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‘Bell’ by Moody’s: Risk to debt sustainability and fiscal space due to ECB – Investors may flee

Her Eleftherias Kourtali

The normalization of the ECB policy will not derail the reduction of the debt of the countries of the region, but will weaken its sustainability as well as the fiscal space, warns the rating agency Moody’s. At the same time, he stressed that the end of bond purchases by the ECB will lead to a gradual change in the composition of debt holders in the countries of the South, increasing the risk of investors fleeing.

More specifically, as Moody’s notes, the shift in monetary policy expectations as a result of rising inflation has led to rising financing costs across the euro area and especially in the periphery. This shift will reverse part of the improvement in debt affordability that began after the global financial crisis.

However, as long as investment confidence is maintained and the European Central Bank does not have to resort to rapid interest rate hikes, it will take time for higher interest rates to lead to higher interest payments, given the relatively long debt duration of these countries. Sound economic growth in nominal terms should also ensure that debt reduction continues.

As Moody’s explains, rising financing costs will take time to fuel higher interest payments. Eurozone bond yields have reached levels not seen since at least 2018, but remain low by historical standards.

Although higher debt and budget deficits will keep borrowing needs higher this year – for example at 25% of GDP in Italy and 19% in Spain and Portugal – effective debt management strategies in countries such as Spain and Portugal adopted since 2012, will slow down any significant shift in interest payments. The average debt duration of Southern European governments is between seven and eight years, locking in the favorable financing costs that came with QE.

In essence, the country points out, southern European countries continue to refinance debt that ends at interest rates below the average cost of their debt. For example, in May the average cost of debt on bond issues advanced by the peripheral countries was between 70-150 basis points lower than the average cost of debt. This is also partly the result of the shorter maturities of the new debt issued in recent months.

However, this gap is shrinking and will continue to narrow for some time due to the changing monetary policy environment. Actually, Moody’s expects rising financing costs to begin to reverse the improvements in debt accessibility seen over the past decade from this year. Debt linked to inflation in Spain and Italy will cause their debt accessibility indicators to deteriorate as early as this year.

At the same time, changing the composition of bondholders will increase the risk of investors leaving, the house warns. The end of the ECB’s asset markets will lead to a gradual shift in the composition of sovereign debt holders to more risk-averse private sector bondholders.

Southern European countries have been key beneficiaries of the ECB bond markets, especially in the last two years when asset markets far exceeded net bond issues. Loans from the European Union) will reduce the additional supply of Italian and Portuguese bonds compared to Spain. Increasing spreads may help attract investors, but countries will be more exposed to peculiar risks that may scare investors.

“Equilibrium risks could terrify investors if governments fail to meet their NGEU reform goals or the domestic political environment deteriorates,” he said.

In addition, higher financing costs will not significantly slow down debt reduction, but will reduce fiscal space. Relatively strong nominal growth due to large EU capital inflows and higher inflation will offset rising interest rate costs and support sustained debt reduction in the periphery.

However, a faster-than-expected rate hike or even slower-than-expected growth could derail debt reduction as southern European countries are likely to continue to run primary deficits. In this context, their ability to provide additional support to the economy without increasing debt would be more limited.

“Higher interest costs will limit the ability of governments to continue to provide fiscal support to the economy without leading to a further increase in their debt,” Moody’s said in a statement.

Source: Capital

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