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EU commission autumn economic forecasts

Fri, Nov 24 2006, 16:44 GMT
by KBC Market Research Desk

KBC Bank

EU COMMISSION AUTUMN ECONOMIC FORECASTS

In this Flash, we provide an update of the EU Commission’s economic forecasts for the euro zone and look into the latest national budget data and their possible impact on government bond spreads.

The EU Commission autumn forecasts highlighted the strong economic performance of the euro zone economy in 2006 and its favorable implications for public finances. Indeed following years of below trend growth, the euro zone economy finally gathered pace in 2006. Sustained strong global economic conditions and increased domestic demand, especially in investments were the main drivers. The recent improvements in the labour market should now also result in a recovery in consumer spending, keeping the economic expansion ongoing. This positive outlook is reflected in the EU Commission forecasts for GDP growth, which project growth to remain at around trend in 2007 and 2008 at respectively 2.1% and 2.2% in the euro zone.

The improved economic conditions are also reflected in the public finances, as higher growth boosted tax revenues. As such, the average budget deficit is seen at 2% of GDP this year, down from 2.4% in the euro area, and at 1.5% in 2007 and even 1.3% in 2008. At the same time, the debt-to-GDP ratio is also expected to decline following the peak at 70.6% in 2005. Over the forecast period, the euro zone debt ratio is projected to decline to 66.9% in 2008.

The improvement in public finances resulted in an outperformance of euro zone government bonds in the course of 2006. As a result, the spread between German government bond 10-year yields and swap rates widened from around 10 basis points in 2005 to around 25 basis points currently.

Strong improvement in public finances leads to a widening in the spread between government bond yields and swap yields.

The table (cf. below) provides an update of the new growth and deficit/debt forecasts for the individual euro zone member states. For the first time, Slovenia is included in the table, as Slovenia will join the euro zone from next year on. The member states are ranked in order of their projected debt-to-GDP ratio.

The table replicates for most member states the improvement seen in the general euro zone figures. As a result only two member states are projected to run a deficit of more than 3% in 2006 compared to four in 2005. Indeed, following several years of excessive deficits, Germany’s and France’s budget deficit is expected to fall below the 3% of GDP this year. As such, only Italy and Portugal are still running an excessive deficit in 2006. But also in these two countries, the deficit is on a downward path. In Italy, the deficit is even projected to fall below 3% of GDP in 2007. Concerning the debt-to-GDP ratio, the upward trend in many euro zone member states is expected to reverse over the forecast period. Only in Portugal, the debt ratio is still on a rising path. Given the gradual improvement in the debt ratio, the number of member states with a debt ratio of above the 60% of GDP reference value will decline from seven this year to six in 2008.

Since the modification of the Stability and Growth Pact (SGP) in March last year, market attention for the national budget situations has increased. The loss of credibility of the SGP resulted in a significant underperformance of mainly Italian, Greek and to a lesser extent also Portuguese bonds, as these countries faced the strongest deterioration in their fiscal position in recent years and already had the lowest rating among the euro zone member states. Mid- October, S&P and Fitch even downgraded Italy’s rating from respectively AA- to A+ and from AA to AA-, as the new government failed to implement rigorous measures in their first budget. Both rating agencies have now a stable outlook, even while S&P was much more criticizing the fiscal situation, which is also reflected in the lower absolute rating.

From the countries under the excessive deficit procedure, Portugal is clearly the ugly duck. Despite the overall economic upturn, economic growth in Portugal remained rather sluggish. This kept the rise in revenues rather limited compared to other euro zone member states. As a result, the budget deficit is projected to remain substantially above the 3% limit throughout the forecast period. As such, Portugal won’t meet the requirements of the excessive deficit procedure to correct its excessive deficit by 2008 without additional measures. The weak performance is also reflected in the debt ratio, which is still on an upward track and is projected to exceed the 70% level by 2008 compared to only 58% in 2004. The negative outlook should still result in an underperformance of Portuguese government bonds compared to its peers. Do not forget in this context that Fitch does still have a negative outlook for Portugal.

Besides Portugal, also Italy is struggling to bring its budget deficit below the 3% level on a sustainable basis. This year, the budget deficit is even expected to rise to 4.7% of GDP from 4.1% in 2005 following a court ruling demanding the refunding of unduly paid VAT for company cars. In the draft budget for 2007, Italy nevertheless targets a deficit below 3%, as required by the excessive deficit procedure. Whether this will be achieved is still rather uncertain, as it is difficult to anticipate the revenues stemming from the measures aiming to fight tax evasion. The autumn forecasts nevertheless project the Italian budget deficit to fall below the 3% level in 2007, but to rise again slightly above this level in 2008. The debt ratio remains the highest of the euro zone member states and won’t fall below 100% throughout the forecast period. As such, Italian public finances remain very vulnerable in case of a rise in the general interest rate level. The greater commitment of the new government Prodi nevertheless resulted in some outperformance of Italian government bonds, even despite the recent rating downgrade.

Greece on the other hand is doing rather well following the significant upward revision of the budget deficit to 7.8% in 2004, due to an accounting scandal and a spending spree related to the Olympic Games. Since, the budget deficit is on a downward path and is now projected to decline to just above the 2.5% of GDP this year in line with the recommendation of the excessive deficit procedure. Despite the improvement in the deficit, the debt ratio is still way above the 60% of GDP reference level and is only projected to decline gradually to below the 100% in 2008. These figures, however, do not take account yet the recent significant upward revision of Greek’s GDP by 25% following the incorporation of the black economy in the data, as Eurostat still has to verify the sources and methods used by Greece. Nevertheless since the top in April, the spread between Greek and German 10-year yields has narrowed from 35 basis points to around 25 basis points currently. The fact that the spread is similar to Italy can be explained by the lower rating.

Also Germany is on track to correct its excessive deficit, as its budget deficit is projected to fall below 3% of GDP in 2006 for the first time since 2002. The major contribution to this improvement comes from the revenue side, thanks to the strong growth upswing. In 2007, the budget deficit is even projected to fall to 1.6% of GDP, as the VAT increase should boost revenues by 1% of GDP. The improvement has already led to a reduction in its borrowing plans this year by EUR 5 B and in 2007 German net borrowing requirements are expected to fall further from EUR 30 B this year to EUR 22 B. The impressive improvement in German public finances is likely to support German government bonds and may lead to a further widening of the spread between German yields and swap rates.

In contrast to what had been projected in the EU Commission spring forecasts, France’s budget deficit is likely to remain below the 3% level in 2006 for the second consecutive year. As such, the excessive deficit procedure will not be reopened. On the contrary, in the coming years the deficit is likely to remain on a downward path to come out at 2.2% of GDP in 2008. However, as this result is less impressive than in Germany, spreads may remain in slight positive territory.

Among the countries that do not have the highest credit rating in the euro zone, Belgium is still doing rather well, even while Eurostat amended the budget deficit from a surplus of 0.1% to a deficit of 2.3% of GDP in 2005 in relation to a debt assumption from the railway company. Despite the government’s commitment to publish budgets in balance, the autumn forecast project the Belgian budget deficit to widen to 0.5% of GDP in 2007 and 2008 from the projected 0.2% deficit this year. The debt ratio, while still the third highest within the euro zone member states, is projected to remain on a firm downward path and to fall to 83.2% of GDP in 2008. Following the rating upgrade by Fitch at the beginning of the year and the positive outlook by Moody’s, spreads with other euro zone issuers are set to remain tight.

To assess the budgetary outlook, it also important to keep a close eye on the general trend in yields and the general risk appetite in the markets. Concerning the first, the outlook is a bit balanced as short-term yields are still on an upward path given the ECB rate outlook, while long-term yields are already downwardly oriented following the US slowdown. A change in trend for yields is mainly important for countries with a high debt-to-GDP ratio like Italy, Greece and Belgium, as this may have a large influence on interest expenditures and consequently budget deficits. Concerning the general risk appetite, the recent rise in ECB rates did not spoil investor’s risk appetite yet. On the contrary, on the corporate bond market spreads are still getting tighter and tighter. This may keep spreads tight between euro zone government bond yields too, despite the strong improvement in public finances in for example Germany.

CONCLUSION

Since the modification of the Stability and Growth Pact in March last year, the national budget situations do get much more attention in the European bond market. In this context, the publication of the EU Commission economic forecast provides an ideal opportunity to reassess the budgetary outlook and its possible impact on government bond spreads. This reassessment shows recent growth upturn in the euro zone also has its positive implications for public finances, as most countries under the excessive deficit procedure are likely to meet their targets. The main exception is Portugal, which will have to take additional measure to bring the budget deficit below the 3% level, but also Italy is not out of the woods yet. This general positive development was also noticed in a tightening of the spreads between euro zone government bonds. As long as yields remain relatively low and investor’s risk appetite remains high this environment of tight spreads may last, despite the underlying differences in performance.

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Published on  Fri, Nov 24 2006, 16:50 GMT

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