Economy

Euro nations want to shake up their debt rules — and it could spell trouble in bond markets

Key Points
  • Complying with the 3% and 60% deficit and debt thresholds will be harder, if not impossible, to achieve post-pandemic.
  • European Commission forecasts point to an average of debt-to-GDP ratio of 100% in the euro zone at least until 2022.
  • Brussels wants to restart talks on how to reform the fiscal rules in the coming months.
People wearing face masks walk in front of a big Euro sign in Frankfurt am Main, western Germany, as the European Central Bank (ECB) headquarters can be seen in the background on April, 24, 2020.
Yann Schreiber | Getty Images

LONDON — The euro zone wants to update its fiscal rulebook, a necessary step to deal with highly indebted nations post-pandemic but one that could also spark nervousness among investors.

The Stability and Growth Pact — the EU's fiscal rulebook — was introduced in 1993 and asks countries to have a public deficit lower than 3% of their gross domestic product (GDP) and a debt pile lower than 60% of their GDP.

Member states have often deviated from these thresholds and clashed with the European Commission, the institution in charge of enforcing the rules. A recent example involved Italy in 2018 and its confrontation with Brussels led to higher borrowing costs for the nation.

The rules need a radical overhaul.
Edward Smith
Head of asset allocation at Rathbones

Investors were concerned that Italy would not be doing its utmost to reduce its debt and that increased yields on Italian bonds.

Over the years, the EU's fiscal rules have been criticized for being too tough to achieve as well as for not being correctly enforced by the commission, which has always avoided fining nations disrespecting the rules.

'The big thing to change'

Complying with the 3% and 60% deficit and debt thresholds will be harder, if not impossible, to achieve post-pandemic. European nations have had to loosen their purses to support their economies in an unprecedented way and that has deteriorated their fiscal positions even further.

European Commission forecasts point to an average of debt-to-GDP ratio of 100% in the euro zone at least until 2022.

That means the 60% (debt-to-GDP) limit "is irrelevant" in the current context, Thomas Weiser, who served as an official to the EU and led preparations for the meetings of euro zone finance ministers, told CNBC earlier this month.

Weiser added that the 60% threshold "is the big thing that would have to change" when updating the fiscal rules.

VIDEO3:4803:48
Economic recovery has been 'delayed, not derailed,' ECB's Lagarde says

Reforming the rulebook was on the EU's agenda before the pandemic, but the issue was side-lined when the virus hit, and the countries decided to focus on their immediate responses.

However, Brussels wants to restart these talks in the coming months.

Speaking to CNBC earlier this month, Paschal Donohoe, who chairs the meetings of the euro area finance ministers, said he expects the European Commission to look at what the future of the rulebook is "during this year."

A spokesperson for the European Commission told CNBC Wednesday that "the calendar for relaunching the consultation process remains to be decided in light of economic developments."

However, Donohoe, who serves as Ireland's finance minister too, expects "a higher tolerance for a period of time for a higher level of debt and higher level of annual borrowing in order to help our economies recover quickly."

'Radical overhaul'

Three market experts have told CNBC that reforming the EU's fiscal rules is a necessary step that the region needs to take.

"Improving fiscal rules is the single most important challenge facing the region," Frederik Ducrozet, strategist at Pictet Wealth Management, said, while Edward Smith, head of asset allocation at Rathbones, said in an email that "the rules need a radical overhaul."

Investors will be monitoring how the rules might change and whether a considerable loosening in the thresholds could lead to market jitters.

"Loosening the constraints creates more inflation risk which could hurt bond prices," Smith from Rathbones said.

"The very difficult task is to determine and to agree on what ratios are sensible or how rules can be shaped otherwise as to be fit for purpose," Maartje Wijffelaars, senior economist at Rabobank said.

"Will it involve debt write-offs or not? Will there be sanctions? Will there be flexibility? And will governments try to follow the rules or look for confrontation time and again as we've seen happening with Italy in many of the past years, for example. All these things will matter," she said when asked how bond market might react.

VIDEO1:0201:02
Lagarde: ECB 'stands ready' to adjust instruments as necessary