Debt-to-GDP ratios among euro area members have diverged since the financial crisis. However, for most countries interest expenses fell.
This is a key risk to budget deficits if bond yields increase. We favor underweighting French sovereign bonds in the 10-year sector and overweighting the periphery at the shorter end of the yield curve.
The October 2017 IMF Financial Stability Report again highlighted the risk from the high indebtedness of developed countries. On average, the debt-to-GDP ratio has increased in the euro area since the financial crisis.
But the dispersion of debt-to-GDP ratios among individual states within the euro area has also increased. While Germany or the Netherlands are expected to achieve lower debt-to-GDP ratios in 2018 than in 2007, Spanish and French debt-to-GDP ratios are still significantly higher.
The high divergence is driven by the different developments of the individual countries’ ratios since 2012. Debt-to-GDP rose for most countries from 2007-2012. However, since 2012, debt levels have fallen in Germany, Ireland, and the Netherlands.
In countries such as France or Italy, the debt-to-GDP ratio has increased, albeit at slower pace. In Finland, Spain, and Greece the ratio continued to increase at a relatively rapid pace. This could make monetary policy more difficult for the European Central Bank since it needs to deal with a more heterogeneous euro area – instead of convergence, divergence has occurred.
Despite the increase in debt-to-GDP ratios for most countries, interest expenses as a percentage of GDP has fallen in most countries. Lower bond yields helped sustain the increased debt levels. With a few exceptions, lower interest expenses were also used to improve budget deficits.
We believe this is an important factor to monitor since an increase in bond yields could also result in higher deficits.
Although most countries have lengthened the average maturity of their outstanding debt, hence higher bonds yields would only lead over time to higher deficits, we see the risk of non-linearity.
First, higher deficits would increase net issuance and could push bond yields further up. Second, for highly indebted countries higher bond yields could quickly raise a question about the sustainability of their debts. This would increase sovereign bond spreads and push bond yields up.
Therefore, we favor underweighting French sovereign bonds against German ones, in particular in the 10-year sector. We also prefer shifting our periphery overweight to the shorter end of the yield curve, which should be more protected against increases in yields and spreads.
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