Government bonds: Could a new debt spiral be starting to form?
Low financing costs are currently still warding off a repeat of the 2011 sovereign debt crisis – but governments will need to improve the sustainability of their debt.
An article by Christian Kopf, Head of Fixed-Income Portfolio Management and a member of the Union Investment Committee (UIC)
- The inflation shock and the actions taken by central banks in response are causing turmoil in the bond market
- Focus is shifting towards the cost to industrialised countries of servicing their debt
- Government bonds continue to offer a high degree of safety (go to quote)
- Inflation is bringing debt ratios down more quickly
- The era of cheap money is over and budget discipline will be required
Over the past two-and-a-half years, unforeseen events such as the coronavirus crisis and the war in Ukraine have been putting a strain on the public finances of many countries. Most recently, the central banks’ monetary policy turnaround has been causing turmoil in the bond market. Many market participants are now concerned that Italy’s national debt could get out of control if the ECB raises interest rates. Are these worries about the sustainability of national debt levels justified? Is the eurozone heading for a repeat of the 2011 sovereign debt crisis?
The inflation shock and the actions taken by central banks in response are causing turmoil
The current environment is challenging. First, the coronavirus pandemic led to a slump in tax revenue. Decisive fiscal policy action successfully mitigated the impact of the crisis. Then, a sharp rise in inflation, triggered partially by this robust fiscal policy response, led to further disruption. In light of the war in Ukraine, many countries have adjusted their security policy in ways that require a substantial increase in public spending. In addition, monetary policy is set to shift. The central banks have laid out plans that will result in significantly tougher financing conditions. Central banks in the eurozone have already terminated all purchases of additional government bonds. And the European Central Bank (ECB) is preparing to phase out negative interest rates.
This monetary policy shift drove up yields in the capital markets. Italian government bond yields spiked after ECB President Christine Lagarde surprised the markets on 9 June 2022 by announcing that the ECB would double the pace of its planned cycle of interest-rate hikes from September. Many market participants are now concerned that Italy’s national debt will get out of control when the ECB raises interest rates. The bank seems to share the concern about potential market disruption. A few days after Lagarde’s announcement, the ECB Governing Council convened an emergency meeting. It now wants to develop a new mechanism for market interventions with the aim of keeping a lid on rising government bond yields.
Focus is shifting towards the cost of debt in industrialised countries
At first glance, concerns about the robustness of public finances seem justified. Whereas governments in the eurozone had, on average, been generating a budget surplus (before interest payments) of just under 1 per cent of gross domestic product (GDP) at the start of the pandemic, they are now running a substantial deficit. The ‘primary balance’, the important key figure for debt sustainability, has dropped to an average deficit of 3 per cent of GDP. At 95 per cent of GDP, the eurozone’s average debt ratio is nearly 12 percentage points higher than in 2019. Italy’s national debt could rise to 151 per cent of GDP this year.
Many national economies can reduce their debt ratios
Projections for the sustainability of selected countries’ national debt in 2022
Sovereign debt ratios are rising more slowly in the eurozone than in the US. According to estimates of the International Monetary Fund (IMF), the US debt ratio has climbed from 109 per cent of GDP to 126 per cent of GDP since 2019. The eurozone’s debt ratio is also significantly lower than Japan’s, which is expected to reach approx. 263 per cent this year.
But at the same time, the bloc has a lower level of debt sustainability because individual member states are accumulating debt in a currency that they cannot control themselves. Central banks in the eurozone are not going to commit to unlimited government bond purchases in the same way as the Federal Reserve and Japan’s central bank. In addition, it is possible for investors in the capital market to stop providing funding to specific EU member states without having to withdraw their capital from the eurozone as a whole.
Government bonds continue to offer a high degree of safety relative to other asset classes.
This means that, for governments in the eurozone, there is no way around slowly scaling back their budget deficit. But will the capital markets grant these countries the time they need to gradually bring down their debt levels? A closer look at the data suggests that the chances are decent. After all, the conditions required for a sustained rise in debt ratios are not currently present. Consequently, government bonds continue to offer a high degree of safety relative to other asset classes.
Compared with pre-coronavirus conditions, budget deficits have increased and the sustainability of government debt levels has deteriorated as a result. But other factors have shifted in a favourable direction. Years of extremely low yields in the market, which allowed governments to borrow at very low costs, have seen the average interest rate on outstanding government bonds fall substantially. In Germany, it now stands at just around 0.6 per cent, in Italy at around 2.0 per cent. This means that the cost of servicing public debt has fallen to historically low levels in industrialised economies. In the case of Italy, for instance, debt service accounted for 13 per cent of government spending 20 years ago. This year, only 6 per cent of public spending was used to pay interest, despite a substantial increase in the country’s debt ratio.
Cost of debt service in Europe is falling
Interest payments as a percentage of national expenditure
The average interest rate of industrialised countries’ government bonds has now dropped below the expected nominal trend growth rate of these economies. For Italy, for example, the IMF forecasts average nominal GDP growth of 3.5 per cent over the next five years due to high inflation. If the numerator of the debt ratio (i.e. national debt) rises by no more than the interest rate of 2 per cent, while the denominator (i.e. nominal GDP) is set to go up by 3.5 per cent in the coming years, the debt ratio will come down, provided that the government does not take on any additional debt.
A higher nominal GDP growth rate does not lead to greater prosperity, but it does help countries to reduce their debt ratio. It currently looks likely that governments will be able to benefit from this effect because it will take quite a while for higher market yields to drive up average interest rates. The average residual term to maturity of Italian government bonds, for example, stands at just under eight years. This means that only about one-eighth of all paper in circulation is replaced each year.
The upside of inflation: debt ratios come down more quickly
In the coming years, the debt ratios of many countries should start to fall more quickly than previously forecast because the nominal trend growth rate of the economy has risen more sharply than average interest on government debt, due to higher inflation.
But for this mechanism to work, governments will need to moderately reduce their budget deficit. Take Portugal, for example: the country had already started to consolidate its finances before the pandemic. In 2012, its sovereign debt ratio was higher than Italy’s at 129 per cent of GDP. Ten years later, despite the pandemic, it stands at 121 per cent and is set to fall more swiftly going forward than the debt ratios of many other countries (including Germany). This disciplined approach is proving beneficial for Portugal. Since 2018, Portuguese government bonds have been carrying significantly lower risk premiums than their Italian counterparts. These favourable financing conditions are one reason why Portugal’s budgetary discipline has not been harmful to real economic growth.
Public finances in the eurozone are much more robust than they were ten years ago.
All in all, there is little to suggest we might be heading for another eurozone crisis like that of 2011, even if the ECB continues to normalise monetary policy. In spite of rising debt ratios, it has become historically cheap for eurozone member states to service their debt. Going forward, interest expenditure will go up. But debt service costs will start to rise only very slowly due to the long residual maturity periods of bonds currently in circulation. Add to that high nominal economic growth and debt ratios are more likely to fall in the coming years.
However, there are political risk factors. For example, the next parliamentary election in Italy could see the current government under Mario Draghi, in which the capital market seems to have confidence, lose its hold on power. Moreover, a lack of social consensus could delay potential steps to consolidate public finances. And then there are the volatile and intermittently illiquid conditions in the eurozone’s capital market. Nonetheless, public finances in the eurozone are much more robust than they were ten years ago. The European Stability Mechanism (ESM) is a reliable system that can counteract a self-perpetuating rise in risk premiums should the need arise. Moreover, the Next Generation EU recovery fund (NGEU) is in place to help stimulate growth. In summary, it can be said that the era of cheap money is coming to an end, and that, based on current data, Italy will need to achieve and maintain a slight primary surplus in its budget in order to stabilise investor confidence. But the case of Portugal demonstrates that this is both possible and conducive to economic success.
As at 14 July 2022.