Threat to debt sustainability
Euro area faces political contagion
by John (Iannis) Mourmouras
Tue 26 Jul 2016
Political risks have increased across the euro area, posing a challenge to the implementation of fiscal and structural reforms. Rising political uncertainty (especially in Spain, Portugal, Greece, Italy and France) and increasing support for populist political parties with eurosceptic credentials contribute to risks for debt sustainability.
Across the whole of Europe the biggest political risk is the UK decision to quit the European Union: a shock to the institutions and norms that underpin markets. Brexit is different from the euro break-up fears of 2012, the global financial crisis of 2008, or the bursting of the high-tech bubble of 2001. This time we face the threat of political rather than financial contagion.
No matter whether we have a full-blown or a ‘light’ UK separation from the EU, the political risk for the rest of the continent is that referendums will mushroom across Europe in a tug-of-war between populist forces and the political establishment. This risk is heightened for countries with strong anti-European sentiment such as Hungary, the Netherlands, Denmark, even France.
A prime factor behind the poor state of affairs is the rise in euro area government gross debt to GDP ratio to 93% in 2015, up by 28 percentage points from its pre-crisis level in 2007. Low sovereign funding costs in nearly all rating categories currently mitigate financing concerns. There is solid demand for government bonds, not least because of the quantitative easing bond purchase programme of the European Central Bank and Eurosystem. Total debt service of euro area governments for the next 12 months is around €1.6tn, or 16% of GDP, comprising 13.9% in principal repayments and 2.1% of interest expenditure.
However, a low interest rate environment – the new global norm, due to persistently low inflation – embodies some drawbacks. It makes governments increasingly hesitant to carry out fiscal consolidation and structural reforms. Brexit could amplify this risk. The initial market reaction after Brexit was a typical risk-off mode – lower and flatter yield curves and wider spreads. The UK 10-year gilt yield fell under 1% for the first time and German bonds up to maturities of 15 years are trading in negative territory.
In addition to the flight to safety, major central banks have shown a rather dovish reaction. The Bank of England is likely to cut its base rate by 0.25 points in August, while the ECB may also ease further, with the QE programme possibly extended beyond March 2017. In Japan there is even talk of central bank financing of the private sector directly with base money (also known as ‘helicopter money’). In the US, the Brexit shock has effectively removed the possibility that the Federal Reserve will raise rates in July. The market-implied probability of a Fed rate hike in 2016 has declined from about 50% on the eve of the vote to roughly 10% today.
As a result, the four major central banks’ monetary policy divergence, the dominant theme in the financial markets since the start of the year, seems to be off the table for now. The problem in the euro area is the persistent low level not only of inflation, but also of nominal demand, showing a 1% annual increase over the last seven years, compared with 3.7% before the 2008 crisis. Anaemic growth coupled with very low inflation is far from helpful for debt sustainability. According to the latest ECB forecasts (June 2016), annual inflation is projected at only 0.2% in 2016. The UK vote will probably reduce the euro area GDP growth projection below 1.6%, with further deterioration expected in ensuing years.
Ever since the Community’s inception in the 1950s, Europe’s leaders have always shown ingenuity in devising policy solutions to cope with make-or-break situations. Unfortunately, post-Brexit Europe has the potential to become an emergency in the not-too-distant future. It is highly likely that we will soon find out whether this method still works.
Prof. John (Iannis) Mourmouras is Bank of Greece Deputy Governor and a former Deputy Finance Minister. This is an abridged version of a speech at the OMFIF Third Main Meeting in North America, at Washington University in St. Louis, on 14 July.
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