Macro Focus From austerity to growth? Group Economics Macro Research Nick Kounis Tel: +31 20 343 5616 Aline Schuiling Tel: +31 20 343 5606 30 May 2013 Europe has changed its approach. The European Commission has signalled a shift in Europe s stance on austerity. Budget consolidation will ease in France, Spain, and Italy, though the Netherlands may need to put in place extra cuts. Before the recent steps, we estimated that budget cuts for the eurozone as a whole amounted to 1.4% GDP this year and 0.7% next year, following 1.8% GDP in 2012. On the basis of the changes, we assess that total fiscal austerity measures will decline to around 0.9% GDP this year and 0.5% GDP next year. Assuming that around half of the previously targeted budget cuts were already carried out in the first half of this year, this implies that the pace of austerity will taper off sharply in the coming months. Room to breathe for recession-mired economies. On the basis of the IMF s estimate of the fiscal multiplier, the reduced pace of fiscal consolidation will lead to a 0.4% total increase in GDP over the next few quarters for the eurozone as a whole. The higher profile in the second half of this year and during the course of 2014 lifts our average GDP growth forecast for next year to 1.3% from 1%. The overall picture is of a moderate recovery in growth helped by slowing austerity and stronger global demand, following nearly two years of recession. The biggest positive impact of the scaling back of budget cuts is in Italy and Spain. Government debt will peak later, but still come down. According to our long-term projections, the scaling back of austerity will lead to a later peak in government debt ratios. For instance, we expect government debt to peak six years later than the government plans in France, and five years later in Italy. This also partly reflects that we are less optimistic on the growth outlook compared to the authorities. Nevertheless, debt should decline in the second half of the decade in France, Spain and Italy, suggesting that solvency is not an issue as long as the ECB s OMT programme is helping to anchor bond yields and hence debt service costs. Policy shift is good news, but there are caveats. We judge that the slowing pace of austerity is a positive step in the eurozone s efforts to resolve the sovereign debt crisis and in some cases could go further. Under the previous austerity plans, negative spirals were developing between consolidation, economic growth and tax revenues. This meant that the strict front-loaded austerity strategy to reduce budget deficits and government debt was for many member states actually self-defeating. However, there are important caveats. In the sovereign debt calculations referred to above, we assumed that member states would continue and in some cases step up austerity in the years beyond 2014. If they do not, debt will eventually balloon. In this respect, it s important for the eurozone to complete the new framework to ensure fiscal discipline. The second caveat is that member states use the breathing space to put in place structural reforms, which can improve the supply-side functioning of the economy. As well as improving living standards, stronger economic growth will drive debt ratios down at a faster pace, and can even reduce the need for future fiscal consolidation.
2 Macro Focus - From austerity to growth? - 30 May 2013 Europe has changed tact Earlier this month, Ollie Rehn, the European Commission s Economic and Monetary Affairs supremo signalled a shift in Europe s stance on austerity. Following downward revisions to the institution s economic outlook, he said that given the fragility of the expected recovery, we recommend a fiscal stance that is appropriate for the economic recovery. Words were followed by deeds, with budget consolidation to be eased in France, Spain and Italy. Although the Commission recommends that the Netherlands puts in place extra cuts next year, the direction of policy for the eurozone as a whole is clear. Reaction generally positive This shift in the growth-austerity balance towards economic growth has been generally received positively. French finance minister Pierre Moscovici declared the end of the dogma of austerity, while German finance minister Wolfgang Schaeuble signalled a certain flexibility on deficit targets as long as there was commitment to reforms. Financial markets have taken the changes in their stride. However, there has been criticism from a not altogether unexpected source. Bundesbank President Jens Weidmann warned that the credibility of the new rules will surely not be increased by taking their flexibility to the limit right at the start. In this research note we assess the impact of the change in targets for the degree of fiscal consolidation, the economic outlook and the future path of government debt. We conclude with an assessment of the implications for the eurozone s fight to resolve the sovereign debt crisis. A slower pace of budget cuts The European authorities had already shown some flexibility with regards to budget deficit targets over the last few months, with both Spain and Italy, for instance, being allowed to revise their deficit targets up. However, the recent steps go further than before. In previous instances, member states were allowed to miss deficit targets related to cyclical short-falls on the back of economic growth disappointments. The recent shifts reflect a real change to the degree of austerity. Spain, Italy and France have been given room to ease the pace of consolidation and could well even deviate somewhat from Commission recommendations next year. On the other hand, the Netherlands has been encouraged to make an extra EUR 6bn of cuts (1% GDP) in 2014, though it is uncertain whether the government will indeed follow this course of action, so we have not yet incorporated the extra austerity in the calculations in the table. Before the recent steps, we estimated that budget cuts to the eurozone as a whole amounted to 1.4% GDP this year and 0.7% next year, following 1.8% GDP in 2012. On the basis of the shifts seen in France and Spain, and the expected change in strategy in Italy, we asses that total fiscal austerity measures will decline to around 0.9% GDP this year and 0.5% GDP next year. Assuming that around half of the previously targeted budget cuts were already carried out in the first half of this year, this implies that the pace of austerity will taper off sharply in the coming months. Table - Fiscal consolidation in eurozone % GDP, + = fiscal consolidation Country 2011 2012 2013 2014 Greece 7.7 6.5 4.9 2.1 Portugal 3.9 6.0 2.0 1.8 Ireland 3.5 2.7 2.7 1.7 Spain 0.5 4.0 2.5 1.0 Netherlands 0.8 1.2 2.5 0.8 Belgium 0.5 3.5 1.2 0.8 France 1.5 1.7 1.5 0.5 Italy 0.8 2.6 0.8 0.0 Germany 0.7 0.6-0.5 0.3 Austria 0.6 0.6-0.5 0.5 Finland 1.0-0.3 0.1 0.3 Eurozone 1.1 1.8 0.9 0.5 Source: Ministries of Finance, EC, ABN AMRO Group Economics Eurozone: easing consolidation to support growth % of GDP % 1.0 0.8 0.6 0.4 0.2 0.0 10 11 Source: Thomson Reuters Datastream, ABN AMRO Group Economics GDP could be 0.4% higher 12 Fiscal consolidation -0.4-0.2 In previous research, we took a closer look at the impact of budget cuts on economic growth. There is a lot of uncertainty about the size of the fiscal multiplier and it will obviously differ from country-to-country and depend of the precise package of consolidation measures. The IMF s baseline view is that a 1% GDP in budget cuts reduces economic growth by 0.6%. The impact on growth is higher in a currency union, but a little lower where financial markets see a significant default risk no action was to be taken. On the basis of the base line estimate, the 13 14 GDP growth (rhs - rev) 0 0.2 0.4 0.6
3 Macro Focus - From austerity to growth? - 30 May 2013 reduced pace of fiscal consolidation will lead to 0.4% total increase in GDP over the next few quarters. Moderate growth to return The list of negatives for the eurozone economy is relatively long. From bank deleveraging to rising unemployment and more recently the rise in the euro versus the yen. However, there can be little doubt that the fiscal tightening has been a major driver of the weakness in the single-currency area. It is surely no surprise that the eurozone economy fell back into recession soon after austerity was stepped up, although the significant increase in financial market stress at the time played an important role as well. The coming slowing in the pace of consolidation should give the economy the room to get its head above water and breathe again. Biggest boost for Spain and Italy In terms of our eurozone GDP growth forecast, we have kept our year average for 2013 unchanged, as the somewhat higher profile in the second half of the year is offset by recent weak data pointing to a more negative evolution in the first half. However, the higher profile in the second half of this year and during the course of 2014, lifts our average GDP growth forecast for next year to 1.3% from 1% previously. The overall picture is of a slow recovery in growth helped by slowing austerity and stronger global demand, following nearly two years of recession. In terms of the country breakdown, the biggest impact of the scaling back of budget cuts is in Italy and Spain (see chart). These projections are of course surrounded by a lot of uncertainty, but they are indicative of the broad trend. Slower austerity impacts the outlook for government debt through several channels. To begin with, and most straightforward, a higher budget deficit raises the level of government debt as long as it lasts. This rise in debt in turn lifts the government s interest payment obligations, implying that (everything else equal) there is also an upward impact on future government deficits and future government debt. On the other hand, we assume that governments will still meet their targets, but just at a later date. This means that by postponing austerity measures now, they will have to implement some extra measures at a later stage in order to still meet these targets. OMT should limit the impact on bond yields Besides the direct impact on the level of debt, the slower pace of deficit reduction could also have an impact on the level of government bond yields, which will have an influence on the level of government debt as well. In theory, higher budget deficits tend to have an upward impact on bond yields, as they create doubt about debt sustainability. However, under the current circumstances, the announcement of the ECB s OMT programme, which functions as a safety net for sovereigns, has significantly reduced worries about debt sustainability and has resulted in a sharp reduction of bond yields in peripheral countries. Since we expect the ECB s OMT programme to continue to have a positive impact on government bond yields, we do not expect a rise in yields due to the slower pace of deficit reduction. Changes in forecasts for 2014 % 4 3 2 1 0-1 -2-3 France Italy Spain Eurozone GDP growth Budget balance Government debt Source: ABN AMRO Group Economics Impact on economic growth transitory Slower deficit reduction should be positive to growth in the short-term, although in the years thereafter it will be negative, as extra austerity measures will have to be implemented at a later stage, which will limit growth in those years. Consequently, in the short-term, the higher level of GDP growth will have some downward impact on the government debt ratio, which will partly compensate for the upward impact of higher budget deficits. On balance, in the short-term, government debt, will rise, however. In the longer-term, the impact on debt will be more neutral, as GDP growth will return to the trend growth rate and countries will have to eventually meet their targets. Box: Government debt outlook for France, Spain and Italy Government debt will peak later, but still come down According to our long-term projections, the scaling back of austerity will lead to a later peak in government debt ratios for Spain, Italy and France, but debt should decline in the second half of the decade (see chart on the right and box for details). France: six year delay in meeting original debt target In its Stability Programme (SP) of 1 May 2013, the French government has not yet included the two year extension for lowering the deficit to 3%, still aiming at a budget deficit of 2.9% GDP in 2014. Considering that it is allowed to postpone
4 Macro Focus - From austerity to growth? - 30 May 2013 this target until 2015, this means that it can spread out the planned austerity measures over a longer period. Consequently, the government debt ratio will probably be higher than currently planned. According to the SP, government debt will rise from 90.2% GDP in 2012 to 94% in 2014, when it will peak. After 2014 it will fall gradually, to reach 88% in 2017. Our own debt calculations were already somewhat higher than the government s, as we think the government s forecast for nominal GDP growth during the years after 2014 (3.7% on average) is too optimistic. If we also include the delays in deficit reduction in our calculations, we project that government debt will continue to rise until 2016, when it will reach 95%. After 2016 it will creep lower. The level of debt projected in the SP in 2017 (88%) will probably be reached with a delay of around six years. Spain: debt ratio edges just above 100% GDP, then falls In its SP of 30 April 2013, the Spanish government has already incorporated the two extra years to reduce the budget deficit to below 3% GDP. According to the SP the deficit will be 2.7% in 2016, down from a realisation of 10.6% in 2012. Consequently, the Spanish government has to implement considerable austerity measures during the next couple of years (equal to around 5.5% of GDP during the years 2013-2016), and there seems to be no leeway to step down this pace of consolidation. The trajectory of government debt in the SP (which covers the period 2012-2016) is that it will continue to rise until 2016, when it reaches close to 100%. Our own calculations are closely in line with the SP s and show that debt will probably continue to rise until 2016 to just above 100%. However, in the years thereafter, it should embark on a downward path. Indeed, around 2022 it should have declined to around 90%. Italy: five year delay in meeting debt ratio target After France and Spain were allowed to shift their budgetary consolidation targets back by two years, the Italian government immediately announced that it would like to postpone consolidation measures by two years as well. In its SP of 24 April, the government aims at lowering its budget balance from -3.0% in 2012 to -1.8% in 2014. The government expects government debt (127% GDP in 2012) to peak at just above 130% in 2013 and to fall during the years thereafter. It expects debt to be 117% GDP in 2017. If we assume that the government implemented already some austerity measures in the first half of this year, but will postpone most of its remaining consolidation plans for 2013 and 2014, government debt will peak at around 132% in 2014. As we are somewhat less optimistic than the Italian government about the medium-term growth outlook (the government sees this at above 3%, whereas we think it is closer to 2%), we also expect debt to decline less rapidly in the years following its peak. The level projected for 2017 in the SP (117%) will probably be reached around five years later than estimated in the SP. Government debt outlook 140 130 120 110 100 90 80 70 60 % of GDP 2011 2013 2015 2017 2019 2021 2023 2025 France Spain Italy Source: ABN AMRO Group Economics Slowing austerity a positive in fight against debt crisis We judge that the slowing pace of austerity is a positive step in the eurozone s efforts to resolve the sovereign debt crisis and in some cases could go further. Under the previous austerity plans, negative spirals were developing between consolidation, economic growth and tax revenues. This meant that the strict front-loaded austerity strategy to reduce budget deficits and government debt was for many member states actually selfdefeating. Arguably, for some member states, such as Greece and Spain, the pace of austerity is still too aggressive this year, but next year for the vast majority, fiscal consolidation falls to more palatable levels. Credibility of long-term consolidation is key However, this positive verdict comes with a number of important caveats. First of all, in the sovereign debt calculations above, we assumed that member states would continue and in some cases step up austerity in the years beyond 2014. After all, the European Commission has pushed back structural budget deficit targets, it has not got rid of them. If Spain and Italy were to give up on austerity after 2014, government debt would balloon over the long-term. So the question arises, how credible the eurozone s fiscal framework actually is. Eurozone needs to complete fiscal framework There was widespread agreement that the original Stability and Growth Pact failed to ensure fiscal discipline and that this was a contributory factor to the emergence of the sovereign debt crisis in the eurozone. Over the last few years, eurozone governments have put in place stricter controls on public finances as well as other areas of economic policy. The so called six-pack and fiscal compact that strengthen fiscal and macroeconomic surveillance came into force in December
5 Macro Focus - From austerity to growth? - 30 May 2013 2011 and January 2013, respectively. However, the fiscal framework is still not complete. The two-pack, which will put in place independent monitoring and integrating EU policy recommendations in domestic budgetary preparations at an early stage, still needs to be agreed. It is planned that this will happen over the summer. It is important that these rules are put into force to increase the credibility that member states will fix the public finances over the long term, following an easing of austerity in the next year or two. A crucial part of the growth agenda The second caveat is that member states use the breathing space to put in place structural reforms, which can improve the supply-side functioning of the economy. Estimates by both the European Commission and the OECD suggest that a welldesigned ambitious reform package can have breath-taking effects on economic growth, especially for the peripheral economies. As well as improving living standards, stronger economic growth will drive debt ratios down at a faster pace, and can even reduce the need for future fiscal consolidation. Stay tuned in to our view on the economy and sectors and download the Markets Insights app via abnamro.nl/marketinsights or directly in the App Store. Find out more about Group Economics at: abnamro.nl/economischbureau This document has been prepared by ABN AMRO. It is solely intended to provide financial and general information on economics.the information in this document is strictly proprietary and is being supplied to you solely for your information. It may not (in whole or in part) be reproduced, distributed or passed to a third party or used for any other purposes than stated above. This document is informative in nature and does not constitute an offer of securities to the public, nor a solicitation to make such an offer. No reliance may be placed for any purposes whatsoever on the information, opinions, forecasts and assumptions contained in the document or on its completeness, accuracy or fairness. No representation or warranty, express or implied, is given by or on behalf of ABN AMRO, or any of its directors, officers, agents, affiliates, group companies, or employees as to the accuracy or completeness of the information contained in this document and no liability is accepted for any loss, arising, directly or indirectly, from any use of such information. The views and opinions expressed herein may be subject to change at any given time and ABN AMRO is under no obligation to update the information containedin this document after the date thereof. Before investing in any product of ABN AMRO Bank N.V., you should obtain information on various financial and other risks andany possible restrictions that you and your investments activities may encounter under applicable laws and regulations. If, after reading this document, you consider investing in a product, you are advised to discuss such an investment with your relationship manager or personal advisor and check whether the relevant product considering the risks involved- is appropriate within your investment activities. The value of your investments may fluctuate. Past performance is no guarantee for future returns. ABN AMRO reserves the right to make amendments to this material.