Policy activism in the euro area to make ballooning debt ratios manageable
High frequency data and surveys are showing that activity in the euro area is starting to recover gradually as lockdown measures are eased, but conditions remain difficult, suggesting that the recovery will be slow, with a record contraction in GDP on the cards for Q2. We project euro area GDP to fall by 9.5% in 2020 overall. Among the five biggest economies, we see the largest contraction in GDP in Italy (-11%) and Spain (-10%). At the same time, we see the debt-to-GDP ratio for the euro area to reach 102% this year, and over 160% in the case of Italy.
However, although debt cancellation or any form of debt monetisation per se is out of question, quantitative easing (QE) for longer (but not forever) still means that effectively the debt burden of euro area government is artificially reduced, likely for years to come. In the case of Italy, if we take out the European Central Bank (ECB)’s bond purchases, the public debt-to-GDP ratio will be closer to 130%.
Along with a tightening of 10-year spreads vs. the Bund, the ECB’s actions have contributed to stabilising volatility on government bonds, and we suspect it will dampen it further as the year progresses thanks to the increase in the central bank’s bond holdings. The impact of the ECB’s presence highlights the importance of the investor base, as the larger the share of stable investors, the less volatile bond prices potentially are.
After a rollercoaster ride since late February, 10-year peripheral spreads vs. the Bund have finally started to stabilise, helped by both the ECB’s increased government bonds purchases and the European Commission’s recovery fund proposal. But we see limited additional compression for both Spanish and French sovereign spreads by year’s end.
By contrast, we still expect the 10-year Italian spread to tighten further into year end, from 177 bps (on 26 June) towards 130 bps. This is supported by valuations, as current spread levels still seem consistent with a high-yield rating if one compares how Italian bonds trade relative to their peers. We do not foresee any additional rating downgrades in our central scenario (55% probability) and hold the view that Italy will keep its investment-grade rating in the coming two years.
In our central scenario, we expect: an EU recovery fund with more grants than loans (likely a slightly watered-down version of the European Commission’s proposal); Italian sovereign yields to be kept low by ECB policies, making Italian debt sustainable over the long run; and Italian euroscepticism to fade or to be held in check thanks to pan-euro fiscal solidarity.