By Paolo Pizzoli, Philippe Ledent
Bond yields and spreads on the rise
The dramatic adjustment in interest rates over the past few months has many implications. One of the most serious of these is the issue of debt sustainability in highly indebted countries, as the sharp rise in yields and other key geopolitical factors threaten to push the Eurozone economy into stagflation or even recession.
The rise in inflation, which began in 2021, has been exacerbated by the war in Ukraine, with price increases far exceeding the field of energy. The European Central Bank’s decision to accelerate its normalization trajectory by stopping net purchases in all its programs and raising interest rates has led to a sharp increase in public debt rates, especially in highly indebted countries. .
Since early December, the 10-year Bund yield has risen 190 basis points, with Italian BTPs rising around 265 basis points. The spread is currently hovering around 200 bps. The ECB’s decision to accelerate the end of net purchases under its asset purchase program put pressure on spreads in highly indebted countries. The days of the ECB fully financing deficits, as seen during the pandemic, are over. However, the temporary reinvestment of maturing bond holdings under the APP and the flexible reinvestment of maturing bonds under the Pandemic Emergency Purchase Program will clearly facilitate the transition to private financing. .
A widening of spreads in a rising rate environment is not surprising: as base rates rise, government bond investors may decide to replace peripheral bonds with German Bunds to achieve the same yield with a better credit profile. At present, the widening of Italian spreads appears to be in line with the post-sovereign debt crisis norm, while Spanish and, more significantly, Portuguese bonds are widening less than the historical statistical relationship suggests.
The sharp rise in interest rates and the decline in support from the ECB have reignited latent concerns about debt sustainability, especially for highly indebted countries. Are these concerns justified? In order to answer this question, we performed some simple public debt simulations for a selection of euro area countries, trying to distinguish those that are most exposed to sustainability risk under different spread assumptions, based on our base scenario. As a sustainability benchmark, we look at the ability of the debt-to-GDP ratio to decline or at least stabilize over time.
Bond yields have risen significantly since the start of the year
Benchmark yield in % for selected euro area countries
Short and medium term sustainability
A common feature of the countries examined is a relatively high weighted average debt maturity, ranging from 7.1 years for Italy and Germany to 18.2 years for Greece, the latter reflecting the dominant role of ultra-high government lending. -long in Greek debt. A relatively long average maturity is a key factor in favor of debt sustainability. The longer the average maturity, the longer it will take for an interest rate shock to affect the entire stock of debt and, therefore, the average cost of debt.
The other factor temporarily helping to ensure short-term debt sustainability is inflation, as long as the market underestimates the outlook for price growth. Inflation (insofar as it is also reflected in the GDP deflator) acts both through the budgetary brake and through the so-called inflation tax, which reduces the real value of the non-indexed debt. Even as governments spend more to help households and businesses cope with soaring energy bills, increased tax revenues due to rising inflation, at least in the short term, outweigh on the increased cost of interest rates incurred to refinance maturing debt, thereby improving public accounts.
A little buffer
The simulations we run, assuming persistent interest rate shocks, show that given that the average maturity of debt is so long, the debt profile is not of particular concern, even with projections of unspectacular growth. Indeed, in our base scenario with moderate trend growth, inflation close to the ECB’s medium-term objective, non-zero but moderate bond spreads and budgetary efforts to reduce primary public finance deficits, no country is on a dangerous trajectory for public finances. To test the resilience of these trajectories, we simulate a doubling of bond spreads relative to our baseline scenario. In the medium term, this means a spread of 300bp for Italy and Greece, 160bp for Spain and Portugal, 90bp for Belgium and 80bp for France. In the short term (2022), spreads are even higher. All other things being equal, such a doubling would represent an additional interest charge of 420 billion euros for the euro zone between 2022 and 2030. That said, the trajectory of the debt ratio of the euro zone as a whole would remain oriented downward path. However, this encompasses very different situations. Italy, Spain and Belgium would no longer be able to reduce their debt ratio (see charts below). A snowball effect would also be observed at the end of the period in Italy and Belgium. The other countries would maintain a downward trajectory of their debt ratios.
Impact of a doubling of bond spreads on the trajectory of public debt
Belgium and Spain
Impact of a doubling of bond spreads on the trajectory of public debt
Growth is crucial
For highly indebted countries like Italy, bringing the debt-to-GDP ratio back on a downward path over the medium term would require a return to stable primary surpluses. Over time, the interest rate shock would gradually apply to more of the existing debt, driving up the average implicit interest rate. When existing debt exceeds nominal GDP growth, the so-called “snowball effect” begins to affect the debt-to-GDP ratio, requiring some compensation in the form of a surplus. primary.
Reducing the primary deficit and maintaining sufficient growth are therefore essential for the stability of public finances. For example, reducing economic growth by one percentage point each year over the forecast horizon relative to the baseline scenario would have a snowball effect in France, Belgium, Italy and Spain, even if one assumes that the primary deficit as a percentage of GDP does not deteriorate from the initial path.
Unsurprisingly, current medium-term budget planning documents in highly indebted countries such as Italy and Greece are already forecasting a return to primary surpluses within the next three years. The level of primary surplus required will critically depend on how effectively countries can move sustainably to a faster growth path. How countries use the Recovery and Resilience Facility, with its mix of spending and reform, will play a key role here.
When considering sustainability risk vulnerabilities, we cannot ignore the fact that investor behavior could lead to market fragmentation, even in the absence of relevant changes in macroeconomic fundamentals. The recent episode where the BTP-Bund spread quickly widened to the 250bp zone is a good example of this, prompting the ECB to call an emergency meeting to announce anti-fragmentation measures.
This publication has been prepared by ING for information purposes only, regardless of the means, financial situation or investment objectives of any particular user. The information does not constitute an investment recommendation, nor investment, legal or tax advice, nor an offer or solicitation to buy or sell a financial instrument. Read more.