European debt threatens to be a political and social impasse
Debt growth has accelerated since 2021, raising financial stability concerns. Despite low interest costs, reforms are necessary to control deficits. Without significant changes, only Germany might meet the 60% target in a reasonable time period.
The potential trajectory of European debt is once again making investors anxious. While political uncertainty in France has been the trigger, the region’s underlying budget dynamics also justify concern. The breaking away of deficits and debt from European Commission rules was most apparent during the pandemic. In 2020 and 2021, debt–to–GDP ratios for the ‘Big 4’ – Germany, France, Italy and Spain – grew substantially, leaving the 60% benchmark set by the European Commission in the dust.
But it is important to recognise that Europe’s budgets were experiencing structural pressure long before the pandemic and the cyclical shocks associated with the Russia/Ukraine war. Between 2015 and 2019, growth in Spanish and French debt averaged 3.0% and 2.9% respectively, Italian debt averaged 2.0% and only Germany’s debt was falling. Behind this trend, was social spending, particularly pension and health costs for an ageing population.
This is why, since peaking in early 2021, the ratio of debt to GDP has only inched down for most of the Big 4 as the Euro value of public debt continued to rise. Relative to GDP, Germany is the closest to the desired 60% target at 63.6%, and Italy the furthest from it at 137.3%.
While GDP growth re–accelerating to trend will help cap debt relative to GDP hence, growth in the value of debt is still far too high. Since 2021, debt growth has accelerated substantially. Spain has lead the way at 5.9%, with France a close second at 5.5%, but Germany and Italy also not far behind; 4.7% and 3.8% respectively.
The cumulative increase in debt raises concerns around growth and financial stability, not just for the individual nations, but the EU as a whole owing to its interconnectedness. As we are seeing currently, the serviceability of debt also needs to be assessed.
Currently though, interest costs make up no more than 10% of government expenditure among the Big 4.
Further, spreads between the 5yr French OAT/German Bund and the 5yr US Treasury yield remain negative. This lower level of term funding costs offers European governments relief in terms of cost of funds, allowing more of their recurring budget to be directed to the economy. Note however, it also means that any benefit from declining global rates will be marginal and that cuts to spending or higher revenue are necessary to reshape the deficit.
Clearly highlighting the need for considered but large– scale reform, if nominal debt remains at its projected 2024 level until the end of the IMF’s projection period in 2029, Germany will have had come into line with the 60% debt–to–GDP ratio set by the European Commission in 2030. Assuming long–term annual GDP growth remains at its 2029 rate, it would instead take Italy until 2099, Spain until 2059 and France until 2068 for debt to reach 60% of GDP.
It goes without saying that the changes made must preserve or increase the strength of the labour market. The Euro Area currently has a very low unemployment rate versus history. Labour market tightness has been more pronounced in services–oriented economies like Italy and Spain over manufacturing–centred economies like France and Germany, but ageing and migration opportunities are constraints on supply for all.
Little further capacity is expected to be attained hence, with the ECB expecting the unemployment rate to only edge down to 6.3% by 2026 from 6.4% today even as growth recovers to trend and then sustains at that level. To increase the availability of labour, retirement ages must be raised (as France has contentiously done), productivity sought, and migration opportunities assessed and encouraged where appropriate.
The degree of difficulty of the changes required and the fractured nature of politics currently on display highlights that debt is instead likely to grow across Europe year on year. The thresholds set by the European Commission are therefore likely to continue slipping further away, at least for the foreseeable future, with Germany a potential exception. Given their comparatively lower cost of borrowing and ample savings however, risks around debt servicing costs should remain benign. This should allow the region time to settle politically and start a new discourse over how to best save and invest to secure future growth opportunities while restricting the cost to the present and future of legacy debt liabilities.
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