BMI View: Growing opposition to austerity will undermine eurozone fiscal reform momentum over the coming years, particularly in peripheral economies with riskier debt loads. While an ECB pledge to 'do whatever it takes' to save the eurozone has lowered borrowing costs and improved debt sustainability, this same pledge is likely to undermine governments' appetite for reform. Sluggish progress tackling debt loads will make the eurozone increasingly reliant on ECB monetary expansion, which itself will be insufficient to prevent the region entering a 'Japan-style' period of low growth over the next decade.
The ECB's 2012 pledge to buy unlimited sovereign bonds through its Outright Monetary Transaction (OMT) facility has made investors too complacent about eurozone debt sustainability. Periphery yields are below pre-crisis levels, equity valuations have recovered, and markets are more stable. A commitment to buy an unknown quantity of bonds, and under an unknown set of criteria, has seemingly done enough to dispel fears of a eurozone breakup, supported by the latest round of ECB policy easing in June. Optimism has also been boosted by Ireland and Portugal (sovereign) and Spain (banking sector) exiting EU/IMF bailouts. Some progress trimming deficits implies the prospect of a eurozone economy defaulting looks remote at present.
However, austerity-weary governments are now facing growing domestic political challenges, and look to be losing the appetite for reform. Low borrowing costs have allowed governments to avoid implementing painful reforms, and governments are relying on improving GDP growth rates to eat away at public debt loads. Paradoxically for the ECB, improving short-term stability and lowering yields looks to have kicked the reform can down the road, committing the ECB to expanding its balance sheet to help secure debt sustainability over the long term.
| Most Bearish On Periphery Reform Momentum |
|2014-2016 Fiscal Deficit Forecast, % GDP (Average)|
Reflecting this, our fiscal deficit forecasts for economies with public debt loads and budget deficits above the 60% and 3% of GDP EU target are more bearish than consensus ( see chart above). We exclude Greece as it remains under the auspices of a sovereign bailout.
Periphery - Progress, But Reforms To Slow: We believe a lack of progress on structural/fiscal reforms will eventually lead to a 'wake up' moment for markets, contributing to a rise in government borrowing costs over the next few years. Spiking bond yields are likely to force periphery governments into cuts that could temporarily depress growth, due to high public debt loads ( see chart below). This persistent threat will hinder policy making and threaten to periodically pull the region back into recession over the next decade.
Our forecasts show we are most bearish on periphery fiscal reform momentum, as the policy anchor provided by sovereign/banking sector bailouts expires. Against this backdrop, Spain had reduced its budget shortfall from 9.6% of GDP in 2010 to 7.1% in 2013, Portugal from 9.8% to 6.3% and Ireland by a remarkable 30.5% to 7.0%.
Bailout exits will make it harder for politicians to blame the EU/IMF for budget cuts, making periphery governments increasingly wary of domestic opposition to austerity. We believe governments are now likely to pull back on austerity in the run up to parliamentary elections (Spain 2015, Portugal and Ireland 2016), hoping to win back support after disastrous showings in the May EU Parliament elections ( see 'More Eurosceptic Voices Following EU Parliament Election', January 10).
| Periphery Debt Burden Here To Stay |
|Public Debt, % GDP|
Reflecting this trend, Spain has announced plans to reduce income tax by an average of 12.5% between 2015 and 2016, ignoring EU Commission calls for a VAT rise to offset the cuts (see 'Reform Momentum On Hold Until 2016', March 27). Sweeping labour market reforms implemented in 2012 are unlikely to be repeated, due to fears of squeezing incomes or increasing unemployment.
Furthermore, Irish Finance Minister said the country will ignore EU, IMF and Irish Fiscal Advisory calls to implement a EUR2.0bn budget adjustment originally planned for 2015. We believe Portugal's government will be wary of cutting spending after the constitutional court invalidated public sector wage cuts of between 2% and 12% imposed earlier this year. Taken together, reform momentum will remain on hold at least until after the next round of elections, where reduced parliamentary majorities for ruling parties could also make passing reform bills increasingly difficult.
France/Italy - Slow Pace of Reform To Persist: Although a periphery style 'about turn' on austerity is unlikely in France and Italy, slow progress tackling deficits and public debt loads will put both countries onto a path of conflict with Germany at a time when inter-state cohesion is already weak. Italy and France had smaller budget deficits during the economic crisis, reducing their need to cut spending as aggressively as the periphery during the prolonged downturn.
| Borrowing Costs Do Not Reflect Credit Risk |
|Government Bonds, % Yield and Spread|
Italy's fiscal deficit is now below the EU's 3.0% of GDP target, allowing Prime Minister Matteo Renzi to target structural reforms. Improving labour market flexibility and reducing employer tax burdens would improve Italy's growth profile and eat away at the country's debt load, but progress will remain slow as political reform is needed first and is likely to face significant challenges. In France, weak GDP growth and a lack of political willpower is likely to impede progress narrowing the budget shortfall, with the ruling Socialist administration struggling to balance the demands of their left-leaning support base and businesses.
A lack of reform momentum will ensure that French and Italian government debt loads (over 90% and 130% respectively in 2013) continue to grow over the next few years. As there is no chance of EU Maastricht debt criteria being met anytime soon, both Italy and France will instead push for relaxed EU budget targets.
This trend is already playing out, with Renzi demanding looser austerity policies in return for Italy supporting new EU Commission head Jean-Claude Juncker, while the German Finance Ministry is opposing a French-backed proposal to ease EU deficit rules. However, this will further stoke Germany's frustrations and is likely likely to shift the balance of power away from France within the EU, and could lead to new strategic alliances being formed in the bloc, most likely with Finland ( see 'On Track For A Collision With Germany', June 24).
| A Missed Opportunity For Italy and France |
|Eurozone - Composite Fiscal Deficits, % GDP|
Austria/Belgium/Netherlands - Posing Less OF A Threat: Comparative fiscal prudence will help Austria, Belgium and the Netherlands register a composite budget surplus by 2018 according to our forecasts ( see above chart). Lower deficits mean that bond yield volatility will play a smaller role determining debt sustainability in the countries over the next few years, and we are closer to Bloomberg consensus estimates on budget deficit projections. However, relatively high public debt loads (75%, 101% and 58% respectively in 2013) will restrict the use of government spending to boost growth, contributing to the region's economic recoveries remaining on a low growth trajectory.
ECB Balance Sheet To Keep Expanding
Given that eurozone (and particularly periphery) governments will fail to deliver reform sufficient to bring debt down to a sustainable level, we continue to believe that the ECB will have to play a bigger role in supporting growth and deficit reduction efforts over the next few years. Reflecting this trend, the ECB has already taken steps to boost demand and ward off deflation at its June policy meeting, announcing a 10bps cut to the refinancing and deposit rates, a 35bbps cut to the marginal lending rate, EUR400bn of targeted long-term refinancing operations (LTROs) and a suspension of the securities market sterilisation programme ( see 'Assessing The Aftermath Of ECB Policy Action', June 6).
Although the ECB's balance sheet has shrunk over the past year after doubling in size to EUR2.0trn since 2006, we believe the balance sheet will grow again over the coming quarters. The bank is paving the way for an Asset Backed Security (ABS) programme, and anaemic bank lending implies some form of quantitative easing (QE) is likely at some point over the next few years. With progress tackling public debt loads likely to remain sluggish, we believe some form of periphery eurozone debt restructuring will also be required over the longer term. Even with these further measures, we reiterate our concern that ECB easing will be insufficient to boost growth ( see chart below) or inflation enough to bring debt under control ( see chart below), unless more significant structural reforms are implemented at the national or federal level.
| No Return To Pre-Crisis Growth Rates |
|Eurozone - Real GDP Growth|
Heading For A 'Japan-Style' Period Of Low Growth
A lack of progress tackling debt loads and limited structural reforms will contribute to the eurozone enduring a 'Japan-style' period of low growth over the next decade or so. The overhang of high unemployment will continue preventing price growth pulling away from near deflationary territory, while the government is forced to spend its financial reserves servicing debt instead of funding productive investment. Against this backdrop, we forecast eurozone real GDP growth to average just 1.4% over the next five years, compared to a pre-crisis growth average of 2.4% ( see chart above). Government spending is forecast to add an average of just 0.3 percentage points (pp) to growth, compared to a pre-crisis average of 1.0pp.
Furthermore, the likelihood of German lawmakers remaining fiscally prudent means that the threat of austerity will not go away, even if demands for aggressive fiscal consolidation have eased of late. Declining working age populations in a number of eurozone economies will also make debt reduction increasingly difficult in a low growth/low inflation environment, with a smaller pool or workers shouldering a larger debt burden in real terms. Government bond yields are likely to remain volatile as a result, with the market periodically demanding fiscal restraint in order to keep borrowing costs low. This dynamic will ensure that eurozone growth remains highly susceptible to perceptions of sovereign credit risk over the next few years, threatening to put the brakes on an already sluggish recovery with little warning. Taken together, we believe these factors mean that debt restructuring is all but inevitable at some stage.
BMI Eurozone Fiscal and Public Debt Forecasts
| Country || Indicator || 2009 || 2010 || 2011 || 2012 || 2013 || 2014f || 2015f || 2016f || 2017f || 2018f || 2019f |
| Austria || Budget balance, % of GDP || -4.1 || -4.5 || -2.4 || -2.6 || -1.5 || -2.8 || -2.0 || -1.2 || -0.7 || -0.6 || -0.5 |
| Austria || Total government debt, % of GDP || 69.2 || 72.0 || 72.8 || 74.1 || 75.3 || 81.5 || 80.5 || 78.6 || 76.2 || 73.8 || 71.3 |
| Belgium || Budget balance, % of GDP || -5.6 || -3.9 || -3.7 || -3.9 || -2.9 || -1.6 || 0.0 || 0.0 || 0.0 || 0.0 || 0.0 |
| Belgium || Total government debt, % of GDP || 95.8 || 97.3 || 98.8 || 101.0 || 102.5 || 102.5 || 101.9 || 100.4 || 98.7 || 97.3 || 96.1 |
| France || Budget balance, % of GDP || -7.6 || -7.1 || -5.2 || -4.8 || -4.2 || -4.0 || -3.7 || -3.1 || -3.0 || -2.3 || -1.9 |
| France || Total government debt, % of GDP || 78.8 || 82.3 || 86.7 || 90.2 || 91.4 || 92.0 || 92.3 || 91.6 || 90.3 || 89.2 || 88.9 |
| Ireland || Budget balance, % of GDP || -13.8 || -30.5 || -13.0 || -8.1 || -7.0 || -5.1 || -3.3 || -2.6 || -2.3 || -2.3 || -2.2 |
| Ireland || Total government debt, % of GDP || 64.5 || 91.2 || 104.1 || 117.4 || 124.3 || 125.7 || 124.3 || 121.6 || 118.4 || 115.1 || 111.7 |
| Italy || Budget balance, % of GDP || -5.4 || -4.4 || -3.6 || -2.9 || -2.8 || -2.9 || -2.8 || -2.7 || -2.6 || -2.5 || -2.4 |
| Italy || Total government debt, % of GDP || 116.4 || 119.3 || 120.7 || 127.0 || 132.6 || 133.8 || 133.7 || 132.8 || 131.3 || 130.1 || 128.8 |
| Netherlands || Budget balance, % of GDP || -5.6 || -5.1 || -4.7 || -4.1 || -3.5 || -3.2 || -2.7 || -1.2 || 0.0 || 0.3 || 0.3 |
| Netherlands || Total government debt, % of GDP || 60.8 || 62.9 || 65.2 || 64.0 || 63.1 || 61.1 || 58.4 || 56.3 || 54.5 || 53.7 || 52.8 |
| Portugal || Budget balance, % of GDP || -10.2 || -9.8 || -4.2 || -6.4 || -6.3 || -5.1 || -3.9 || -3.4 || -3.1 || -2.7 || -2.4 |
| Portugal || Total government debt, % of GDP || 83.0 || 93.2 || 110.1 || 120.5 || 126.3 || 132.9 || 137.8 || 137.2 || 136.2 || 135.0 || 133.3 |
| Spain || Budget balance, % of GDP || -11.1 || -9.6 || -9.6 || -10.6 || -7.1 || -6.2 || -5.6 || -3.9 || -3.1 || -2.7 || -2.6 |
| Spain || Total government debt, % of GDP || 54.0 || 61.6 || 84.6 || 93.4 || 101.0 || 99.1 || 102.0 || 103.1 || 103.4 || 103.3 || 102.6 |
| Source: National Sources/BMI |
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