Dr Hans-Jörg Naumer* (Allianz Global Investors) | Who is going to pay? That question is heard quite often in connection with the corona-related fiscal packages. Quite rightly. Governments have adopted huge packages to stabilise their economies. While there is no shortage of suggestions of how the new public expenditure and old debt is to be funded, many people seem to be overlooking the fact that the current low or negative interest-rate environment is already making a major contribution to debt reduction. This article will analyse the impact of implicit interest rates, growth and inflation on debt ratios in Germany, France, Spain and Italy.
The Corona Pandemic and the Issue of Financing
The G-20 countries have implemented an unprecedented level of fiscal countermeasures. Take the European Union, for example: The planned fiscal packages here amount to just under 21% of gross domestic product (GDP).
The packages differ widely by country, both in terms of amount as well as composition. In general, these are measures that will directly affect expenditures, but also include guarantees and loan guarantees. They can be drawn on as needed to avoid difficult situations.
There is a question about debt sustainability. Or more precisely, who is going to pay for this? We should not overlook the debt-reducing effect that will be provided by extremely low, and even negative, bond yields. Countries that have access to cheap refinancing have less reason to fear how they will repay the mountain of debt. Ideally, it will repay itself over time – thanks to yields, inflation and growth. Indeed, the “Negative Interest Club” continues to grow, as shown in Figure 1.
Figure 1: Yield as a percentage of the market capitalization of bonds
Across nearly all maturities, German government bonds no longer offer a positive return. Negative yields are now a familiar part of the picture in the bond markets of other European and non-European countries, as well. Globally, just under 60% of the global market for government bonds now (end of May 2020) have a yield of below 1%. Just under 20% of all government bonds have a negative yield – worldwide. In nominal terms. In other words, this does not even include the loss of purchasing power caused by inflation, regardless of how low it may be. Even for Spain, the implicit interest rate has decreased significantly.
The Impact of Low/Negative Interest Rates
The implicit interest rates that countries have to pay on their debts demonstrate how convenient low/negative interest rates can be. If one compares the average level of implicit debt incurred since the beginning of the financial crisis up to the present (2008 – 2020) with the average for the previous ten-year period (1997 – 2007), the interest rates for Germany, France and Italy have (nearly) halved (see Table 1). Compared with the implicit interest rate for 2020 assumed by the European Commission, these are once again significantly lower.
Table 1: Average implicit interest rates for selected countries
Can the yield/interest rate level help countries to grow out of their debt over time? This question is examined below in an analysis of scenarios for four Euro zone countries (Germany, France, Spain and Italy). The primary considerations build on Contessi, who in turn relies on Domar.
The relationship between the real interest rate at which public debt is refinanced and the real economic growth rate is of central importance. If we assume that the primary budget is balanced, the decisive factor for debt dynamics is that the real interest rate must be below the real growth rate over the long term. Only then will government debt be paid down over time. The public sector will grow out of its debt, so to speak; i.e., the debt-to-GDP ratio will decline. If that is not the case, primary surpluses have to be achieved. In order to make progress on reducing the debt, the more the real interest rate exceeds the growth rate, the greater the primary surpluses must be.
The Mechanics of Reducing Debt
The scenario analyses examined the trend in debt-to-GDP ratios through the formula dt+1 = (1+rt+1) / (1+gt+1)*dt – pbt+1 based on Contessi and Domar (see box). The debt-to-GDP ratio (“d”) compares the level of debt of the country or region under review to the gross domestic product (GDP).
Box : The “Debt-Reduction Formula”
dt+1 = (1+rt+1) / (1+gt+1)*dt – pbt+1
where rt+1 = nt+1 – pt+1
d = debt-to-GDP ratio
n = country’s nominal interest rate
r = country’s real interest rate
g = real GDP growth rate
pb = primary balance-to-GDP ratio
p = inflation rate
For public budgets, the primary balance is defined as the difference between government revenues (excluding net borrowing) and government expenditures (but excluding interest payments on government debt).
For the current time period (the years 2020 and 2021), the European Commission’s estimated debt-to-GDP ratios (as of May 2020, i.e., including the fiscal measures already agreed to within the context of the pandemic) served as the starting point. Here, we analyzed how the real implicit interest rates (“r”) at which public budgets are refinanced affect the primary balance (“pb”), initially assumed to be in balance (in relation to growth) over the period under review, and (real) growth (“g”) through this formula.
To further analyze individual variants, assumptions were then made about inflation (“p”) and the primary balance (“pb”). For real growth, the assumptions used the OECD’s long-term estimates, which extend to the year 2060. The modeling for implicit interest rates applicable to the respective budgets uses the European Commission’s current estimates for the year 2021 (see Table 1).
For assumptions regarding future changes in the implicit interest rate on government debt, the model takes into account that the interest rate reacts to changes in the government bond yield level with a lag effect. This means that changes in yields on the capital markets will only have a delayed effect on financing costs for public debt through the refinancing of maturing government bonds. Therefore, for the respective countries, initially a sliding decrease in the implicit interest rate to a low p.a. rate in the year 2030 was assumed that was equal to the average decrease in the respective country over the years 2008 – 2020. While varying by country, this decrease ranged from slightly above 20 basis points to slightly below 30 basis points. The increase in the implicit interest rate that then begins in 2031 according to the model proceeds until the year 2060 in the simulation. The Ultimate Forward Rate promulgated by the European Insurance and Occupational Pensions Authority, as used under the Solvency II regulations, was chosen as an approximation for a “normal” interest-rate environment. The model assumes that the implicit interest rates again increase by 20 basis points p.a. beginning in 2030 and then are capped at this long-term interest rate pursuant to EIOPA.
Since German government bonds serve as a de facto benchmark for pricing bonds from other Euro zone countries, for those bonds/countries yield spreads on the long-term interest rate were included in the calculation which are equal to the average p.a. yield spread of the respective country vis-à-vis Germany for the years 2008 to 2020. The intention was that deviations in the average duration of the budgets’ underlying government bonds should also be taken into account. It was assumed that there will not be any changes in creditworthiness over the next few years/decades, i.e., that there likewise will not be any deterioration in creditworthiness, that would lead to higher credit spreads and, therefore, to higher interest rates.
So, will negative/low interest rates lead to a decrease in the mountains of debt? For more on this, consider the following scenarios.
Scenario 1 – Base Scenario: Balanced Primary Budget
The debt-reducing effect of additional decreases in implicit interest rates is obvious – albeit also quite varied – in each country analyzed. It depends on the debt-to-GDP ratio at the beginning of the analysis. This is demonstrated by the base scenario, which assumes a balanced primary budget. Here, the following applies: the higher the initial level of debt, the less pronounced the effect will be. It also becomes clear that the higher the average inflation rate, the easier it is to reduce the debt. For inflation, a range of +/- 1% around the European Central Bank’s inflation target was examined.
Germany as an example: Assuming an inflation rate of 3%, the debt-to-GDP ratio drops steadily. At an average inflation rate of 2%, the debt-to-GDP ratio drops to slightly under 48 by 2044 and then starts increasing again slowly. At an average inflation rate of 1%, the debt-to-GDP ratio is below the Maastricht criterion of 60 in 2036. Afterwards, the debt-to-GDP ratio continues to decrease slightly until 2041, then begins to rise again (see Figure 2a).
France as an example: In France, too, the debt-to-GDP ratios initially decrease quite significantly, depending on the assumed inflation rate. However, sustained stability is only achieved with a 3% inflation rate. With a 2% inflation rate, the debt-to-GDP ratio drops below 70 by 2046. With an inflation rate of 1%, the debt-to-GDP ratio drops to a low of just under 88 in 2042, then increases to 120 by the end of the period under review (see Figure 2b).
Spain as an example: In this Euro country, decreases in debt-to-GDP ratios are only temporary under all three inflation scenarios. Of course, these declines are significantly weaker than, for example, in the case of Germany or France. The lowest debt-to-GDP ratio of slightly below 81 is reached in 2043, assuming 3% inflation. If we assume only 2% inflation, then in the best case a debt-to-GDP ratio of 98 is narrowly achieved in 2038 (see Figure 2c).Italy as an example: In the case of Italy, a pronounced inflation rate of 3% is required in order to achieve a noticeable decrease in the debt-to-GDP ratio. An interim low of 113 is reached in 2042 before the debt-to-GDP ratio starts to rise again. If we assume an inflation rate of only 2%, the debt-to-GDP ratio
will reach its lowest point in 2037, at just over 133. After that, it will rise to 204 in 2060. With the lowest inflation rate of 1%, the debt-to-GDP ratio will increase steadily to 300 in 2060. Therefore, substantial additional efforts will be required to achieve a reduction in debt (see Figure 2d).
Figures 2a to 2d: Trend in the debt-to-GDP ratio with a balanced primary budget, using Germany, France, Spain and Italy as examples
Scenario 2: Positive Primary Budget
A sustained primary surplus of 1% p.a. would make a noticeable contribution towards reducing the debt-to-GDP ratio.
In the case of Germany, each of the three inflation scenarios yields steady decreases in the debt-to-GDP ratio. With 3% inflation, the debt is virtually repaid by 2060. With an inflation rate of only 1%, the debt-to-GDP ratio drops to around 34 by the end of the period under review.
France is able to reduce its debt-to-GDP ratio to around 21 in the year 2060 with a 3% inflation rate. If the inflation rate is only 1%, the debt-to-GDP ratio will reach its lowest level of just under 66 in 2049. After that, it will rise back to 73 in 2060.
Spain can also achieve reductions in its debt-to-GDP ratio, but they will only be sustainable with an inflation rate of 3%. If the inflation rate is only 1%, Spain will decrease its debt-to-GDP ratio to 99 in 2038. After that, it will rise back to 150.
In Italy, none of the inflation scenarios will lead to a sustained decrease in the debt-to-GDP ratio, despite annual primary surpluses. If the average annual inflation rate is 1%, Italy will initially decrease its debt-to-GDP ratio to 144 in 2034. After that, it will rise back to 236 by 2060.
Reducing Debt through Low Interest Rates
For debt reduction, the decisive factor is the debt-reducing effect of low implicit interest rates. The debt-reducing effect is noticeable for each of the countries analyzed. In Italy’s case, however, without an additional primary surplus, a decrease in the debt-to-GDP ratio is only achievable with an inflation rate which is above the ECB target rate over the long term. The future trend will be highly dependent on the future level of implicit interest rates.
Again, the following analyses of Spain and Italy demonstrate the importance of the low yield level, which ultimately also affects the countries’ implicit interest rates.
Spain as an example: If the implicit interest rate for 2020 were 3.4% (equal to the average implicit interest rate for the years 2008 – 2020) instead of 2.25% (European Commission), the decrease in the debt-to-GDP ratio would be noticeably less favorable. Without further measures, the debt-to-GDP ratio for all three inflation scenarios would continue to increase steadily (Figure 3a). Italy as an example: Similarly, the implicit interest rate in Italy should be 3.44%, instead of 2.4%. Even in this case, the debt dynamics are clearly more pronounced. Only in the – unlikely – case where the inflation rate is 3% from 2022 on, assuming everything else remains the same, there would be a temporary decrease in debt (Figure 3b).
Figures 3a & 3b: Trend in the debt-to-GDP ratio, using Italy and Spain as examples, with a balanced primary budget and initially higher implicit interest rates
The higher the inflation rate is and the lower nominal yields are – or the longer low/negative interest rates persist – the easier it is to achieve a reduction in debt. In the end, creditors, i.e., subscribers of government bonds, will pay for a portion of the debt reduction themselves, by investing at real interest rates that are below the real growth rate.
*PhD in Economics, is the Director Global Capital Markets & Thematic Research at Allianz Global Investors.
