipline has become the norm in Portugal’s policy making, with the government’s debt-to-GDP ratio declining 14pps between 2015 and 2019, supported by elevated primary surpluses combined with robust growth.

The economy has become better positioned for sustained growth

The economy has become increasingly better positioned for sustained growth since 2014 as banks rebuilt capital buffers and liquidity, while households and corporates have started belatedly deleveraging. The public debt-to-GDP ratio rose sharply to around 134% of GDP in 2020 due to the pandemic crisis, from 117% in 2019. However, the government retains a sizeable cash buffer, equivalent to around 12% of GDP as of 2020, providing some flexibility in funding plans.

We expect the public debt ratio to resume a downward trend in 2021 despite primary deficits of around 2% of GDP in 2021 and 1% in 2022. Low interest rates and robust growth expectations, underpinned by Portugal’s EUR 17bn recovery and resilience programme, pave the way for post-crisis public debt reduction.

For a look at all of today’s economic events, check out our economic calendar.

Giulia Branz is Analyst in Sovereign and Public Sector ratings at Scope Ratings GmbH. Jakob Suwalski, primary sovereign analyst of Portugal at Scope Ratings, contributed to writing this commentary.

Italy, Spain Face Post-Pandemic Political Tests: Can EU Funds Ensure Near-Term Political Stability?

It is not clear. Italy is enjoying a rare phase of political calm while a reshuffled government of Spain may have engineered some momentary political stability of its own.

At the very least, Italy and Spain are examples of how euro-area governments are feeling their ways toward normalising budgetary policies after the Covid-19 crisis and addressing longer-term issues of sustainable growth vis-à-vis a mix of reform and use of EU recovery resources.

Sea change in Italy since Draghi’s rise to premiership

In Italy, there has been a sea change on the political end since February, with formation of the government of former ECB President Mario Draghi, who benefits from a strong absolute majority in parliament.

Draghi has accomplished some main objectives in his short time in office so far, namely accelerating the vaccination campaign and drafting the recovery programme.

Structural reform of Italy’s large and diversified economy remains paramount, all the same. Draghi needs to reconcile differing opinions of political groupings within his government – concerning judicial reform, competition policy and fiscal reform among other priority areas – in plans he aims to present later this month. Progress in ridding Italy of the bottlenecks that limit the nation’s growth potential is indeed vital.

A lengthier period under Draghi’s stewardship could be positive for Italy’s credit ratings

But how long will Draghi remain as head of government?

The current legislature ends in 2023, but early next year, Italian MPs elect the next Italian President.

Pre-pandemic, Draghi was the clear candidate to replacing President Sergio Mattarella in this role, in view of Draghi’s political stature and broad-based political support. Now the circumstances are less clear. One option is for Mattarella to seek a new term to allow Draghi to continue on as Prime Minister until 2023.

This could give Draghi the adequate time to oversee critical reforms and other measures to help ensure Italy achieves a more durable recovery while avoiding snap elections at this current critical juncture. A lengthier period of political stability in Italy would be considered as positive for Italy’s BBB+/Negative credit ratings.

Spain’s political situation remains challenging, though a temporary period of stability is possible pre-elections

In Spain, the political situation remains challenging, with a minority government of Prime Minister Pedro Sánchez’s Socialist Party and far-left Unidas Podemos (UP) facing a degree of instability after regional elections in Madrid, after which UP-head Pablo Iglesias resigned as Deputy Prime Minister.

Nonetheless, a potentially more encouraging development has been the government’s decision to partially pardon nine Catalan politicians and officials imprisoned after the illegal Catalan independence consultations of 2017. This move should facilitate more conciliatory relations between central and regional governments and ensure the Catalan pro-independence party, ERC, continues to support Spain’s central government in passage of critical legislation, most importantly the 2022 Budget.

These circumstances may lead to a temporary phase of political stability in Spain before elections due by December 2023.

EU Recovery funds support government stability and reform momentum

For Italy and Spain, the recovery and resilience programmes should support government stability and reform momentum over coming years. The large-scale EU funds allotted to the countries, with Italy and Spain being among main beneficiaries of EU funding, incentivise political groups to place differences aside for the moment to avoid stalling a fledgling recovery.

Simply reducing by half the gap between Italy’s and Spain’s respective performance compared with the strongest EU nations in terms of structural reform implementation would raise output by around 17% and 10% over 20 years, according to the European Commission. Leaving aside the social benefits, such growth would significantly help the countries manage elevated budget deficits and public debt.

On 16 July, the Agency I represent affirmed the ratings of Spain at A- and revised the Outlooks to Stable, from Negative. Our next scheduled sovereign credit review of Italy is on 20 August.

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

A Draghi Government would have Longer-Term Implications not Only for Italy but Europe at Large

The former ECB president has accepted “with reservation” the responsibility of seeking to form a “government of national unity” to lead Italy out from the crisis as well as to ensure a robust spending and reform programme in exchange for EU recovery funds.

Draghi’s decision has reduced the likelihood of snap elections, which we have considered unlikely and which would otherwise consume government time and energy amid a severe public-health crisis. At time of writing, Draghi appears on route to consolidating a majority in Parliament and to forming a new government in the period ahead.

Draghi’s mission is to ease political uncertainty and enhance Italy’s budgetary response to this crisis, ensure efficient implementation of Italy’s share of EU recovery funds and produce a more effective strategy on vaccination – where Italy and the EU have lagged. According to a recent poll, more than half of Italians want Draghi to remain as prime minister until 2023, when the next general elections are due.

Italy needs an effective and stable government to remain in place for the duration of the current legislature till the middle of 2023. After 66 governments over roughly the past 75 years, Italy cannot afford to continue with policy paralysis. A very short Draghi administration only before presidential elections of 2022 would similarly maintain political uncertainty.

Ratings implications for Italy as well as for the remainder of the EU

With Italy’s debt at record levels of around 160% of GDP, the new government will need to emphasise a sustainable policy framework that favours recovery near term through the strategic investment of EUR 209bn of EU funds and that defines a vision for fiscal discipline longer term. How any Draghi premiership manages this difficult balancing act will inform credit-ratings implications; however, short term, a resolution of political uncertainty, accelerating a path out of crisis and any sustained easing of Italian borrowing rates would be positive for ratings.

Draghi has the advantage of his high standing with investors as well as with Italy’s EU partners. The support of European institutions has been fundamental in facilitating the ever-lower borrowing rates that Italy has benefitted from despite higher debt. The spread on Italy’s 10-year government bonds is currently trading below 100bps over Germany’s – the narrowest in more than five years.

Draghi is, moreover, well placed to ensure Italy’s voice is heard in regard to institutional reform in the EU, including as it pertains to the EU’s fiscal framework, such as the Stability and Growth Pact, or with relation to a common euro budget – this bears implication not only for Italy but for the remainder of the EU.

No easy political path

The scale of any parliamentary majority Draghi gains will be critical for ensuring the longevity of an administration and its capacity to undertake required regulatory and administrative reform in partnership with the European Commission.

Any very broad unity government with competing for internal policy preferences alongside a part-technocratic, part-political composition could, however, ensure also the same discordance over time that curtails governability.

Italy’s economy contracted 8.9% in 2020, less severely than the 9.6% slump Scope had anticipated. Italy has historically a weak track record for the efficient deployment of EU structural funds: over the 2014-20 EU budgetary period, Italy spent (only) 43% of allocated monies.

For a look at all of today’s economic events, check out our economic calendar.

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

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).

Download the full Scope Ratings report.

For a look at all of today’s economic events, check out our economic calendar.

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.