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The Seven Key Questions We Ask About Eurozone Government Debt Profiles

Since eurozone governments put their economies into lockdown in mid-March, we have sharply lowered our European macroeconomic forecasts, reflecting our expectation that the pandemic will do more damage to economic growth and public finances than the 2008-2010 global financial crisis.

Despite our projection that government debt will increase on average by just under 15 percentage points (ppts) of GDP for the larger euro area member states, since March 13 we have affirmed the ratings on Austria, Spain, Belgium, Germany, France, Greece, Italy, and Portugal. We have done so because we think that the willingness and ability of countries to service their debt on time and in full depends more on their monetary flexibility and economic resilience than it does on their public debt to GDP ratio at any point in time. While government debt to GDP is a relevant component of our sovereign rating methodology, our analysis of sovereign creditworthiness is informed by other, equally important, aspects of a government's debt profile. Indeed, apart from other rating factors (institutional assessment, economic assessment, external assessment, monetary assessment), it is precisely these aspects that can explain differences in our assessments of government debt positions between sovereigns with a similar stock of government debt in GDP terms.

There are seven key questions we ask ourselves when assessing a government's debt profile beyond its debt to GDP ratio.

Is debt denominated in domestic or foreign currency?   Perhaps the key difference between sovereigns and companies is that governments can create the currency in which they borrow. Sovereigns that borrow in a currency they cannot create are far more vulnerable to default than those that borrow in their own legal tender, as are economies in which the private sector is highly indebted in a foreign rather than domestic currency. High foreign currency debt--so-called "original sin"--is largely absent in the euro area economies. Wealthy economies typically benefit from deep local currency capital markets fed by sizeable pension systems backed by household savings. In this context, we note the speed of the European Central Bank's (ECB's) monetary policy reaction in response to COVID-19 this year compared to its delayed deployment during the 2008-2012 global economic and financial crisis. During the global financial crisis, several eurozone sovereigns issued in dollars, partly owing to market questions around central bank supportiveness. That is not the story in 2020.

What is the average maturity of a country's debt?   Currently, most eurozone member states' average debt maturities exceed seven years, meaning that only one seventh of the debt has to be refinanced every year. The average maturity of public debt in Ireland stands at 10 years. For Greece, it is 20 years including official obligations, which make up 82% of total Greek government debt. Having a long-dated debt profile goes a long way to immunizing a country's budget from the immediate cost of an interest-rate shock. In the case of Italy, a 100 basis points rise in its cost of issuance tomorrow would increase interest expenditure to GDP during the first year by an estimated 0.1 ppts of GDP, and by 0.3 ppts in the second year.

How much of the stock of government debt is held by residents and nonresidents?   In the euro area, domestic ownership varies from member state to member state. In Italy's case, as of end-January 2020, 68% of the government debt stock was held by domestic residents, largely by domestic banks and other financial institutions. Italy's national central bank, the Banca d'Italia, holds an estimated 17% of Italy's public debt, as a consequence of its purchases in the secondary market after the ECB introduced the Public Sector Purchase Program (PSPP) as part of the QE it launched in 2015. Governments rarely default to domestic residents, as this invariably decapitalizes a country's banking system and leads to a protracted economic crisis and the government having to recapitalize its financial system. One reason why Greece's debt to GDP ratio barely declined in the aftermath of its 2012 default is because--following the sharp reduction of exposures by nonresidents and the pre-default swap of ESCB holdings--Greece defaulted principally to its own domestic banking system. The price of that default was the price of Greece borrowing from official creditors to recapitalize its badly damaged banks. Debt to GDP briefly came down after the default before rising again as Greece took on official loans to finance the necessary capital injection into its domestic financial system.

Is government debt commercial or non-commercial?   We determine whether government debt is commercial or not based on the identity of the creditor. Our credit ratings are assessments of the likelihood of default on commercial debt only. Public creditors such as governments, central banks, and supranationals (such as the European Financial Stabilisation Mechanism, its replacement the European Stability Mechanism [ESM], the ECB, and all national central banks in the Eurosystem) are not commercial creditors. The status of a central bank's holdings in this context will be characterized by its policies with respect to government debt purchases. The Eurosystem, for example, regularly reinvests the proceeds from its PSPP into additional government debt purchases. In the case of Greek government bonds, which have not been eligible for the PSPP, the Eurosystem has been transferring the profits made on its holdings (SMP/ANFA) to the Greek government as a part of the official creditor agreement, subject to compliance with the program conditions and post-program monitoring. We expect the ECB's supportive orientation will continue in order to avoid any policy-induced disruption in its monetary policy transmission across the eurozone.

Beyond the considerations of ECB operations, sovereigns such as Greece, Ireland, or Portugal, in which a significant percentage of government debt is official rather than commercial, typically benefit from a long-dated maturity structure and very low nominal borrowing costs. Just under one-fifth of Irish government debt is made up of bilateral non-commercial loans from the U.K. and EU. Add to this an estimated 15% of Irish government bonds held by the ECB, and that leaves over one-third of the country's debt stock in the hands of non-commercial creditors. The split is broadly similar for Portugal, with 21% of Portuguese government debt owed to the EU-IMF, and just under 17% held by the ECB (Banco do Portugal in this case) at the end of 2019. The benefits to the lifespan and cost of a country's debt profile that come from bilateral loans in our view outweigh the de facto preferred creditor status of bilateral lending from the EU to euro area member states such as Greece, Ireland, and Portugal when we assess the likelihood that they would default to commercial creditors.

Are governments subject to a lumpy maturity structure or do they have a large portion of outstanding floating-rate or inflation-linked debt that would render funding costs more volatile and sensitive to policy rates or inflation dynamics?   In our view, these are not important considerations for any eurozone member, though some have a component of floating rate bonds (17% of Italy's government debt stock). For many emerging market borrowers there are frequently debt redemption spikes. In general, the higher you go up the rating ladder, the smoother the maturity schedule. This is because higher rated sovereigns typically benefit from liquid domestic capital markets and hence have the capacity to build out a yield curve, particularly at the long end. Last week, Spain issued a 30-year bond at a weighted average rate of 1.67%.

Is government debt issued under foreign law or national law? Are collective action clauses inserted into the terms of the security?   All things being equal, it is more challenging to restructure foreign law debt than domestic law debt. Put simply, a national law can be modified to alter the terms of a domestic law security (an alteration that we would probably consider tantamount to a default). For example, sovereigns (other than the U.K. or U.S. themselves) cannot modify U.K. or U.S. law to suit their debt-servicing requirements. In accordance with the ESM treaty, beginning on Jan. 1, 2013, all euro area governments introduced collective action clauses into their debt securities with a maturity exceeding one year. The purpose of these clauses is to make it easier for governments to restructure debt, and to limit the capacity of non-participants (holdouts) in debt restructurings to litigate against countries in default.

Finally, but probably most importantly, what is the fiscal cost of servicing public debt?   The current average yield at issuance for every member of the eurozone is far below the average cost of debt. For example, as much higher coupon debt originally issued before 2015 matures, it is being replaced during 2020 at considerably lower rates. Italy's current average yield of issuance is 0.8%, and Spain's is 0.3%, whereas the average cost of debt (across their entire profiles) for Italy and Spain is 2.5% and 2.0%, respectively. Those estimates exclude the dividends that national central banks are paying to eurozone central governments on the back of their interest earnings on these holdings. As a consequence, interest payments to revenues, as well as a percentage of GDP, has come down materially since 2015, and--after a break in 2020--will continue to fall, despite rising debt to GDP.

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This report does not constitute a rating action.

Primary Credit Analyst:Frank Gill, Madrid (34) 91-788-7213;
frank.gill@spglobal.com
Secondary Contact:Marko Mrsnik, Madrid (34) 91-389-6953;
marko.mrsnik@spglobal.com
Additional Contact:EMEA Sovereign and IPF;
SovereignIPF@spglobal.com

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