Scope Ratings sovereign analysts Giacomo Barisone and Dennis Shen discuss five pressing questions for policymakers and investors:
1) The euro area’s near-term outlook for recovery remains challenging given renewed increases in Covid-19 cases and the slow vaccine rollout. What is Scope’s outlook on growth?
Giacomo Barisone: We continue to expect the recovery to gain a firmer footing by early spring 2021 as pandemic-related restrictions are slowly relaxed. However, amid the sluggish vaccination rollout in the European Union due to supply constraints and rising numbers of Covid-19, the recovery will remain uneven and subject to setback. The scale of the recession last year was also less severe than anticipated in the euro area – especially in countries such as France – as Europeans adapted to lockdown conditions by the fourth quarter of 2020. This reduces some of the upside to 2021 growth. We do see downside risks to our December forecast for 5.6% euro-area growth in 2021.
2) Euro-area core inflation increased sharply in January, reaching 1.4% – its highest level since 2015. Will underlying inflation pressures rise significantly in the euro area?
Dennis Shen: There is plenty of inflation globally – but this inflation is mostly in asset prices rather than in consumer prices. As noted in our 2021 Outlook, there is downside risk to the global recovery from any correction in inflated property, equity and bond markets, which could tighten global financial conditions. We are seeing such a correction in real time in debt markets, but EUR 5.6trn of euro-area government debt was still negative yielding as of end-February. Consumer-price inflation will rise near term from February’s 0.9% headline rate in the euro area – but this increase is linked in significant part to temporary factors such as higher energy prices as well as one-offs like the reversal of the German VAT reduction. Longer term, we see continued structural limits to sustained higher consumer price inflation. Indeed, ECB forecasts this week indicated average annual HICP inflation does not exceed 1.5% in any of the next three years. As the ECB considers a symmetrical inflation objective – implying somewhat greater future tolerance of more elevated inflation – we expect monetary policy to remain highly accommodative even as inflation rises.
3) Higher inflation expectations have caused bond yields to increase globally and triggered ECB action Thursday. What is the outlook for monetary policy moving ahead?
DS: The increase in global yields, while led by reflation concerns in US markets, has certainly made euro-area financial conditions less accommodating. Nevertheless, the sell-off has remained more moderate in the euro area: 10-year Bunds at time of writing are yielding around -0.3% compared with -0.6% at the start of this year.
The ECB has sought to ease or reverse this increase on the long end of the curve – talking down markets and backing words up with a pledge on Thursday to (temporarily) “significantly” speed up asset purchases over the coming quarter. There is still nearly EUR 1tn of unused ammunition under the Pandemic Emergency Purchase Programme (PEPP)’s EUR 1.85tn remit as of end-February, so no immediate need to increase the aggregate size of the programme. The ECB could, however, extend in the future the suggested earliest end-date of PEPP purchases of March 2022 and/or the earliest end-date for reinvestment of expiring bond proceeds should this be needed to re-emphasise its “lower for longer” message.
4) The recovery hinges on the already-sizeable fiscal stimulus to continue being extended. What is the outlook for euro-area public finances?
GB: The outlook for government finances is challenging. The aggregate general government deficit of the euro area widened to 8.8% of GDP last year from 0.5% in 2019 and the aggregate public-debt ratio rose to 101.7% of GDP from 85.9% in 2019 with large differences across member states. The EU’s fiscal framework will remain suspended until at least 2023 to support a sustained rebound over coming years, as governments still need fiscal support in anchoring recovery.
Still, once recovery gains traction, fiscal consolidation, particularly among highly indebted sovereign borrowers, will be critical. Here, a revision of the EU’s overly complex fiscal rules, replacing, as an example, unobservable structural targets with measurable expenditure rules, could be a credible route to facilitating the required adjustment.
We expect governments will selectively and gradually phase out emergency budget measures introduced in 2020, particularly as they are set to benefit from windfall tax receipts as growth recovers. Even so, for many countries of the euro area – such as Italy, Spain and France – public-debt ratios are structurally on an upward trajectory looking through the cycle.
5) Does the sharp rise in public-debt ratios across euro-area countries come with debt sustainability risks, in Italy or Spain as an example?
GB: We believe EU institutional reform – including steps taken toward more significant fiscal union via the Recovery and Resilience Fund – and the highly accommodative stance of the ECB will ensure debt sustainability risks are manageable at least near term. Political wrangling around the management of the Fund has been resolved for the moment in Spain’s case and, more recently in Italy, with a more constructive reform and strategic framework since the appointment of Mario Draghi as Prime Minister. Nevertheless, longer-term debt sustainability risks remain a significant concern.
Read more on Scope’s views about the 2021 recovery and ECB policy in the Sovereign Outlook 2021 (published 9 December 2020).
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