Euro Area: Inverted Yield Curve, Rising Yields Test Governments’ Debt Management, Fiscal Reforms
Rising interest rates across an inverted yield curve – an unusual phenomenon – are a strong message from investors about their bearish inflation and growth expectations. The German yield curve remains deeply inverted despite some recent flattening amid broad pessimism regarding the country’s near-term growth outlook, in line with our forecast of a contraction of 0.4% in GDP this year.
More consequential to the fiscal outlooks of euro area sovereign borrowers is the overall increase in interest rates, which has shifted yield curves upwards over the past two years. Bond yields have been higher since this spring as markets adjust to post-pandemic inflation and tighter monetary policy. The yield on the benchmark 10-year German government bond stood at around 2.7% in September, up nearly 300bp from September 2021 and the highest since 2011.
Net annual interest payments for France, Germany, Italy, and Spain are projected to rise to approximately 5.4% of general government revenue by 2028, up from 3.8% in 2020 (Figure 1). This places considerable pressure on euro area sovereign borrowers, particularly those with high debt levels and structural fiscal constraints, as they finance budget deficits and manage maturing debt.
Figure 1. Net interest payments in four largest euro area economies, 2007-28F
% of general government revenue
Interest Bill to Remain Modest in Germany, More Onerous in France
Germany’s increase is expected to be relatively modest, with interest costs reaching 2.1% of revenue by 2028, up 1.1 percentage points from 2020. France will experience the sharpest increase, reaching 5.2% of revenue by 2028, up 2.9 percentage points from 2020. Italy, despite a moderate increase of 1.1 percentage points over the same period, will stabilise at a higher level of 8.2% of revenue by the end of the forecast period.
While interest payments as a share of revenue should remain below their recent historical peak on average (6.5% in 2012), they are expected to reach their highest level since the global financial crisis in France.
Expectations of Higher Rates for Longer Weigh on Investor Sentiment
The gloomy outlook for rising interest costs and a gloomy outlook for inflation and growth are starkly represented by short and longer-term yields on euro area government bonds. The gap between 10-year and one-year government bonds across the euro area’s largest economies hovers close to multi-decade lows, and stands in negative territory for Germany, France and Spain (Figure 2).
Investors are increasingly expecting the ECB to maintain a “higher for longer” interest rate strategy to curb inflation, indicating a significant shift from the pre-pandemic monetary policy paradigm.
Figure 2. Spread: 10-year – one-year bond yields
Significant Support Remains for Euro Area Sovereign Debt Sustainability…
However unsettled investor sentiment looks, it is essential to consider the broader context of other more favourable aspects of euro area public-sector finances. This includes the notably better debt-maturity profiles of many government issuers, coupled with the fact that the average interest rate on outstanding debt has materially declined over the last decade due to the earlier low-interest environment.
Servicing existing debt will increase only moderately for the region’s largest government borrowers. A favourable debt structure, such as longer average maturities (Figure 3) and a modest share of inflation-indexed bonds except for France (around 12% of the total for France), helps mitigate the consequences of higher issuance costs.
Figure 3. Average maturities of French, German, Italian and Spanish sovereign debt
years (Scope credit rating of sovereigns in parentheses)
An additional supporting factor is the ECB’s large ownership of bonds issued by highly indebted countries. Banco de España and Banque de France held 28% and 23% respectively of their government’s bonds in Q4 2022, contributing to the sustainability of public debt. This is even as these shares are gradually falling as the ECB accelerates its quantitative tightening. Highly indebted euro area members also benefit from a significant amount of high-coupon bonds maturing this year, suggesting a more gradual impact of higher debt-issuance costs on average interest payments.
Furthermore, real effective interest rates, which consider the actual cost of borrowing by accounting for inflation, are expected to remain reasonable compared with past decades (Figure 4).
Figure 4. Real effective interest rates in four largest euro area economies (2007-28F)
… but Pressure Builds for Growth-enhancing Structural Reforms
Germany, France, Italy and Spain also have the advantage of economies in which nominal growth is running ahead of the average interest rate they pay on their debt. Such a differential, likely to persist for some years, affords governments some fiscal space in that they can stabilise public debt-to-GDP without generating primary budget surpluses. The differential will be most favourable in Germany (-2.3% on average over 2023-28) and Spain (-2.0%).
As a result, in the short term, sovereigns can afford a gradual fiscal consolidation process, which avoids a marked hit on growth. Deployment of EU recovery funds offers governments some flexibility to manage public finances and debt without jeopardising growth.
Germany stands in a strong position with ample fiscal space to increase spending. However, the situation is quite different for Italy, where the increase in real effective interest rates will be much more significant compared with the other three major euro-area economies, leaving little fiscal room. France’s fiscal space is also limited, while Spain, despite facing growing structural fiscal pressures, benefits from strong current growth in the economy and in tax revenue.
The longer-term concern is that the space is still narrowing for euro area governments to follow through on needed fiscal reforms.
While rising interest payments are not necessarily an immediate threat to the sustainability of euro area sovereign debt, addressing long-term budgetary imbalances remains crucial to ensure current credit ratings. Ambitious reforms are needed to build the fiscal space required to absorb growing budgetary pressures from multiple sources beyond interest costs, such as rising welfare and healthcare spending related to ageing populations, investment in the energy transition to meet long-term net-zero goals and upward pressure on defence spending.
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Brian Marly is an Analyst in Sovereign and Public Sector ratings at Scope Ratings GmbH. Jakob Suwalski, Senior Director at Scope Ratings, contributed to authoring this commentary.