Few signs of fiscal reform

The document designed to restrain fiscal abuses of the past that contributed to the flaring up of the sovereign debt crisis in the euro area “periphery” in 2010-2012 remains little more than a paper promise: Europe’s public debts continue to climb and the hopes of sustained and real reforms of the fiscal space are fading. 

This is all more alarming, given that last month European sovereign debt markets staged yet another rally, with end-of-July yield on 10-year German bund falling to 1.12 percent, down 231 bps on five years ago, based on data from TradeWeb.

French 10-year bonds are now at their lowest levels of 1.4 percent a drop of 223 bps on same period in 2009.

Euro area peripheral countries’ bonds are also hitting all-time record lows, down to 2.16 percent for Ireland (a drop of 849 bps over three years), 2.65 percent for Italy (off 321 bps from three years ago) and to 2.47 percent for Spain (off 360 bps compared to three years ago).

In all of the above, with exception of Germany, government debts rose over the same period of time in both absolute terms and relative to GDP.

Taking into the account the divergence between sovereign risk pricing in the markets for government bonds and CDS and the underlying fiscal fundamentals, it is now only a matter of when, not if, the markets will start re-pricing euro area debt to the downside.

Since the onset of the euro area crisis four years ago, national and European politicians have promoted the idea of increasing fiscal policy harmonization and coordination as the panacea to the problems faced by the member states. The theory behind this latest push for harmonization is that previous policy frameworks, namely the Stability and Growth Pact signed in 1997 and reformed in 2005, failed to control growing imbalances between individual states. Sustained and significant fiscal and current account deficits, accumulation of public debts and the risk of growing reliance on one-off and short-term sources of public revenues all went unchecked in the past.

The cornerstone of the new coordination mechanism was the Fiscal Compact, signed on March 2, 2012. Signatories to the new treaty agreed to implement a set of binding budgetary rules, stipulating core metrics for fiscal convergence.

Firstly, annual structural government deficit must not exceed 0.5 percent of GDP. Countries must also implement an automatic correction mechanism to reduce the deficits. The structural deficit could be allowed to grow to 1 percent of GDP provided government debt to GDP ratio stays below 60 percent. Secondly, for countries with debt-to-GDP ratio in excess of 60 percent, there is a debt brake rule. Under this rule, member states must make an annual reduction in debt-to-GDP ratio in the amount of 1/20th of the difference between the actual debt-to-GDP ratio and the 60 percent target ratio.

There are different timings as to when the various measures come into force for different countries, with some member states, such as Ireland, left outside the debt brake rule until at least 2019.

Still, the markets expectation was that the euro area will be moving toward the new fiscal regime as soon as possible. Policymakers signaled as much by promoting the Fiscal Compact as an answer to the confidence crisis sweeping across the sovereign debt markets at the time. In a way, the Fiscal Compact also underpinned the “Draghi put” policies of the monetary easing. In order for the ECB to act on its core policy targets, including the Outright Monetary Transactions (OMT) and Long-Term Refinancing Operations (LTROs), member states had to commit to curbing the more egregious fiscal abuses. Even the ECB stress tests of the banking system across the euro area will implicitly rely on sustainability of the sovereign debt markets, as government bonds take up significant shares of banks balance sheets.

Since March 2012, euro area’s government bond yields fell back to the levels below those prior to the crisis. Credit default spreads for euro area “peripheral” countries have fallen by 72 to 95 percent. Debt issuance for the “peripheral” sovereigns normalized to such an extent that we are now witnessing emergence of the super-long-dated bonds, with maturities of 30 years, 40 years and even 50 years in the case of some of the crisis-hit states.

Meanwhile, the latest figures from the Eurostat clearly show that debt-to-GDP ratios in the majority of the euro area states are rising, not falling. The underlying nominal levels of public debt remain on an upward trajectory.

Per Eurostat and national-level data, 18 out of EU28 countries have seen increases in government debt/GDP ratios in Q1 2014 compared to Q1 2013. Half of the increases were in excess of 5 percent of GDP. Year on year, the highest increases in the ratio were recorded in crisis-hit Cyprus (+24.6 percentage points), Slovenia (+23.9), and Greece (+13.5). At the end of Q1 2014, fifteen of the EU28 countries had debt-to-GDP ratios in excess of 60 percent. Overall, euro area government debt in Q1 2013 stood at EUR8.793 trillion or 92.5 percent of GDP. In Q1 2014 this rose to EUR9.056 More than 18 months since the enactment of the European Treaty on Stability, Coordination and Governance, known as the Fiscal Compact, the 26 EU member states, signatories to the treaty, have been doing preciously little to change their fiscal policies and institutions.trillion or 93.9 percent of GDP.

These numbers exclude intergovernmental debt, which also rose year-on-year [see chart 1].


Based on IMF data and forecasts, euro area government debt levels over 2013-2014 will be around EUR 330 billion higher than the levels implied by the Fiscal Compact rules. On deficits side, excluding Germany, euro area cumulated 2013-2014 deficits will exceed the Fiscal Compact-stipulated bounds by EUR 116 billion.

In 2014, government deficits will exceed the convergence criteria bound of 3 percent of GDP in eight euro area countries and will be within the forecast margin of error at the bound in three other countries. More ominously, since the signing of the Fiscal Compact treaty, fiscal balances have deteriorated, not improved, in nine states [see chart 2].


Similar picture emerges if one were to consider structural deficits bounds. In eight out of seventeen states reporting (with Estonia structural deficits estimates not available), structural balances are expected to deteriorate in 2014 compared to 2011-2013 best performance.
In simple terms, Europe is nowhere near getting its fiscal house in order.

Instead, the national governments’ addiction to debt-financed spending is returning back, fuelled by business-as-usual attitudes to economic policy formation in European capitals and markets’ benign attitudes to risk.

Even in the countries that have long been heralded as the success stories of the current crisis, there is an on-going push to reverse painful gains achieved during the years of the “Great Austerity.”

In Ireland, this May, the electorate handed down defeats in the local and European elections to the government coalition. The government parties’ losses amounted to public support levels dropping by roughly a third for Fine Gael and by more than 60 percent for the Labour Party.

These results triggered a change of leadership at the Labour Party and a complete reshuffle of the government. But they also led to a change in the rhetoric in the Irish Dáil (parliament) and at the government table. Whilst Ireland has been pre-committed by the EU and IMF agreements to deliver further deficit cuts of some EUR 2 billion in 2015, the Cabinet discussions on Budget 2015 are now firmly focused on reducing these measures to appease angry electorate.

Similar dynamics – voter revolt followed by scaling back of fiscal discipline by the incumbent politicians – are evident in a number of other European countries. Across the fiscally weak euro “periphery” states, in Italy, Spain and Portugal there are ongoing reversals of austerity in favor of increased deficit financing of public expenditure. Even in Greece, the government is actively promoting the agenda of “fiscal independence” from the EU-IMF-ECB troika. No one, not even the European Commission, can deny that in the Greek case, “independent fiscal policies” can only stand for the return to business as usual, status quo ante the 2010 crisis. [see chart 3]


All of this revaluation of the fiscal position is being driven by the political factors, and all of it is sustained by the significantly improved risk-pricing of the European sovereign debt. Chart 3 shows just how dramatic the swing in risk appraisals of the most vulnerable euro area “peripheral” states has been.

Within just six months of 2014, 5-year cumulative probabilities of default for sovereign debt in Cyprus have fallen from roughly 45 percent at the end of Q4 2013 to roughly 29 percent at the end of Q2 2014. Over the same period of time, probabilities of default for Spain have halved from 12 percent to just over 6 percent, those for Italy have fallen from over 14 percent to close to 8.5 percent, for Ireland from 10.3 percent to 4.5 percent and for Portugal from 24.5 percent to 15.6 percent. Meanwhile, for a much more reforms-focused and stronger performing Iceland, the cumulative 5-year probability of default has risen from 13.4 percent to 15.7 percent.

In short, there is a widening chasm developing between markets pricing of sovereign risks in the euro area, including the so-called “periphery” and the realities of the declining force of fiscal reforms in these countries. Given the strong inertia built into fiscal policies and sovereign balance sheets, the only way of restoring some semblance of realistic risk valuations in the euro area sovereign markets is for a dramatic re-pricing of sovereign debt to the downside.