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Threat to debt sustainability

by John Mourmouras

Threat to debt sustainability

Political risks have increased across the euro area, posing a challenge to the implementation of fiscal and structural reforms. Rising political uncertainty and increasing support for populist political parties with eurosceptic credentials contribute to risks for debt sustainability.

The biggest political risk is the UK decision to leave the European Union. 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 there is 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 Europe is that referendums will mushroom across the continent in a tug-of-war between populist forces and the political establishment.

A prime factor behind the poor state of affairs is the rise in the euro area government gross debt to GDP ratio to 93% in 2015, which has risen 28 percentage points from its pre-crisis level in 2007.

Low sovereign funding costs in nearly all rating categories currently mitigate financing concerns. 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.

Low nominal demand

In addition to the flight to safety, major central banks have shown a rather dovish reaction. The Bank of England cut its base rate by 0.25 points in August, while the ECB may ease further too. In Japan there is even talk of central bank financing of the private sector directly with base money. 

The market-implied probability of a Federal Reserve rate hike in 2016 has declined in recent months. 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.

Unfortunately, post-Brexit Europe has the potential to become an emergency in the not too distant future. In the past European leaders have had the ingenuity to work through such upsets. We may soon test again this form of crisis management.

Prof. John (Iannis) Mourmouras is Deputy Governor of the Bank of Greece 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.