Recovery Depends On Reform
This report does not constitute a rating action
Remy Carasse Paris +33-14-420-6741
Frank Gill Madrid +34-91-788-7213
Marko Mrsnik Madrid +34-91-389-6953
Louis Portail Paris
Jaime Vara de Rey Madrid
Of the 30 European developed sovereigns that we rate, the outlook on 23 of them is stable. Our outlooks on Andorra, Cyprus, Estonia, Greece, and Italy are positive, while our outlooks on Guernsey and Spain are negative.
GDP growth in the euro area is expected to be 4.4% in 2022, which should help governments start to consolidate oversized budgetary deficits and the ECB start to normalize monetary policy.
The euro area's supranational response to the pandemic has combined quantitative easing and the pooling of fiscal resources behind the Next Generation EU Fund (NGEU). This has buttressed the creditworthiness of all member states.
At the national level, however, significant political fragmentation could cement opposition to labor, pension, and other structural reforms, which could have negative implications for growth, budgetary positions, and sovereign ratings.
The 23 stable outlooks in the developed European rated universe indicate ratings that are not likely to change in 2022. In nominal terms, most European economies have recovered to at least the 2019 level. The remaining supply-chain bottlenecks contributed to rising price inflation, although wages have not yet followed. Despite rising prices and the spread of the omicron variant in late 2021, we forecast real GDP in the euro area will grow by 4.4% this year, following an estimated rebound of 5.1% in 2021 (see "Economic Research: Eurozone Economic Outlook 2022: A Look Inside The Recovery," published on Nov. 30, 2021).
In 2021, we revised the outlooks on Cyprus, Estonia, Greece, and Italy to positive. These actions were based on the supportive policy response to the pandemic led by the ECB and EU, which facilitated progress in implementing structural reforms in those four sovereigns. In 2022 and beyond, we expect to see robust growth supporting budgetary consolidation in those economies.
In Italy, an ambitious reform program, the Piano Nazionale di Ripresa e Resilienza (PNRR), aims to implement a comprehensive modernization of the Italian state and economy. A steering committee overseen by the prime minister, Mario Draghi, will oversee targeted reforms. Draghi heads up a grand coalition of nine parties, which control large majorities in both houses of parliament. Last year, Italy implemented reforms pertaining to the judicial system, market competition, and public administration. By 2026, the EU is set to disburse an amount equal to 11.8% of Italy's GDP, in loans and grants through the NGEU, to help it invest in digitization, transportation links, and energy infrastructure.
It is unclear who will replace outgoing president, Sergio Mattarella, when his term ends on Feb. 3, 2022. If the Italian parliament appoints Mr. Draghi, it will leave the prime minister's office empty, which increases the risk that the current unity government could dissolve, triggering early elections. This might disrupt the implementation of reforms under Italy's PNRR. Nevertheless, in our base-case scenario, we assume that the economy will expand by 4.7% this year, and that the Italian government will focus on implementing the remaining PNRR reforms. Our view is supported by the relatively uncontroversial parliamentary approval of the 2022 budget on Dec. 30, 2021.
The Greek economy has undergone significant structural reforms over the past decade and will benefit substantially from available facilities under the NGEU agreement. Greece is set to receive grants of €17.8 billion (about 10% of 2021 GDP) by 2026 and loans of €12.7 billion (7% of GDP). These will support the country's green transition, digitalization, and reforms to the labor market and public administration. If used efficiently, we consider these funds could fast-track structural improvements in the economy, contribute to stronger growth, and benefit balance-of-payment developments during 2021-2026.
Our outlook on Spain remains negative. Although almost 90% of the adult population is vaccinated in the country and the Spanish and European policy response to the pandemic should yield higher growth and a re-energized reform agenda, the implementation risks are considerable. The current government is constrained by its lack of a parliamentary majority, in our view. Efforts to narrow significantly the budget deficit in the medium term could falter if the governing coalition cannot address Spain's long-standing financing gap in its social security system. We do not think that the recent pension reform will be sufficient to fully contain the rising burden of pensions, given the magnitude of the demographic shift. Further increases in employment would help to ease the pressure. Spain's rate of unemployment, at 14.1%, is the highest in the euro area; Greek unemployment fell below Spain's in June of last year.
Although it is too early to assess the impact of the proposed labor market reform, we view as positive the reform's focus on reducing the use of temporary employment contracts. About a quarter of the workforce relies on such contracts. That said, we do not think that the proposal will transform the labor market in a way that would meaningfully lower Spain's rate of unemployment. The government has historically relied on the economic cycle for budgetary consolidation. Momentum on government debt reduction could therefore stall as soon as 2023, unless it implements additional deficit-reducing, structural budgetary measures. One positive factor for 2022 and beyond is the potential for a buoyant recovery in Spain's tourism sector, which accounts for just under 12% of GDP, and 13.5% of employment.
Chart 1 | European Developed Sovereigns--Outlook Distribution
Note: We revised the outlook on Andorra to positive and that on Guernsey to negative on Jan. 14, 2022. Source: S&P Global Ratings.
Today, 11 notches separate our 'BB' rating on Greece from our 'AAA' ratings on Denmark, Germany, Liechtenstein, Luxembourg, the Netherlands, Norway, Sweden, and Switzerland. The region's developed sovereigns have a wide array of institutional, external, budgetary, financial, and economic circumstances and prospects, which affect our ratings on them. The average European developed sovereign rating remains more than one notch lower than in 2007. Although external imbalances and private sector indebtedness have declined since the last economic and financial crisis, the pandemic exacerbated some of the vulnerabilities reflected in our sovereign ratings. In particular, sovereigns that had undertaken insufficient budgetary consolidation or already had high government debt at the start of the pandemic found themselves more fiscally constrained. It was therefore harder for them to address the economic effects of COVID-19 than it was for countries that had managed to lower their government debt in GDP terms.
Chart 2 | European Developed Sovereigns--Ratings Distribution
Source: S&P Global Ratings.
Chart 3 | European Developed Sovereigns--Ratings History
Government debt in Belgium, Cyprus, France, Greece, Italy, Portugal, and Spain is now above 100% of GDP. Over the past two years, European governments have been deploying comprehensive emergency measures to safeguard incomes and shield businesses from the pandemic's temporary, but severe, liquidity shock. This budgetary support resulted in very large budget deficits. This reopened the debate about the need to reform EU fiscal rules; we expect the debate to continue throughout 2022.
Offering budgetary support has allowed employment to recover quickly and smoothly. Employment now exceeds pre-crisis levels in several countries, including France, and net job creation is increasing strongly. This is in sharp contrast to the situation after the global financial crisis hit in 2008. The unemployment rate in the euro area was 7.2% in November 2021, compared with about 11.5% in November 2014.
Governments are committed to unwinding their large fiscal imbalances from 2022. Cutting the pandemic-related budgetary measures expenditure will be key to this--last year, general government spending was close to 7 percentage points of GDP above pre-pandemic levels in the euro area's six largest economies. We expect fiscal deficits to decline significantly this year across the developed European rated universe, as governments phase out the one-off COVID-19 measures and their finances benefit from favorable cyclical developments. That said, fiscal deficits in Italy, Slovenia, Spain, and the U.K. are still forecast to exceed 5% of GDP. The fiscal position in Liechtenstein, Andorra, and Luxembourg will be in surplus, or close to balance. Faster-than-expected fiscal consolidation and a reduction in government debt would boost sovereign ratings.
Given the economic recovery and rising inflation, the ECB is likely to tighten its stance this year, which will have economic and budgetary implications for the euro area. The relatively low unemployment rate opens the door to sustained, higher medium-term inflation. That said, we don't expect wage growth to outpace productivity in the monetary union in 2022; therefore, it will not exert significant inflationary pressure (see "Where Is The Wage Inflation? Not In Europe," published on Dec. 16, 2021). Overall, we expect inflation in the eurozone to gradually decelerate, and we do not expect the ECB to hike rates before 2024. Nevertheless, the ECB has been reducing its net purchases under its pandemic emergency purchase program and will halt them altogether in March 2022. We think it is unlikely to try and taper its asset purchase program before end-2023.
In contrast, the Bank of England raised interest rates in December 2021, for the first time since the onset of the pandemic. We expect that the Bank of England will raise the policy rate again in 2022, to keep inflation expectations well anchored (see "Latest European Economic Snapshots Show A Robust Expansion Ahead," published on Dec. 6, 2021). Inflationary pressures will persist for the next few months and be significantly exacerbated by the increase in regulatory caps on household energy bills in April; they should start fading later this year. Although inflation is set to run extraordinarily high initially and remain well above the 2% target for the rest of the year, it will only dampen, not derail the recovery momentum, which is supported by the gradual realization of pent-up demand, strong labor market, and a large buffer of extra household savings. We forecast the U.K. economic recovery will continue at a high, but decelerating pace, with GDP expanding by 4.6% in 2022, after a 6.9% rise last year.
Beyond the strong medium-term growth outlook, structural challenges, such as the aging population, pose significant downside risks to Europe's growth performance and long-term public finances. For example, Lithuania has a shrinking working-age population. This adverse demographic trend has contributed to the mismatch between wage growth and average productivity gains in recent years. In Spain, we estimate that the recurrent pension deficits explain about half of the country's structural budgetary deficit. In Italy, the population has declined by 0.4% per year on average since 2015.
The more highly indebted sovereigns are likely to depend on the EU's large funding facilities when addressing their financial challenges. The NGEU program is worth up to €750 billion (about 5.5% of EU GDP) for spending at the national level. The EU aims to disburse €672.5 billion--with grants making up almost half--under the Recovery and Resilience Facility (RRF). It has disbursed €46.4 billion in grants and €19.9 billion in loans so far. The RRF emphasizes productive investment into areas such as digitization and the green transition to tackle the challenges of climate change. It also aims to directly address potential divergence in future economic performance between member states. Fiscal spending in these areas is more likely to boost competitiveness, productivity, and therefore potential growth, especially given the investment gaps that have opened up in recent years compared with other major world economies. As a condition of receiving these funds, the EU governments have committed to structural reform implementation.
Strong opposition to reform proposals in many European countries could derail reform agendas, however. For example, some European economies faced labor or pension reform strikes in response to proposals. In our view, the risk of political fragmentation or policy complacency is not negligible, especially ahead of the elections in Europe this year in countries such as Italy, Portugal, France, Slovenia, Austria, and Latvia.
Table 1 | EMEA Developed Markets Sovereign Rating Score Snapshot
*Deterioration since June 2021. §Improvement since June 2021. Source: S&P Global Ratings.
Table 2 | EMEA Developed Markets Economic Outlook
