Her Eleftherias Kourtali
While higher inflation will help reduce pressure on debt sustainability, increasing bond yields makes debt service more difficult, Goldman Sachs points out.
With the ECB approaching its first rate hike in light of persistently high inflation, bond yields have risen sharply in recent months. This, however, has the opposite effect on debt sustainability: while Higher inflation reduces the real value of debt and therefore reduces pressures on debt sustainability, Higher interest payments increase the cost of debt service. Given these opposing forces, Goldman Sachs is looking at the issue of debt sustainability in eurozone countries, focusing on the factors that raise debt sustainability concerns as well as higher interest rates.
The key to debt sustainability is its ability to service it, as the American bank emphasizes. Debt service capacity, in turn, is determined by the (increase in) the nominal tax base or total government revenue, which generally increases with inflation. High energy prices are currently reducing the GDP deflator (through higher import prices) and therefore the debt-to-GDP ratio is likely to be volatile in the coming quarters.
However, as Goldman Sachs adds, beyond this short-term volatility, the medium-term effect of higher inflation will support debt sustainability. For example, as it states, tax revenues in the first quarter in Italy are about 15% higher than in 2019, suggesting that high inflation contributes to the expansion of its fiscal space
Assessing the medium-term outlook for debt sustainability, in the Goldman baseline scenario, the debt-to-GDP ratios of the euro area countries are gradually declining in the coming years, given the constructive long-term outlook for growth and inflation. Taking Italy as an example, investments from the Recovery Fund are expected to lead to higher-than-average growth over the next decade.
Inflation is also likely to remain above the 2010-2020 average), leading to a healthy primary balance surplus and a gradual decline in the debt-to-GDP ratio.
However, in addition to the baseline scenario, there are two major risks to debt sustainability over the next decade, as the American bank emphasizes. These are the lack of fiscal consolidation in response to high debt-to-GDP ratios and the impact of higher interest rates on debt service costs.
Assessing the “response” of governments to high debt-to-GDP ratios, two conclusions can be drawn. First, governments with more intense “responses” (such as Germany and Spain) are less likely to embark on a rising debt-to-GDP ratio trajectory than governments with more limited “action”, such as Italy and France. Second, when the interest rate-growth rate gap (i.e., the rate at which a country’s public debt increases relative to its output) becomes unfavorable, governments with a weaker “response” face a higher risk of feedback from sustainability concerns. debt to higher government bond yields ..
Based on the above, Goldman then assesses the debt sustainability concerns in the light of the ECB’s interest rate policy uncertainty. The findings suggest a gradual decline in debt-to-GDP ratios across the euro area in the coming years, if the ECB’s deposit rate rises to 1.25%, even if sustainability concerns are fueled by bond yields. However, it is found that the risk of rising debt ratios significantly strengthened — especially in Italy and France— if the interest rate moves higher, to 2.25%.
Overall, Goldman concludes, there is still room for fiscal sustainability to become a major concern for the eurozone. But, as he has pointed out in the past, an ECB backstop – a new tool / program – could provide market security against the risk of fragmentation following major external shocks across the eurozone or self-fulfilling prophecies in high-debt countries, in particular in a world with higher ECB interest rates.
In this case, the new tool should have flexibility in terms of the capital key and without a pre-purchase limit, but some form of terms. GS estimates that in order for these conditions to be implemented, the tool can be linked to the implementation of the EU Recovery Fund, but the details remain unknown at this time.