The eurozone needs to discuss changing its fiscal rules – a task that could have implications for the market.
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The eurozone will soon unveil changes to its fiscal rules – a move that could have significant implications for the cost of government borrowing and the region’s bond markets.
The European Commission, the executive branch of the EU, is coming next week with a proposal to reform the tax rules that have been in place for almost 30 years. The rulebook has been criticized for being too opaque, too difficult to implement and not well enforced.
“Simplification, stronger national ownership and better enforcement will be the defining features of an improved framework, with the overall objective of supporting debt sustainability and sustainable growth,” said Paolo Gentiloni, Europe’s Commissioner for Economy, at an event in October.
Why is the eurozone revising its rules?
Fiscal discrepancies between eurozone member states (which share the euro currency) have always been a controversial topic in the region and have led to divisions among them.
To cite just one example, France has repeatedly violated the deficit rules and has never been fined despite what the law required. This would then ease pressure on smaller euro economies, which also exceeded deficit targets to correct their fiscal stance. At the same time, Germany and the Netherlands would blame the European Commission for not enforcing the rules with fines.
However, the Covid-19 pandemic created similar economic tensions across the region, forcing governments to spend significantly more to address the health crisis – translating into higher government debt across the bloc. The fact that they all faced this challenge reinforced the notion that they needed to update the tax rulebook.
Therefore, the main idea in the revision of the rules now is to help euro countries correct their debt levels. At the end of the second quarter, government debt stood at 94.2% of GDP in the 19-member region. It rose from 86% at the end of the first quarter in 2020 to 99.6% at the end of the first quarter of 2021 due to higher costs related to the pandemic.
The need to correct fiscal rates is becoming increasingly relevant in times of war in Europe, an energy crisis and severe pressure on the cost of living.
What could they look like?
“We want to move towards more tailored requirements based on debt stability,” an EU official working on the preparations for the proposals told CNBC.
The rulebook states that countries should not have a mountain of debt exceeding 60% of their GDP (gross domestic product). This benchmark will not change, according to the same official who preferred to remain anonymous as the details are not yet public.
But of course it is more difficult for Greece and Italy to meet this threshold, as their debt-to-GDP ratios are above 150%. Germany’s public debt stood at just under 70% of GDP at the end of 2021.
The same official said the plan is to have the commission conduct a debt sustainability analysis for each country and then design a series of actions to help each country correct their fiscal position. They would have a precise timeline to do it with milestones to be reached during that period. Member States would have a say in the preparation of this series of actions.
However, the question some capitals will have about the new plan is how the European Commission will enforce it.
“The rules currently leave a lot of room for discretionary assessment by the committee and the council [which is made up by the member states]Dutch Finance Minister Sigrid Kaag said in a letter sent to the European Commission last week and seen by CNBC.
She added that “causes rules to be applied in an opaque and sometimes inconsistent manner. This should be addressed in the upcoming review.”
The release follows previous comments by German Finance Minister Christian Lindner, who also wants the upcoming changes to strengthen enforcement of the rules.
Markets are watching
Market players will pay attention to the details and how the discussions will develop in the coming months.
“The interest burden on the large public debt-to-GDP ratio will increase significantly in the coming years, so it is crucial to put in place simpler but credible rules to ensure the sustainability of public debt while addressing the medium-term challenges of European economies – demographics, energy and green transitions,” François Cabau, Eurozone economist at AXA Investment Managers, told CNBC via email.
European governments face higher costs in entering the markets as interest rates have normalized. This marks a significant change from the ultra-easy monetary policy that has been conducted in the eurozone over the past decade.
For example, the yield on the 10-year Italian government bond was 4.463% on Thursday. In 2020 and 2021, the same return was usually below 2%.
Henry Cook, an economist at MUFG bank, said that “ideally any adjustment to fiscal rules would provide a greater degree of flexibility with regard to the individual circumstances of each member state, while also providing credible sanctions for flagrant violations.”
“The most likely outcome is that the EU continues to muddle through and national governments are given a lot of leeway when it comes to fiscal choices,” he added.
Any signs that countries are not determined to correct their fiscal stance could drive up their borrowing costs even more.
When do these come into effect?
Regardless of the details to be presented next week, it is likely that they will spark a lengthy debate among eurozone finance ministers.
This means that in an optimal scenario the fiscal rules will be changed from 2024 onwards. A second EU official, who would not be named due to the sensitivity of the upcoming talks, said an agreement should be reached before the 2024 EU parliamentary elections and thus before the political debate focuses on this vote.