IS A DEBT TARGET FOR THE EMU FEASIBLE?

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1 IS A DEBT TARGET FOR THE EMU FEASIBLE? Paolo Canofari, Piero Esposito SEP Policy Brief No February 2014 Introduction The newly elected government led by Alexis Tsipras is challenging the European institutions with the request to revise the existing agreement on the structural reforms and fiscal consolidation to be implemented in the current and next years. In particular, Tsipras asks for a reduction of the primary surplus required to reach the target level of 60% in the debt to GDP ratio by The request is to allow a more gradual adjustment toward the target by running an average primary surplus of 1-1.5% instead of the required 4%. This pattern is likely to postpone the goal by approximately two decades (see figure 1). In a recent paper Carlo Bastasin (Bastasin 2015) argued that such a revision is possible by adopting as a target the reduction of the total public debt for the Eurozone as a whole rather than for each individual country. From a political point of view, this change would be consistent with the policy preferences expressed by both the Greek and German governments in terms of fiscal stance since the latter is committed to a balanced budget rule which would allow to reach the 60% target already in The German commitment to the absolute stabilization of its public debt represents the key factor for the success of the proposal since it allows the other countries to reduce the average consolidation efforts without compromising the target for the Euro area as a whole. This note aims to assess the economic feasibility of a EMU-wide rule by quantifying, on the one hand, the amount of resources freed by the application of the balanced budget rule in Germany and, on the other, the additional costs for Greece and the other high debt countries in the EMU arising from a relaxation of the country specific debt target. The note concludes by showing that a discount on the average adjustment proportional to the size of the excess of debt would allow to reach the 60% target for the Euro area debt to GDP ratio by

2 The evolution of the Greek public debt under different scenarios on the average primary balance In order to provide meaningful estimates of the evolution of the Greek public debt between 2015 and 2040 it is crucial to understand what are the real costs that the country will face in order to pay the interests on the existing debt stock and to allow for a stable reduction of its weight on GDP. The effective nominal interest rate on public debt up to 2020 has been calculated by considering the actual financing needs, obtained by subtracting from the IMF interest payments forecast (see IMF 2014) based on accrual accounting the postponement of the payments to the EFSF (see Alcidi and Giovannini 2015). After 2020 we assume a smooth convergence of the real interest rate to 2.2% in 2030 which will be maintained until The chosen level is 100bp below the OECD forecasts (see OECD 2014) because of the assumption that Greece will still rely mainly on institutional sources to finance its debt in the following decades. 1 For the period we use OECD forecasts for the average growth and inflation rates, while for the period up to 2019 we use the projections of the most recent IMF World Economic Outlook. We simulated 5 scenarios with constant primary balance throughout the period respectively at 0,1,2,3 and 4% of GDP. We also consider a scenario where we incorporate the IMF assumptions on the primary balance, that is 4.5% up to 2017, 4.2% up to 2021 and a constant 4% thereafter. Figure 1 shows the five paths of public debt to GDP ratio between 2015 and Assuming a null primary balance, our simulation indicate a stabilization of the Greek debt to GDP ratio around 140% from 2028 while, at the opposite, an average primary balance of 4% would allow to reach the 60% target by the first half of the 2030s. Considering the intermediate scenarios, a 1% primary balance throughout the period might be not enough since it implies a debt to GDP ratio slightly below 120% in 2040 and a very small pace of reduction. On the contrary, a 3% surplus would allow to meet the target in 2040 while a 2% surplus would bring the debt level, by that time, at 90% of GDP stabilizing it in the long run at 80%. The latter case (an average primary surplus of 2%) represents what the Greek government is basically asking and it is also in line with the German preferences (Bastasin 2015), a condition that would make it more likely to be accepted by Germany and by the other creditor countries. Figure 1: Public Debt/GDP ratio in Greece under different assumptions on the average primary balance 1 Darvas (2015) estimates that a reduction of the planned primary surplus to 1.5% would generate 40bn of additional financing needs. This additional requirement should be included in the new agreement between the Greek government and the European Commission and it is taken into account by our simulations through the assumption of a lower implicit interest rate with respect to the OECD forecasts. 2

3 Source: own elaboration on IMF and OECD data Assessing the German reduction in public debt In this section we calculate the amount of saving arising from the application of the balance budget rule by the German government. We do so by applying the well-known equation displaying the debt dynamics: 2 Where changes in the debt to GDP ratio depend on the growth adjusted real interest rate (i-g-π) and the primary surplus (s). Since the budget balance is given by the primary surplus minus the amount of interest paid, the zero rule implies that id t-1 =s t so that the debt dynamics will be given by: which means that the debt to GDP ratio will be reduced every year at a rate proportional to the nominal GDP growth. We simulate this pattern in figure 2 (blue line) where assumptions on real growth and inflation have been still obtained from the last OECD Economic Outlook. The depicted pattern indicate that in 2040 Germany would approach a debt to GDP ratio of 30% if the balanced budget rule is applied throughout the period. The maximum cuts in the consolidation requirements of high debt countries can be calculated by comparing the pattern just described with that resulting from the exact application of the debt rule. The latter implies that the 60% target is reached in 2030 and maintained throughout the following decade (red line in figure 2). The difference between the two dynamics indicates that every year, on (2) (1) 2 All the simulation are run without considering stock flow adjustments which are likely to be of lower importance in the long run. 3

4 average, the structural adjustment of high debt countries can be reduced by 49.6bn without compromising the 60% target for the Euro Area as a whole. Figure 2 Evolution of the German Debt to GDP ratio in the two scenarios Source: own elaboration on IMF and OECD data. A simple rule for the allocation of resources Once we obtained an estimate of the average amount of savings with respect to the trajectory implied by the 60% rule for the Euro Area we need to assess whether the resources freed are enough to allow for a substantial reduction of the average consolidation effort in high debt countries. By applying the IMF and OECD forecasts on real GDP growth between 2015 and 2040 for the countries with a debt ratio above 90% we find that, on average, a percentage point of GDP (in 2015 prices) corresponds every year to 72.2bn (column 1 in table 1). This means that a reduction of the consolidation effort by 1% for all these countries would not allow to reach the debt target by 2030 since it exceeds the German over-consolidation. Different results can be obtained by changing the distribution of the consolidation discount. In particular, if the percentage reduction is linked to the excessive debt level (i.e. the part of debt exceeding 60%) the total discount will be perfectly coherent with the reduction of the German debt under the balanced budget rule. As an example, let us consider the following rule: 1) For a debt to GDP ratio between 90% and 110% the annual discount is 0.5% of GDP; 2) For a debt to GDP ratio between 110% and 140% the annual discount is 1% of GDP; 3) For a debt to GDP ratio above 140% the annual discount is 2% of GDP; 4

5 The last column in table 1 shows the average reduction of the consolidation effort resulting from the application of this rule throughout the period for each country. The overall reduction would amount to 51.7bn which roughly corresponds to the average over-consolidation of the German government. Since the assumptions underlying the German growth and inflation are rather conservative, especially considering the surprisingly high growth rate registered in the last quarter of 2014 (0.7% with respect to the previous quarter), and since the exercise is built on a discount rule resulting from the debt level in 2015, it is clear that the risk of missing the 60% target for the Euro area is rather low even in case of a worsening in macroeconomic fundamentals. To sum up, we have shown that adopting the target of a 60% debt to GDP ratio for the Euro area as a whole is a perfectly feasible strategy and would allow high debt countries to undertake a lower consolidation effort. Lower required primary surpluses for these countries would free resources to implement growth enhancing policies which can further strengthen these economies and the whole Euro area. Table 1 Potential resource reallocation in bn (2015 prices) Resources freed by the German balanced budget rule: 49.6bn Debt/GDP in % of GDP Consolidation discount Ireland Greece Spain France Italy Portugal Belgium Cyprus Total 111.9* Source: own elaboration on IMF and OECD data; *average ratio. 5

6 References Alcidi, C. and Giovannini A. (2015), The Cost of servicing Greece s debt: A Sisyphean task?, CEPS Commentary, 4 th February Darvas, Z. (2015), The maths behind an amended Greek plan, Bruegel.org, 11 th February 2015 available at IMF (2014), World Economic Outlook, International monetary Fund, Washington DC, October OECD (2014), Growth prospects and Fiscal requirements over the long term, OECD Economic Outlook 2014/1, Chapter 4. 6