Economic and financial forecasts are shrouded in uncertainty, now more than ever. Even so, the outlook for euro-area sovereign credit ratings has to be discouraging. The shock now hitting the euro area is threatening to become a severe threat to public finances.
During the previous crisis, the euro-area general government debt ratio shot up from 65 per cent of gross domestic product in 2007 to 90 per cent in 2012. But after years of belt-tightening and budget consolidation, only about a quarter of that financial crisis-induced debt increase had been unwound by the end of 2019, when the ratio stood at 84 per cent.
For illustrative purposes, let us assume a “10/10” scenario, in which this year’s growth rate of the euro area’s nominal GDP shrinks by 10 percentage points compared to 2019 (as nominal GDP grew by 3 per cent in 2019, this corresponds to a 7 per cent contraction in 2020) and budget deficits worsen by 10 percentage points (as the 2019 deficit was 0.9 per cent of GDP, this corresponds to a 10.9 per cent deficit in 2020).
Under this scenario, euro-area public debt would shoot up from 84 per cent to 103 per cent of GDP this year.
That debt build-up would take some pretty rapid growth to unwind. But following the previous financial crisis, it took the euro area three years to return to 2008 levels of nominal GDP and five years to reduce the peak budget deficits (2009 and 2010) by two-thirds.
Assuming a comparable pace of economic and fiscal correction from 2021 onwards, euro-area public debt would continue to rise to 112 per cent of GDP by 2022. In this scenario, the increase in public debt burdens would eclipse the debt accumulation during the previous crisis. More worryingly, it would do so with the most vulnerable member states starting off from a significantly weaker position.
Of course, the euro area is not a country. It has no debt of its own; member states do. Unfortunately, the countries with the highest debt ratios are the ones that would see their debt pile grow fastest. Under the “10/10” scenario, Italy’s debt, for example, would rise to 158 per cent of GDP this year and pile up to 167 per cent in 2022. By that time, the debt ratio of France would be 135 per cent, Portugal 144 per cent and Spain 129 per cent.
Germany’s debt would stay contained at 80 per cent and the Netherlands’ near 70 per cent, but the dispersion of debt ratios within the euro area would continue its inexorable rise. And this simulation does not even consider that high-debt countries such as Spain and Italy appear to be, at least for now, more affected by the health emergency than higher-rated, lower-debt sovereigns.
Lower rated high-debt sovereigns, and Italy in particular, would approach debt levels that will raise questions about the sustainability of public finances. But since they lack flexibility on exchange rates and monetary policy, such governments have lower debt-bearing capacities than those able to fully deploy these adjustment levers, like the UK or Japan.
So far, the rating agencies have remained conspicuously silent. Moody’s and S&P have not announced a single change of outlook for any EU sovereign. An outlook change is not a downgrade, but merely an indication that a downgrade is becoming more likely during the next two years. This contrasts with the rather swift way the agencies have cut ratings for corporate issuers, where the political and public backlash against the agencies is typically more muted.
But, as shown above, public finances are likely to deteriorate more now than during the euro crisis. Back then the average S&P/Moody’s rating of the original euro area members (excluding Greece and the special case of Ireland) was lowered by 2.6 notches between 2008 and 2011. Downgrades for what used to be known as “the periphery” were much steeper: 4.5 notches for Italy and 9 for Spain and Portugal.
If we assume that the ultimate ratings response to the coronavirus crisis will be proportionate to the agencies’ reaction to the euro crisis, then the average rating will go down by about three notches. That would be a problem. The ratings of Italy, the largest European debtor, are only one or two notches above the investment-grade divide, depending on the agency. The same is true for Portugal, while Spain currently has a somewhat more comfortable three- to four-notch buffer.
Considering the outsized economic repercussions threatening Italy, the scenario of that sovereign slipping into speculative, or junk, territory should not be dismissed. The experience of Greece in 2010 is sobering: when it dropped out of investment-grade bond indices, there was a huge amount of forced selling, and the high-yield investor base to catch that falling knife was simply not there. We know how it ended. Italy’s debt is 20 times larger. The financial fallout could be as well.
The writer is chief economic adviser of Acreditus, a risk consultancy headquartered in Dubai. He was S&P’s sovereign chief ratings officer between 2013 and 2018
