Eurozone public finances face a pivotal year in 2024. The emergencies of the COVID-19 pandemic and the Russian-Ukraine war (and associated energy price hike) are giving way to increasingly normal macroeconomic conditions and falling inflation. Yet, successive shocks have heightened debt level concerns for some sovereigns. S&P Global Ratings expects those concerns, coupled with the European Central Bank's (ECB) current monetary tightening stance, will require EU countries to focus on budgetary consolidation.

Fiscal frameworks have also moved to the forefront of the EU's agenda, with the re-introduction, this year, of European fiscal rules that were suspended in 2020. These budgetary requirements aim to ensure fiscal discipline in the EU. The new rules introduce greater flexibility compared with the earlier version, yet their reintroduction means eurozone countries with moderate to high government debt-levels will find themselves subject to greater scrutiny and pressure to reduce borrowing.

Sovereigns will face shared challenges as they travel the path to debt reduction. Higher interest costs will weigh on budgets, while tepid economic growth will erode increases to government revenue. And long-term secular spending pressures lurk in the background, including growing old-age-related spending, pressure to increase defense spending, and the need for new investment (including in the transition towards greener energies and digitalizing European economies).

There are significant differences between countries, not least in terms of debt burdens and the political will to deliver budgetary consolidation. Progress toward improved budgets is therefore likely to prove uneven. Greece (BBB-/Stable), Cyprus (BBB/Positive) and Portugal (BBB+/Positive), are already rapidly reducing sovereign debt positions, albeit from significantly high levels, and are set to continue. Italy (BBB/Stable) and Spain (A/Stable), are pursuing less ambitious debt reduction trajectories, while government debt/GDP ratios in France (AA/Negative) and Belgium (AA/Stable) are likely to stagnate without additional budgetary consolidation efforts. Meanwhile, we expect only mild debt reduction in Germany (AAA/Stable) and Austria (AA+/Stable), both of which benefit from signficantly lower debt levels than their neighbors, and thus stronger fiscal buffers.

Higher Interest Rates Are A New Challenge To Fiscal Consolidation

Since mid-2022, when the ECB started to hike policy rates, yields on government bonds have surged, pushing up interest payments for most eurozone sovereigns (see chart 1). That differs from the pre-pandemic environment, when broad improvements in budgetary performance were underpinned by declining interest payments as a share of GDP, due to the low interest rates environment.

The full impact of the shift to higher policy rates won't be fully passed through to interest payments for about eight years, which corresponds to the average maturity on outstanding debt in the eurozone. This long maturity and low average cost of outstanding debt is the legacy of the ECB's quantitative easing.

Chart 1

Higher interest payments will not affect eurozone sovereigns equally:

• Italy and Spain, whose 2026 interest payments are projected at 4.6% of GDP and 3.0%, respectively, will have some of the highest interest bills in the eurozone. Further debt reduction will require additional deficit-reducing measures that more than offset the increase in interest payments.

• Portugal's and Greece's interest payments, which were similar to Spain's in 2022 (2.4% of GDP), will remain contained out to 2026. This will be supported by the countries' still significant shares of lower cost official debt (at about 20% for Portugal and 75% for Greece) and the expected decline in government debt as a share of GDP (interest reduces mechanically on declining outstanding debt). Greece will also benefit from a very long average maturity of about 20 years, which extends the time before higher yields pass-through into interest payments.

• Cyprus's interest payments/GDP should also prove contained, for reasons similar to those affecting Greece and Portugal, though at a lower level of below 2% of GDP due to its lower debt level.

• France and Belgium's interest payments/GDP will rise beyond 2% by 2026 due to higher yields and stagnant debt levels. Austria, meanwhile, will experience a steep increase in interest payments/GDP, though the ratio will remain below 2%.

• Germany's interest payments will rise but remain below 1% of GDP by 2026. That mild increase is due to low debt levels.

Further Debt Costs Increases Will Depend On The Pace Of Quantitative Tightening

It seems likely that ECB policy rates have peaked, although we do not expect the monetary authority to start cutting rates before mid-2024. The ECB's quantitative tightening, which began in March 2023, could accelerate if the ECB more rapidly curtails reinvestment of maturing sovereign bond holdings, which were originally acquired under the Pandemic Emergency Purchase Programme (PEPP), launched in March 2020.

All else being equal, faster quantitative tightening could push up bond yields and interest payments. We believe, nonetheless, the ECB will seek to avoid financial fragmentation, which could occur if ECB monetary policy transmission is unequal across the eurozone. Such fragmentation could lead to a sharper rise in yields in some countries (typically those with weaker credit fundamentals).

Nevertheless, we expect the impact of an eventually more active quantitative tightening by ECB on the government's borrowing conditions won't be symmetrical to the effects of quantitative easing. This is because, among other factors, we believe that an active disposal of assets would be much more gradual than the rapid pace of asset purchases during quantitative easing. Furthermore, tightening would take place against a background of solid economic growth and an expected decline in the net supply of government bonds.

Challenging Macroeconomics And Persistent Spending Pressures

Governments will be faced with difficult macroeconomic conditions in the near term, and especially over the first half of 2024. The eurozone as a whole avoided a technical recession in 2023, yet economic growth will remain shallow in 2024. At the same time, the inflationary windfall that boosted growth across most revenue categories in 2022 and part of 2023 has mostly faded. Some relief is likely from a rebound in economic activity beyond 2024, which should offer cyclical support to budgetary performance.

While our economic projections suggest that conditions for ongoing budgetary consolidation will be relatively favorable beyond 2024, secular trends could prove a long-term complication. These trends include: pressure to boost defense spending to 2% of GDP by 2030 (particularly for NATO members below that target (see chart 2)); costs associated with the green and digital transitions--though some sovereigns are receiving significant support from the EU's Recovery and Resilience Facility and REPowerEU program (see "Next Generation EU Will Shift European Growth Into A higher Gear," April 27. 2021) ; and spending related to the demographic shift toward an increasingly elderly population (see chart 3).

Chart 2

Chart 3

Budgetary Performance Isn't Uniform Across The Eurozone

We see four broad groupings of sovereigns in the euro area based on current primary balance and budget balances, their government budget targets (see chart 4), and their government debt levels (see chart 5).

Chart 4

Chart 5

High debt levels and steep debt reduction: Greece, Cyprus, Portugal 

Greece, Portugal, and Cyprus, have already brought previously elevated debt/GDP below pre-pandemic levels (162% for Greece in 2023, 105% for Portugal, and 79% for Cyprus).

That performance was the result of strong budgetary consolidation. Cyprus posted a budget surplus in 2022, Portugal in 2023, while Greece returned to a primary balance surplus in 2022. Moreover, the results have been underpinned by the trio's contained response to inflationary shocks, resilient tourism-driven economies, and a significant boost to government revenues from much higher-than-budgeted inflation.

We expect the three countries will post primary budgetary surpluses in excess of 2% of GDP in 2024 (see chart 4). However, given their already significant post-pandemic budgetary consolidation, additional budgetary improvements are likely to be less substantial over 2025-2026.

The improvements and ongoing positive trends led to last year's decision to upgrade Greece (see "Greece Upgraded To 'BBB-/A-3' On An Improved Budgetary Position; Outlook Stable," Oct. 10, 2023) and our revision to positive of the outlooks on Portugal (see "Portugal Outlook Revised To Positive On Resilient Growth And Government And External Deleveraging; Ratings Affirmed," Sept. 08, 2023) and Cyprus (see "Cyprus Outlook Revised To Positive On Continued Macroeconomic Normalization; Affirmed At 'BBB/A-2'," Sept. 01, 2023). Further improvement in the countries' public finances could trigger positive rating actions.

It is noteworthy the extent to which these countries' situations contrast with their performance in the wake of the sovereign debt crisis in 2010. Then they were among the euro area sovereigns forced to enter International Monetary Fund (IMF)/ European Financial Stability Facility (EFSF)/ European Stability Mechanishm (ESM) reform programs.

Moderate debt levels and moderate debt reduction: Austria and Germany 

Germany's and Austria's debt/GDP levels have increased compared to pre-pandemic levels but remain low compared to the selected peers discussed here. We forecast Germany and Austria will post moderate budget deficits in 2024 while retaining ample fiscal and external buffers--a combination that supports their stable outlooks. Germany's primary balance in 2024 may be smaller than our forecast due to budget cuts of around €17 billion (0.4% of GDP in 2024). Those cuts, agreed in late 2023, were in response to a ruling by the constitutional court, enforcing Germany's debt brake, which limits the federal government's structural deficit to 0.35% of GDP. Such fiscal constraints could pose long-term risks to growth, especially given the country's need for investment, notably in the green transition.

High debt levels and moderate debt reduction: Italy and Spain  

Debt levels in Italy and Spain continue to exceed pre-pandemic levels and we forecast a moderate reduction over 2024-2026 of 1% of GDP for Italy and 3% of GDP for Spain. We expect the pair will reduce their primary budget deficits, continuing recent improvements, though their primary balances are likely to remain narrowly in negative territory in 2024. But high interest payments will underpin still relatively high budget deficits. Although Italy and Spain's debt reduction trajectory is slow, we believe it remains within the scope of their current ratings and reflect this in our stable outlook on the pair.

Stagnating high debt: France and Belgium  

France's and Belgium's debt levels have increased since the pandemic and appear set to remain close to their current levels until 2026. The pair will likely post the largest primary deficits among eurozone sovereigns in 2024. The negative outlook on France reflects our uncertainty relating to our forecasts for its public finances amid high, albeit slowly declining, budget deficits and elevated general government debt. France's track record of budgetary consolidation is relatively weak, the country has not reported a primary budget surplus since 2007.

What It Will Take to Return to 2019 Debt/GDP Levels

The magnitude of the challenge facing some governments is demonstrated by comparing their planned primary balances to the levels required to return debt/GDP to 2019 levels (see chart 6). Given most governments' plans to pursue steady budgetary consolidation out to 2026, it seems inevitable that many will fall short of returning to 2019's metrics. That is particularly the case for countries with signficant budget gaps and large government debt/GDP ratios.

The gap between the average 2024-2026 primary debt balance required to return government debt to 2019 and our forecast of that average is largest in France, where is stands at about 5% of GDP. That is inkeeping with our expectation of the sovereigns's slow budgetary consolidation, which is a key factor in our negative outlook on France.

The gap is about 2% of GDP in Spain, Belgium, and Austria, and below 2% in Italy and Germany. A failure to fully implement measures to reduce debt could prompt negative rating actions on sovereigns that are left with large deficits and high government debt.

Chart 6

New Rules Make Debt Reduction A Priority

New EU fiscal rules will come into force in 2024 following an agreement among member states, in December 2023. The rules have been suspended since 2020, allowing governments to deviate from the EU's budgetary requirements to support their economies during the pandemic and energy price shocks.

Notably, the excessive deficit procedure, which is activated when a country breaches the rules, will come into force from mid-June 2024, after the European elections. Thereafter, the relevant EU institutions will begin assessing if sovereigns outside of the regulated limits are fully implementing corrective actions required by the new fiscal rules.

The new rules maintain the previous upper limits for budget deficits, at 3% of GDP and 60% of GDP for government debt. Yet the framework also includes new measures that provide a degree of flexibility. They include:

• Fiscal adjustment targets that will be country-specific and fleshed out in a bespoke four-year plan agreed with the European Commission. The plan can span up to seven years if countries commit to growth enhancing reforms;
• Performance monitoring primarily based on net primary expenditure. This serves to limit pro-cyclical bias and avoids raising the fiscal consolidation bar too high for countries with high interest payments; and
• The use of debt sustainability analysis (DSA) to determine pathways to net expenditure reduction. This has the advantage that it can incorporate the impact of growth and investments in the analysis, instead of merely focusing on expenditure cuts that can have a recessionary impact.

The Fiscal Rules Are Positive But Don't Alter Our Assessments

While the introduction of new rules is welcome, it doesn't alter our assesment of sovereign creditworthiness. That is notably because S&P Global Ratings' focus will continue to be on each individual country's fiscal trajectory rather than on the EU thresholds and regulations. It also reflects our conviction that further improvement in public finances ultimately depend on national economic factors and individual governments--including their ability and will to comply with the rules. That compliance may, in turn, rest on the European Commission's capacity to enforce its rules.

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Related Research

• Global Aging 2023: The Clock Ticks, Jan. 18, 2023.
• Next Generation EU Will Shift European Growth Into A higher Gear, April 27, 2021.
• Economic Outlook Eurozone Q1 2024: Headed For A Soft Landing, Nov. 27, 2023.