Euro zone government debt will surge this year due to the COVID-19 pandemic, but while another debt crisis is unlikely, large differences in indebtedness as countries emerge from the downturn could seriously test their unity. The International Monetary Fund expects debt in the 19 countries sharing the euro to jump by more than 13% of GDP to 97% this year as Europe-wide lockdowns cause an unprecedented 7.5% euro zone recession. But despite massive expected borrowing, the effect on yields has so far been small.
Interest on bonds of already highly indebted Italy, Spain, Greece or Portugal is up by only 40-50 bps - kept in check by massive European Central Bank bond buying.
“As the ECB is literally cleaning up all the secondary market ... the risk of a sovereign debt crisis is close to zero,” Saxo Bank’s economist Christopher Dembik said, echoing many economists and officials.
The biggest difference compared to the euro zone debt crisis of 2010-2012 is the ECB. Then, there was no unconditional ECB pledge to do “whatever it takes” to support the euro. As soon as it was made, in mid-2012, the crisis ended.
Neither was there the ECB’s Outright Monetary Transactions scheme of unlimited sovereign bond purchases or an experienced bailout fund with an unused lending capacity of 410 billion euros, ready to lend cheaply and practically without conditions.
But rather than market panic, it is the fact that the South will have to recover from the downturn while carrying huge debt, in contrast to the North, that worries markets and euro zone officials alike.
The key risk is political: to stay intact, the euro zone must not allow nationalist and Eurosceptic parties in the South to capitalise on the hardships of recovery with huge debt levels and swing public opinion against the EU, economists said.
“The ECB can buy a lot of Italian bonds but it cannot convince markets that Italy wants to stay in the euro forever,” said Holger Schmieding, chief economist at Berenberg bank.
“The tail risk that a future Italian government may want to leave the euro is one the market is watching. It’s not about the details, it’s about the risk of political backlash,” he said.
The backlash could take the form of popular resentment in Italy at its relatively limited ability to respond to the epidemic compared with Germany or the Netherlands.
Germany’s immediate fiscal response to the pandemic was almost seven times larger than in Italy, where the crisis has been harsher, the chairman of the euro zone’s finance ministers, and Finance Minister of Portugal, Mario Centeno, told the European Parliament, adding that such “fragmentation” undermined the single market and the euro.
Yet the future debt differences will be big. The IMF sees Greek debt rocketing almost 22 points to 200% of GDP this year, Italian almost 21 points to 156% and Spanish 18 points to more than 113%. France, Portugal and Belgium will also be badly hit.
By contrast, Germany is expected to increase its debt by only 9 points to 69% and the Netherlands by 10 points to 58%. Austria, Finland, Slovakia and the Baltics will see similar or slightly bigger increases, but to much lower levels than southern states.
“I would bet 100 euros that a debt crisis will not return in the next one or two years,” said ING economist Carsten Brzeski, noting the euro zone’s very strong political will to avoid such a crisis when all its economies are suffering from the epidemic.
“However, I would probably also bet another 100 euros that an existential crisis of the euro zone will return. To some extent, the corona crisis is an accelerator. It will bring back the fundamental question on what is the right policy and how to deal with high government debt,” he said.
“The current crisis will lead to new economic divergence between the North and the South. The South will be hit harder by the crisis and the North will get out of the crisis faster and stronger,” Brzeski said.
The issue lies at the heart of discussions that EU leaders will hold on Thursday on how to ensure equal chances for economies to recover given their very different starting points on public indebtedness. At stake is the EU’s biggest asset - the single market of 450 million consumers which cannot function well if differences between countries are too big.
“There is a risk that the current crisis leads to further divergence of fundamentals among euro area countries,” said Reza Moghadam, chief economic adviser at Morgan Stanley.
The solutions adopted so far have failed to address the problem of debt sustainability in high-debt countries like Italy and of euro zone “fragmentation”: different rates of growth, productivity, unemployment, or bank lending, Moghadam said.
To prevent such divergence, the EU is scrambling for ideas to prevent a massive debt build-up in the South while at the same time avoiding debt mutualisation or transfers unacceptable in Berlin, The Hague, Vienna or Helsinki.
“There certainly is a very real risk of serious political tensions between the North and the South, both in the medium term and in the near term,” one senior euro zone official said.
“Debt levels are the main issue here, because they will rise a lot everywhere, but for the South the rise will be more critical and thus limit their room for manoeuvre a lot in the years to come,” the official said.
To avoid debt building up in the South, some, like Spain, call for grants - money that would be borrowed by the whole EU, but then transferred to the neediest with interest on the loans serviced through, for example, an EU tax on polluters.
“If we find an agreement to give part of the financial assistance as grants, this would make the debt issue less problematic,” a second senior euro zone official said.
But the idea of grants is just as inflammatory to some as debt mutualisation, officials said.
“Such transfer union proposals are not going to fly, corona crisis or no corona crisis,” the first euro zone official said.
“And this will, of course, make Italy, Spain, Portugal and France very unhappy, and there you have it then - political tensions on the rise once again.”
