Citi: The ‘catastrophic’ consequences of the ECB’s turnaround on governments and debt management

Her Eleftherias Kourtali

The ECB will soon withdraw its monetary stimulus measures – negative interest rates and net asset purchases – that have prevailed for the past eight years. This, according to Citigroup, will have a significant impact, including on the behavior of the governments of the eurozone countries. He points out that the reversal of the ECB’s policy will lead to a greater increase in the cost of financing governments than the increase in bond yields, a significant increase in the cost of servicing existing debt and a corrosion of the fiscal space, while an increase inflation will lead to higher borrowing requirements.

In general, although governments are heavily indebted, sovereign debt managers typically seek to limit public finances’ sensitivity to interest rate volatility through the relatively long-term issuance of fixed-rate debt. And governments’ fiscal positions theoretically vary depending on the interest rate cycle, which means that when central banks raise interest rates it is the time for governments to have lower lending requirements anyway.

In the current context, however, Citi points out, raising interest rates will have a greater impact on governments and will limit the budgetary space available to them for the following reasons:

First, an increase in policy rates in the current environment is not a consequence of a cyclical improvement in the economy, as Citi points out. It is the consequence of a largely external exacerbation of inflation. Rather than being the result of a booming economy (which would boost government revenue and reduce spending), it is causing private demand to erode due to shrinking real incomes. Thus, Rising inflation is likely to lead to higher debt requirements, not lower ones. Thus, governments may need to borrow more than anticipated at a time when their financing costs are rising, a situation which since the financial crisis and the euro crisis has led to a structurally inefficient implementation of fiscal policy purposes in Europe. Indeed, governments’ ability to pursue counter-cyclical fiscal policies and their confidence in their debt stability are largely based on the fact that their financing costs are reduced when they need to borrow more. This is not happening now.

A second observation is that the cost of financing governments is actually rising more than what bond yields suggest. This is a direct consequence of the termination of the central bank’s net asset purchases. In recent years, governments have issued fixed-term, long-term bonds, which were then bought by the central bank, which financed these markets by issuing reserves. Given that, from a budgetary point of view, the central bank is a subsidiary of the government, whose profits or losses always end up in the public sector, it makes sense to look at both balance sheets to understand the true nature of government funding. This, according to Citi, leads to the conclusion that – for an amount equal to the total net purchases of the central bank – governments were not financed with long-term fixed-rate bonds, but in the form of floating-rate debt adjusted to the interest rate paid by the central bank in the excess reserves, therefore, in the case of the ECB, the deposit rate (-0.50%).

However, as Citi points out, as the ECB puts an end to net asset markets, this debt swap is no longer taking place, and therefore the real cost of financing governments is – again – repaying their bonds at issue, which is significantly higher. Citi strategy analysts estimate that government issues in the 11 largest eurozone countries will shift from -103 billion euros in 2021 (due to the ECB) to +223 billion euros in 2022. The shift in financing costs from -0 , 50% on whatever returns governments have to pay in the primary market essentially leads to this difference.

A third point is that not only will the cost of new financing and the transfer of governments increase, but the cost of servicing existing debt will also increase significantly. The reason is that, as explained above, a significant portion of government debt has been substantially exchanged for floating-rate debt based on the ECB’s deposit rate. Thus, as the ECB raises the deposit rate, so does the cost of servicing this share of public debt.

Citi strategists estimate that the ECB’s share of public debt under asset purchase programs (PSPP and PEPP) is 26% in the case of Italy, 27% for France, 33% for Spain, 38% for Germany and even higher in Portugal (39%). The increase in the ECB’s policy rate will be fully implemented in these amounts.

This increase in debt service costs may not appear immediately in government financial accounts because central banks do not need to mechanically attribute profits or losses to governments. They have room to keep them, and in particular, in case of loss, they do not need to be recapitalized immediately. However, one would expect finance ministers and debt management agencies to take a holistic view of how interest rate hikes affect their balance sheets. If they do, they will conclude that raising policy rates is effectively eroding the fiscal space in a way that can hardly be ignored, at a time when governments are likely to have to use it.

Finally, the mainly exogenous imported nature of current inflation suggests that the GDP deflator is not growing in line with the same trend in consumer prices, but much less, therefore will have a limited positive effect on public debt / GDP than many would think.