Debt Pressures in Europe: Inflation, GDP Growth and Budgetary Discipline

Record inflation in Europe has been good for over-indebted governments because inflation erodes debt. Also, the more expensive a product becomes, the higher the income from the VAT applied to it is, effortlessly bringing more money to the budget. But as the era of record inflation comes to an end, as politicians and central bankers assure, governments will again begin to feel the pressure of debt, a legacy of the days when low interest rates encouraged them to spend money they did not have.

Such pressures can be manifested by the need to find new sources of income or by problems on the international financing markets. If investors believe that a state has unsustainable deficits and debts, they will demand more to lend money, and financial evaluation agencies can downgrade sovereign ratings, making access to financing markets more difficult. Debt will thus become more expensive.

In Eastern Europe, Portfolio.hu sounds the alarm about Hungary’s debts. Inflation and GDP growth have kept debt in check so far. But if the economy does not continue to advance strongly enough, in 2024 the debts may reach worrying levels. The government believes it can reduce debt from 73.3% of GDP in 2022 to 56.3% of GDP in 2027. The EC is not so optimistic. Portfolio.hu calculated that the government’s projections could come true this year, but only thanks to particularly strong inflation. Hungary has the highest inflation in the EU.

In order for the forecasts to come true next year as well, there will be a need for vigorous economic growth and strict budgetary discipline. That the strength of inflation is decreasing is shown by Spain, where the indicator, adjusted to be comparable with those of other European countries, slowed down from 3.8% in April to 2.9% in May, close to the 2% threshold targeted by the ECB .

It is a slowdown in inflation of a magnitude that no one expected and it is caused by the drop in fuel prices and the slowdown in food prices. Spain is a special case in the European inflationary landscape because it took early measures to protect itself from the inflation created by the explosion of natural gas prices. But what is happening there with prices can be considered a trend indicator for Europe as well. Under the leadership of Socialist Prime Minister Pedro Sanchez, Spain has turned into a welfare state, with higher social spending and lower budget revenues. The debt, one of the highest in the EU, is increasing.

According to the calculations of the Spanish central bank, the cumulative debt of public administrations rose by 1% in March, compared to the previous month, to the record level of 1,535 billion euros. But relative to GDP, debt fell from 113.2% in December to 113% – and this shows how a rising debt-to-GDP ratio can fall if the economy is moving forward. The levels considered optimal in the EU treaties are below 60% of GDP, but this threshold is currently contested, given the economic and demographic transformations and the massive spending and subsidy programs introduced by governments during the pandemic and the energy crisis. In the last 12 months, Spain’s public debt increased by 5.6%. The government is optimistic that it can bring debt down to 110% of GDP by 2024, but the ruling party has struggled in recent local elections, with voters signaling they prefer right-wing parties.

The rating agency Fitch confirmed this month the qualification “A-” of the long-term Spanish debt, with a stable outlook, noting the persistence of the current account surplus and the high added value that the economy produces. Spain seems like a happy case. Inflation data from there had positive effects across the eurozone, with government bond yields (funding costs) falling as investors believe the retreat in inflation will encourage the ECB to slow the pace of interest rate hikes.

Portugal declares itself to be more ambitious, intending to reduce its debt below the level of Spain or France this year, although it is not expected to be a very good year from the point of view of economic growth.

The tool used in this sense is strict budgetary control. Italy, with a debt of 144% of GDP in 2022, is not doing so well. Despite concerns that the ECB’s interest rate hikes to curb inflation will plunge Italy into financial market hell, they have so far been calm, with Italian yields not rising dangerously high. But higher interest rates also make the cost of servicing the debt of over 2,000 billion euros higher. The average yield for government bonds issued between January and April jumped from almost zero in 2021 to 3.4%, writes Reuters. Debt service has risen from 3.6% to 4.4% of GDP in 2022, and this jump most likely does not fully reflect the ECB’s interest rate hikes so far. Therefore, debt costs will most likely continue to rise. Oliver Bäte, CEO of Allianz, explained the calm in the markets by the fact that the ECB is still reinvesting huge sums of money in government bonds. Also, some countries, such as Greece, have made enormous progress compared to the situation they were in when the sovereign debt crisis broke out. On the other hand, France and Germany continue to spend as if they had all the money in the world, says the banker. “The debt problem is moving towards the center of Europe, and, on top of that, we have weaker economic growth there than in the periphery. Things cannot continue like this, and the politicians will have to tell this to the people as well”, said Bäte.