Europe’s policy response to the COVID-19 economic crisis has increased budget deficits and public debt but so far cushioned the potential blow to sovereign ratings. The post-pandemic ratings trajectory will depend on governments’ ability to deliver sufficient economic growth to restore fiscal balances.
NEW YORK – From a European sovereign credit-risk perspective, the COVID-19 pandemic differs from other recent crises. First, the current economic crisis arose from recession-inducing lockdowns to combat a viral contagion, rather than from an asset-market contagion caused by a failing financial system. Second, Europe’s policy response has been far more robust than previously. Once the pandemic ends, the trajectory of European sovereign ratings will depend on governments’ ability to deliver sufficient economic growth to restore fiscal balances.
Our own sovereign rating actions since March 2020 have taken into consideration the nature of the shock triggered by this public-health crisis – massive, but exogenous and temporary – and how well countries have been able to respond to it. For now, monetary and external flexibility as well as economic resilience are better indicators of sovereign creditworthiness than a country’s debt-to-GDP ratio.
Globally, we have downgraded nearly a quarter of the sovereigns we currently rate. Most are lower-rated emerging- or frontier-market borrowers that had pre-existing vulnerabilities and less financial resilience and flexibility to deal with COVID-19 and its economic consequences. This includes seven defaults, all by sovereigns that were at the lower end of our rating scale (“B” or below) before the pandemic.
But in Europe, we have so far mostly made negative revisions to our rating outlooks rather than actual downgrades. Since the pandemic began, we have taken fewer sovereign rating actions in Europe than we did during the global financial crisis that started in 2008 and the subsequent eurozone sovereign-debt crisis.
This is mainly because of massive direct and indirect fiscal support at the national level and the European Central Bank’s rapid and unprecedented measures, supported by EU policy, aimed at mitigating the pandemic’s economic fallout. These efforts have so far been effective, and should allow for a more rapid recovery. Although this policy response has increased fiscal deficits and pushed public debt to new highs, it has thus far cushioned the potential blow to sovereign ratings.
Moreover, the costs of new government funding are near all-time lows across the eurozone. This not only ensures effective transmission of monetary-policy stimulus to the economy, but also enables expansionary fiscal policy to work without impairing sovereign access to capital markets. A decade ago, by contrast, markets restricted access to eurozone sovereigns out of concern about their macro-financial risks amid a largely insufficient monetary-policy response, thus sparking the debt crisis. Several governments had to seek emergency funding from the European Stability Mechanism or from outside of the eurozone with the International Monetary Fund, while Greece and Cyprus defaulted.
The ECB’s decision last December to increase its pandemic emergency purchase program (PEPP) to €1.85 trillion ($2.25 trillion), and extend the facility until March 2022, signals that the central bank will continue to ensure that EU governments can finance their extraordinary fiscal measures at low cost. We estimate that the PEPP’s remaining funds are enough to cover nearly all eurozone government debt issuance expected this year.
In addition, governments are refinancing maturing debt more cheaply, which is lowering the average interest rate on outstanding debt and reducing the rollover risk by extending its average maturity. The ECB’s measures attest to its highly credible and effective monetary policy – another factor underpinning eurozone sovereign ratings.
ECB policy is buttressed on the EU level, specifically through the Next Generation EU plan, whose linchpin is the Recovery and Resilience Facility (RRF). The plan is sizeable, totaling €750 billion ($911 billion), redistributive, and aims to help more highly indebted member states. We estimate that it could add up to 4.1% to EU GDP over the next five years. And the EU would finance the RRF by issuing debt in its own name, providing the ECB and investors with a new, liquid, euro-denominated benchmark instrument, which in turn would benefit the euro’s status as a reserve currency. But significant challenges remain. Europe currently is racing against time to vaccinate everyone before further new coronavirus variants develop and spread widely. And once the pandemic is under control and economic recovery is underway, governments will face the tricky task of winding down massive stimulus without endangering growth. Premature austerity could impede recovery, but delays in normalizing policy could widen fiscal imbalances and hinder necessary structural changes. At the same time, governments will need to address climate change and aging populations, while provisioning for a digital future and preparing to cope with the next public-health crisis.
A decade ago, Carmen Reinhart and Kenneth Rogoff famously argued that recessions happen with eerie regularity, and it is folly to claim otherwise. Of course, they were describing recessions caused by endogenous financial or economic imbalances, whereas today’s pandemic-induced downturn was truly exogenous. But Europe’s financial and policy response this time has caused governments to go deeper into debt.
It is clear that sovereign deleveraging will take several years at best. Although today’s extremely low interest rates will buy governments time, they are not a substitute for the fiscal and structural reforms needed to rebuild the macroeconomic foundation for long-term sustainable growth. To borrow from Reinhart and Rogoff, this time may be different for Europe, but policymakers still have much to do.
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