Is a sovereign debt crisis possible in Europe?

With interest rates rising, fears of a sovereign risk return are emerging in Europe. After the 2011 Greek crisis, the economic and financial situation in the euro zone has improved. Peripheral countries are less exposed to this risk. So are investors overly pessimistic about this?

Poor potential growth is a source of concern

Investors are concerned about weak potential growth, particularly a declining working-age population and declining per capita productivity. In the absence of growth, states will face increasing difficulties in controlling their public finances and paying their debts. Italy is the country most affected by the virtual stagnation of GDP in terms of volume in two decades. France, Spain and Germany have grown by just 3% since 2022, with more than 25%.

Doubts about the ability to pay public debts lead to a rate differential with Germany, which reaches two points for Italy and one point for Spain (10-year government bond rate differentials). At the end of 2022, there was a slight tension in the exchange rates of Southern European States, which is a sign that investors persist in believing in a possible sovereign debt solvency problem. Thus, Italy’s 10-year rate crossed 4.6% in December before falling in January and returning to 4% in mid-January.

The threat of interest rates must be put into perspective

Real long-term interest rates (interest rates – inflation) are still negative for eurozone countries, with the exception of Italy of course. For the latter, real interest rates remain negative if we consider core inflation rather than price growth. As real long-term interest rates are lower than potential growth, the conditions for public debt sustainability are met.

The situation is markedly different from the situation that prevailed during the Eurozone crisis between 2011 and 2013. After this crisis, Southern European countries rebalanced their balance of payments, Germany and the Netherlands reduced their borrowing from these countries. The current account balance increased from -10% of GDP in 2008 to +0.5% in 2021 for Spain and from -2.5% to +0.2% for Italy. Southern European countries had to reduce their domestic demand to eliminate their external deficit. In 2022, domestic demand was 8% below 2008 levels in Spain and 5% below 2008 levels in Italy.

Compared to the period of the sovereign debt crisis, the external deficits of Southern European countries are low or even zero. However, in terms of financing, external deficits are more dangerous than government deficits. In the first case, the country has to make settlements with foreign countries, which is more complicated than internal settlements. Furthermore, before the health crisis, Southern European countries were running primary surpluses (before debt interest is taken into account). Their three-year government deficit is at the euro zone average. National debt financing and some control of deficits reduce the likelihood of a crisis in Italy or Spain.

France, limited risk

Experts point to the fact that France, which continues to grow in debt and accumulate a trade deficit, may be the weak link in the euro zone. If there is a sharp deficit in the trade balance, more than 150 billion euros in 2022, the current balance of payments is less, thanks to the surpluses created by services and especially tourism. Its deficit should be 2% of GDP for 2022. France can count on the strength of its financial system and substantial household savings.

Despite a decline in the birth rate in recent years, France’s population continues to grow, encouraging potential growth. This situation is different from, for example, Italy. Finally, France benefits from an efficient system for the collection of taxes and social security contributions, which is a guarantee of safety for foreign investors, even as the margins of mandatory collection increases in this area are becoming weaker. At the beginning of 2023, France is not under the control of financial markets, as evidenced by the low interest rate difference with Germany (0.5 points).

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