September 1, 2023

News in Charts: Risks facing the euro area

by Fathom Consulting.

The cost-of-living crisis has yet to trigger a pronounced recession in the world’s leading economies. However, high interest rates to curb inflation are likely to push the euro area into recession in 2024. Another possible effect of higher rates is increased fiscal fragility. As interest rates increase, so does the cost of government borrowing. Loose fiscal policy due to the cost-of-living crisis and COVID-19, combined with increased interest rates to curb inflation, have increased fiscal risk. It is notable therefore that, as can be seen from Fathom’s market-implied probability of default indicators in the chart below, this increased risk does not seem to be troubling investors.

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This lack of concern is in sharp contrast with the findings of Fathom’s Financial Vulnerability Indicator, which currently shows a high level of risk for sovereign crises. This is especially true for France and the countries of the New Hanseatic League (NHL).[1]

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There are two main factors driving a higher risk of sovereign crisis. First is debt, incurred in the high degree of fiscal support over the past three years. As can be seen from the chart below, euro area countries implemented substantial fiscal loosening in response to COVID-19 and the cost-of-living crisis, though countries of the New Hanseatic League were more cautious than other euro area states. The current condition of public finances in the euro area is greatly at variance with the pre-pandemic period, when budget deficits had more or less closed in most countries.

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The second factor driving up the euro area’s risk of sovereign crisis is higher interest rates, increasing the cost of servicing the rapidly increasing stock of government debt.

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It is worth noting, however, that it can take a while for increased interest rates to have a material impact on government finances. This typically happens when the government has to roll over its debt. As can be seen from the chart below, the residual maturity for the euro area is long (typically more than 8 years). This point is important if high rates are expected to be a temporary phenomenon, but largely irrelevant if they are expected to remain high.

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Going forward, will there continue to be a high risk of sovereign crisis? The end of the energy crisis, with the price of natural gas falling back to around its 2021 level, has already led to some narrowing of budget deficits. Moreover, fading inflation implies that the ECB’s tightening cycle is approaching its end. If the euro area experiences a recession next year, as Fathom predicts this week in its Global Outlook, Autumn 2023,[2] this could cause the ECB to reverse course and decrease interest rates. This combination of fiscal tightening and lower rates implies that the risk of sovereign crisis is likely to decrease over the coming year — unless another shock was to hit the euro area.

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The views expressed in this article are the views of the author, not necessarily those of Refinitiv Lipper or LSEG.

[1] The countries included in this grouping are: Denmark, Estonia, Finland, Ireland, Latvia, Lithuania, the Netherlands and Sweden, although we only include those that are euro area members in the charts and data used for this note. The ‘other euro area’ grouping used in this note excludes the NHL countries and also Germany, France and Italy.

[2] Charts and analysis from Fathom’s Global Outlook, Autumn 2023 will be available to LSEG Datastream users via Chartbook.

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