The pace of fiscal correction in Europe appears to be slowing, with policymakers turning to an "austerity lite" approach that has given some sovereigns more time to meet their deficit targets. This represents a change from the "growth versus austerity" debate that has been simmering for years, pitting the advocates of pro-growth macroeconomic demand management against those who favour cuts in government spending and tax hikes amid a prolonged economic recession.
What does this policy shift mean for the debt crisis in Europe and the creditworthiness of sovereign borrowers? In essence, we see the policy change as a practical response to the ongoing recession in Europe, rather than a fundamental shift away from structural fiscal consolidation, which we expect will continue.
Heightened refinancing risk
The initial focus on austerity as a euro-zone policy response to the financial crisis was motivated primarily by the degree of loss of unfettered access to the capital markets. We believe it was this heightened refinancing risk, rather than inherent political preferences or other reasons, that motivated sovereigns to try to cut public deficits aggressively. In our experience, increased market pressure seems to lead to a tighter budgetary response. This pattern could suggest the sustained drop in interest rates for peripheral euro-zone sovereigns since the peaks of last summer have provided the foundation for a slower pace of fiscal consolidation.
During the past 12 months the policy approach in the euro zone has gradually become more varied, with a less singular focus on up-front fiscal retrenchment. But the policy approach has not changed fundamentally. We believe the recent shift in rhetoric is an acknowledgement of a more gradual policy approach that has been evident since mid-2012. A growing consensus among governments seems to endorse a more moderate pace of deficit adjustment to mitigate the negative knock-on effects on growth. The direction of travel remains unchanged but the consolidation journey is being conducted in a lower gear.
The framework we as a rating agency use to determine our sovereign ratings, known as our sovereign rating methodology or criteria, is not biased toward austerity. It takes into account multiple factors that can affect sovereign creditworthiness over time. Indeed, under our criteria we assign a higher weight to economic factors than to fiscal ones.
A sovereign rating ultimately looks at whether the government can service its debt load. Sustainable economic growth is an important factor in determining a sovereign’s debt service capacity, and so is the sovereign’s willingness to honour its financial obligations. At the same time, we have noted that a sovereign’s failure to secure prudent public finance management can materially and negatively influence its debt service capacity, even in cases where it enjoys a buoyant economy.
Nevertheless, in many cases the sustained consolidation of public finances is, in our view, a key contributing factor to sovereign creditworthiness. Fiscal space is not infinite, particularly for sovereigns with limited monetary flexibility, such as euro-zone members. Governments with strong credibility in capital markets and lower debt to GDP are able to engage in countercyclical fiscal policy in bad times. Those that have inherited a high debt load and are plagued by weak institutions often do not. We find that where public debt ratios are high and deficit financing is prohibitively expensive, nations have few if any credible alternatives to fiscal consolidation.
This demonstrates to us that fiscal caution remains relevant. While current debt levels are not extraordinarily high by some historical precedents, we believe they need to be assessed in the light of having been amassed in peacetime and the lower future growth potential as our societies age. Under our criteria we would not likely change our ratings if there was a temporary slippage in a sovereign’s progress towards consolidation if we were to see evidence of a viable strategy to secure sustainable public finances and economic growth over the longer term.
In this new, austerity-lite phase of the crisis there are many dangers lurking for sovereigns. In particular, we believe that relative ease of access to the capital markets could contribute to complacency and policy reversals. That complacency could lead to the fragile agreements among European policymakers unravelling if some consider too early that the region’s troubles have passed and previously agreed actions can be shelved or watered down. Budgetary correction still has years to run in several euro- area sovereigns. If investors doubt governments’ commitments, the latter may find themselves forced to intensify austerity again, with all the social risks that would entail.
Moritz Kraemer is head of EMEA sovereign ratings at Standard & Poor's ratings services.
