Debt rules in Europe are changing. And that could have big implications for bond markets

The eurozone will soon unveil changes to its fiscal rules, a move that could have significant implications for government borrowing costs and the region’s bond markets.

The European Commission, the EU’s executive arm, will next week present a proposal to reform fiscal rules that have been in place for nearly 30 years. The regulation has been criticized for being too opaque, for being too difficult to implement and for not being well enforced.

“Simplification, stronger national ownership and better enforcement will be defining features of an improved framework, with the overall objective of supporting debt sustainability and sustainable growth,” said Paolo Gentiloni, European Commissioner for economy, at an event in October.

Fiscal discrepancies between eurozone member states (which share the euro) have always been a controversial topic in the region and have caused divisions among them.

To cite just one example, France has repeatedly broken deficit rules and has never been fined despite what the law stipulated. This would then ease pressure on smaller European economies, which were also breaching deficit targets to correct their fiscal stances. At the same time, Germany and the Netherlands would criticize the European Commission for not enforcing the rules with fines.

However, the Covid-19 pandemic has caused similar economic strains across the region, forcing governments to spend far more to deal with the health crisis – resulting in rising public debts across the bloc. . The fact that they all faced this challenge reinforced the idea that they needed to update the budget regulations.

Therefore, the main idea of ​​the revised rules is now to help eurozone countries correct their debt levels. At the end of the second quarter, public debt stood at 94.2% of GDP in the 19-member region. It fell from 86% at the end of the first quarter of 2020 to 99.6% at the end of the first quarter of 2021 due to the rising costs associated with the pandemic.

The need to correct fiscal positions becomes even more relevant in times of war in Europe, energy crisis and severe cost of living pressures.

“We want to move towards more personalized requirements based on debt sustainability,” an EU official who is working on the preparations for the proposals told CNBC.

The regulation states that nations must not have a debt greater than 60% of their GDP (gross domestic product). This benchmark does not change, according to the same official who preferred to remain anonymous as the details are not yet public.

But it is naturally more difficult for Greece and Italy to respect this threshold given their debt ratios above 150%. Germany’s sovereign debt stood at just under 70% of its 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 set of actions to help each nation fix its fiscal situation. They would have a specific timeline to do so with milestones to be achieved during that time. Member States would have a say in the preparation of this set of actions.

However, the question some capitals will have about the new plan is how the European Commission will implement it.

“The rules currently leave a lot of room for the discretionary judgment of the commission and 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 this “caused rules to be applied in a non-transparent and sometimes inconsistent manner. This should be resolved in the next review.”

The post follows earlier comments from German Finance Minister Christian Lindner, who also wants the upcoming changes to strengthen enforcement.

Market participants will be watching for details and developments in the discussions in the coming months.

“The interest burden on large public debt-to-GDP ratios is expected to increase significantly in the coming years. It is therefore essential to implement simpler but credible rules to ensure public debt sustainability, while at the same time managing the medium-term challenges of European economies – demographics, energy and green transitions,” Francois Cabau, eurozone economist at AXA Investment Managers, told CNBC via email.

European governments face higher costs when tapping markets as interest rates normalize. This marks a significant change from the ultra accommodative monetary policy that has been implemented in the Eurozone over the past decade.

The yield on 10 years from Italy government bonds, for example, were trading at 4.463% on Thursday. Throughout 2020 and 2021, the same return was generally below 2%.

Henry Cook, an economist at MUFG bank, said that “ideally any update to the fiscal rules would allow for a greater degree of flexibility linked to the individual circumstances of each member state while providing credible penalties for flagrant breaches.” .

“The most likely outcome is that the EU continues to tangle with a lot of leeway given to national governments when it comes to budgetary choices,” he added.

Any sign that countries are not committing to correcting their fiscal positions could drive up their borrowing costs even further.

Regardless of the details that will be presented next week, they are likely to start a long debate among eurozone finance ministers.

This means that in an optimal scenario fiscal rules will be changed from 2024. A second EU official, who declined to be named due to the sensitivity of the upcoming talks, said he had to be an agreement before the European legislative elections of 2024 and therefore before the political debate focuses on this vote.