Elevated interest rates, political turmoil, and economic uncertainty portend a crisis on the horizon in 2024

The EU is poised for a delicate balancing act in 2024 as it grapples with escalating debt levels amid elevated interest rates that could squeeze a number of member states. It is a tense situation that has the potential to turn into a full-blown crisis by the year’s end.

Among EU countries, France and Italy emerge as the front-runners in terms of national debt, with approximately €3.05 trillion and €2.85 trillion, respectively. Although France leads the ranking in nominal debt terms, Italy’s higher debt-to-GDP ratio raises concerns about the sustainability of its fiscal position.

The European Central Bank (ECB) has faced scrutiny, particularly due to the unintended consequences of its previous longstanding policy of negative interest rates. The decision to discontinue the negative deposit rate, a policy that had been in place since 2014, has sparked debate. Critics argue that the rate hikes themselves may not be sufficient to address the underlying issues, especially given the ECB’s past bond purchases.

The decision to adjust interest rates in response to the elevated Eurozone inflation in mid-2022, which ended up reaching double digits in October of that year, did not generate significant controversy at the time. Nevertheless, the ongoing debate revolves around whether these measures will effectively address the broader economic challenges and potential repercussions of the ECB’s past policies.

A retrospective glance, particularly at the Eurozone crisis in 2010, raises apprehensions that a similar scenario with even greater consequences could unfold. Current debt levels and the limited options for some countries to address them through conventional measures such as tax hikes or spending cuts fuel concerns of a ticking time bomb in 2024.

Neither Spain (lhs) nor Italy (rhs) relied on the ECB to fund recent debt issuance. But when the next shock comes – as during COVID – both will be back to 100% dependence on ECB for funding. Europe needs to address these debt overhangs instead of sweeping them under the carpet… pic.twitter.com/YqFILuho9G

— Robin Brooks (@RobinBrooksIIF) January 15, 2024

In addressing the debt burden, European governments face the added challenge of rising interest costs – a result of the ECB’s higher interest rates. With the inflation outlook appearing unfavorable, the ECB has signaled that it has no intention of cutting interest rates this year. In this light, Germany, France, and Italy appear particularly vulnerable. By 2028, a substantial increase in interest burden is anticipated, with Germany at 2.1% of revenues, up from just 1% in 2020.

Germany currently has some financial leeway, whereas France and, especially, Italy face challenges. In France, interest payments could account for 5.2% of government revenues by 2028, an increase of 2.9 percentage points since 2020. In Italy, the share could be even higher at 8.2%. Despite efforts by the government under Prime Minister Giorgia Meloni, it’s noteworthy that financial market skepticism toward Italy has grown, particularly reflected in an increase in the risk premium for Italian government bonds. This uptick occurred notably in October amid government projections of higher deficits, leading to a spike in spreads.

However, it’s important to acknowledge that spreads have since come down significantly in the last few months, indicating a shift in market sentiment. The question arises: Is this improvement temporary, signaling a period of calm before the storm, or does it signify a more sustained change in investor confidence? 

German economy contracted 0.3% in 2023, matching estimate. #Germany is the only G7 economy to have shrunk in the past year. pic.twitter.com/0Z285QnHo4

— Holger Zschaepitz (@Schuldensuehner) January 15, 2024

The ongoing debt growth rates of many Eurozone countries, coupled with chronic deficits, suggest they may struggle to manage these additional costs. The choice to finance the emerging gap with new debt could accelerate a debt spiral.

It becomes evident that achieving a soft landing from the recent sharp interest rate hikes is essential for maintaining the financial stability of the EU. This would be the desired outcome, as it would help mitigate potential repercussions on the broader financial landscape. Particularly concerning is the question of who ultimately bears the burden of these interest payments, as German taxpayers already shoulder substantial loads. The room for Eurozone governments to implement necessary budget reforms could diminish in the long run; the debt time bomb is ticking.

The ECB is facing a dilemma. If it cuts interest rates too early, it risks prolonged stubborn inflation. On the other hand, higher interest rates could push some key EU countries into a debt trap, meaning they could only cover their interest obligations by issuing new debt.

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Hard times ahead for France – minister

There are signs that the ECB is treading on thin ice as 2024 gets underway. The bloc’s finance ministers have yet to present a clear plan on how to reduce the debt. Indebtedness significantly exceeds the 60% of GDP limit set in the Stability and Growth Pact. For some observers, this persistent level is gradually becoming a new normal. The efforts of heavily indebted countries to reduce their debt will be crucial in the years to come.

However, political discord within the EU complicates the task of formulating a unified plan to address the debt issue. Germany is advocating for clear budgetary guidelines for all countries to ensure swift debt reduction. In contrast, France and Italy are arguing for individual debt reduction paths that would take into account the unique circumstances in their respective countries.

The EU Commission and finance ministers face the challenge of reaching a new consensus on debt rules. Failure to do so could result in the reactivation of previous regulations with strict limits on new borrowing, leading to conflict and uncertainty.

Meanwhile, the EU is grappling not only with national debts but also with its first ever bloc-level debt. The financing of the post-Covid recovery program is proving more expensive than anticipated due to high interest rates. However, member countries have been reluctant to bear the additional costs, and a new struggle for distribution within the EU is emerging.

Overall, signs suggest that 2024 will be a critical year for the EU and its financial stability. The debt crisis, coupled with political discord and economic uncertainties, could pose a serious test for the future of the EU.

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