Is Europe Headed for a New Round of Debt Crises?

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About the author: Daniel Gros is a distinguished fellow at the Centre for European Policy Studies.

Financial markets must prepare for a rough ride. More than a decade of low interest rates abetted by massive central-bank bond buying has covered up many vulnerabilities. These market conditions have fostered the widespread adoption of strategies thought to be safe, but that in fact work only in a low-interest-rate environment.

These market dynamics are also the reason why a return of the euro crisis is unlikely. The risk of investing in Italian government bonds is known today. This was different during the first decade of the euro. In that era the bonds of all euro-area governments had traded without any significant risk premium. Spain was rated AAA and Italy AA until 2009. But suddenly the markets discovered that Spain, Portugal and Greece had run massive current-account deficits during the preceding boom period, deficits that could no longer be financed in a risk-averse environment. The ensuing collapse of these economies then exposed the fragility of banks’ balance sheets, which national supervisors had hidden almost everywhere. The ratings tanked. Surprised risk-averse investors started to sell the so-called PIGS (Portugal Italy, Greece and Spain) en masse. 

Volatility in Southern euro area bonds is thus now anticipated. The European Central Bank even created a special instrument to counter any excessive movement in the risk premia paid by some countries. This instrument is officially called the “Transmission Protection Instrument” or TPI, which some have translated as “To Protect Italy.” Still, it was probably not even needed because the fundamentals have changed so much. 

The so-called peripheral countries have corrected their external disequilibria. The main country facing a high-risk premium, Italy, has been running a sizable current account surplus for some time. Moreover, the banking sector across the EU has been much strengthened. Nonperforming loan ratios in Spain and Italy have fallen from peaks of over 13% and 17% respectively around the middle of the past decade to around 4% now, for both countries. Banking supervision has been centralized in the Single Supervisory Mechanism at the ECB, thus ending national forbearance. The Single Resolution Fund is on track to achieve its target of a fund of 80 billion euro (equivalent to $78 billion) by the end of next year. Though specific cases of weak banks persist, in Italy as elsewhere, all in all the banking system is no longer a source of major risks.

Another oft-overlooked element that differentiates today from 2012 is that the current inflation burst, not matched by corresponding increases in interest rates, helps public finances. The so-called snowball effect—the difference between the growth rate of nominal gross domestic product and the interest cost of public debt—is now a stabilizing force, rather than a destabilizing one. In 2012 that difference was equal to seven percentage points of GDP for Italy, and still 5.7 points in 2013. By contrast, today it is expected to be minus 4.5 percentage points in 2022 and minus three percentage points in 2023, therefore reducing, not augmenting, the debt-to-GDP ratio. This is because the growth rate of nominal GDP is much higher than the interest cost. The combination of nominal growth and interest cost—10 percentage points better today than in 2012—has never been as favourable as now at any time in recent memory. The same consideration applies to Spain and Portugal, the other countries which in 2012 came under severe financial stress.

Some Southern euro-area countries will have fiscal problems even with these favorable interest rates, but they are not the only ones to spend large amounts to protect their citizens from high energy prices. Germany recently introduced a  recent 200 billion euro package, for instance. The Southern euro zone will remain an area of concern for investors, but the problems are known and widely anticipated. 

History seldom repeats itself, but it rhymes. What might rhyme this time is that when rates and risk aversion increase, the biggest surprises will come from supposedly safe investments, like British pensions funds. Investors should thus fret less about the return of the euro crisis, but pull back on any investment strategy based on low and stable rates. 

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