Stronger EU Architecture and Debt Profiles Shield Euro Area Periphery From Wider Financial Fragmentation

Yields on euro area peripheral countries’ government bonds have sharply increased from very low levels in February, reflecting a wider rise in euro area bond yields and largely discounting a rate hike before the end of the year. However, the risk of severe financial fragmentation in the euro area remains low.

Risk premia in southern European countries – Greece (rated BB+/Stable), Italy (BBB+/Stable), Portugal (BBB+/Stable), Spain (A-/Stable) – are discounting tighter future monetary policy, particularly after ECB February decisions confirmed the halt of net asset purchases under the Pandemic Emergency Purchase Programme (PEPP) by March 2022. The central bank has also shifted its guidance towards the possibility of a rate hike before the end of this year.

Highly indebted euro area governments are comparatively more reliant on central bank support

We recognise that highly indebted euro area governments are comparatively more reliant on central bank asset purchases to retain favourable market conditions and are more sensitive to rising financing costs, given in general the need to refinance large volumes of debt and their history of restricted market access during the euro area sovereign crisis.

The impact of higher yields on debt sustainability needs to be seen in the context of improved debt structures, however, for these four southern euro-area countries. The countries have extended their average debt maturity over the past decade, which means that the cost of new debt only rolls in over a longer period.

The average cost of issuance remains moderate under historical standards and, for most countries, below the cost of outstanding debt, thereby supporting a continued reduction in the interest burden on the back of robust economic growth over coming years. With higher inflation, real yields remain negative despite the recent rise in risk premia.

Flexibility has also become a core element of ECB monetary policy

Flexibility has also become a core element of ECB monetary policy. In December, the PEPP reinvestment phase was extended until at least 2024, including a temporary increase in net purchases under the Public Sector Purchase Programme to smooth the exit from the PEPP. Also, the ECB can re-start the latter programme in cases of emergencies after communicating readiness to adjust flexibly PEPP reinvestment under renewed market fragmentation.

The EUR 800m in Next Generation EU recovery funds also asymmetrically favour the countries with weaker economies, underpinning an encouraging medium-term economic outlook.

All factors point to stronger commitment and a clearer path towards long-run financial integration in the euro area.

Other challenges confront southern European sovereigns’ debt sustainability

Over the long run, however, other challenges emerge in terms of the ability of government in Greece, Italy, Portugal and Spain to sustain high levels of public debt, including the possibility of future political instability, which could hamper government efforts to implement required reforms to make effective use of EU recovery funding and address countries’ challenges such as adverse demographic trends and moderate-to-weak growth potential, which place structural pressure on their budgetary performance.

Without the implementation of important reforms, structural factors impede any substantial reduction in debt, which in a context of future rate increases and normalisation of monetary policies, will increase these countries’ vulnerabilities to financial shocks.

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Giulia Branz is Analyst in Sovereign and Public Sector ratings at Scope Ratings GmbH. Jakob Suwalski, Director in Sovereign and Public Sector ratings at Scope Ratings, contributed to writing this commentary.