Belgium: Reducing debt remains the main challenge

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This post is a guest contribution by Olivier Bizimana of  Morgan Stanley.

Budget consolidation in Belgium is underway. The draft federal budget for 2011 passed the Belgian parliament last week. The caretaker government aims to cut the overall fiscal deficit to 3.6% of GDP in 2011 from 4.1% of GDP in 2010. In addition, Belgium’s Stability Program, published in April, aims to reduce the fiscal deficit to 0.8% of GDP, which should bring the debt-to-GDP ratio down to 92.2% in 2014. Our near-term view on Belgium has slightly improved, with the preparation of a comprehensive consolidation strategy by the caretaker government. However, the ongoing political impasse keeps us cautious, as Belgium remains vulnerable to a shift in market confidence, given its sizeable public debt and the uncertain market environment.

The key challenge for Belgium is to reach more sustainable debt levels in the medium term. Given the rising costs related to an aging population and high interest payments, additional structural efforts will likely be required to reduce public debt as a share of GDP over the longer term. We believe that for a country like Belgium, which has a high level of public debt, the priority is a relatively rapid reduction in debt, given its sensitivity to changes in interest rates and growth.

Market Concerns Have Eased for Now

Almost a year after the general elections, the political impasse in Belgium persists. The political parties have been unable to find sufficient common ground to start talks to form a coalition government. After several rounds of consultation, the King has appointed Mr. Elio Di Rupo, leader of the French-speaking Socialist Party, as ‘formateur’. He is in charge of forming a new coalition government and will be the Prime Minister if he succeeds. The appointment of Mr. Elio Di Rupo as a ‘formateur’ may not necessarily accelerate the formation of a coalition government, as there is as yet no agreement among the political parties on the main source of the political deadlock, state reform. The appointment of a ‘formateur’ is nevertheless an encouraging step towards the formation of a government. At the time of writing, whether Mr. Di Rupo will succeed where others have failed is unclear. Should the deadlock persist, new elections cannot be ruled out.

Meanwhile, the sovereign risk premium, measured either by the government bond spread versus the OIS over the same maturity or the sovereign CDS spreads, has shrunk since February. The reduction in market concern on Belgian sovereign debt is presumably due to the various initiatives taken by the caretaker government to consolidate public finances. However, general market concerns persist and volatility is still high – a reflection, in our view, of global uncertainty on the outcome of the sovereign debt crisis in the euro area periphery. The ‘hierarchy’ of sovereign risk premiums, ranking countries from the lowest perceived risk to the highest, is unchanged, though the spreads have widened.

Could Belgium Be Affected Again by Market Sovereign Debt Concerns?

In our view, the risk of a spillover of the sovereign debt crisis to Belgium, and other core countries in general, remains. Despite a comprehensive fiscal consolidation plan, the ongoing political impasse could weigh on investor confidence. Given the high uncertainty on the outcome of the crisis in the euro area periphery – in particular whether or not those countries perceived as most fragile (Greece, Ireland and Portugal) may have to restructure their public debts – markets are likely to remain in ‘contagion mode’, sensitive to the next ‘weakest link’. While we believe that the overall macroeconomic situation in Belgium is solid (strong external position, high household savings rate), as long as the political uncertainty persists, the trigger for renewed market tensions should remain.

Could Belgium’s Rating Be Downgraded?

The likelihood of lowering Belgium’s rating, currently at ‘AA+/A-1+’, has considerably decreased. In December 2010, S&P had revised its outlook on Belgium’s rating to negative from stable and warned that if the country failed to form a government soon, its sovereign rating could be lowered by one notch, potentially within six months by June 2011. The risk that S&P might downgrade Belgium’s rating in June has diminished in the near term, notably because the caretaker government has been able to prepare the 2011 budget and a Stability Program. However, the risk of a rating downgrade remains to the extent that a reduction in public debt over the longer term requires structural reforms that only a stable government would be able to implement. According to S&P, even in the event that a government is formed, if it is ineffective in putting public finances in order, the agency may consider lowering Belgium’s rating within two years.

Budget Consolidation on Track

The 2011 federal budget was passed by the Belgian parliament in mid-May. The caretaker government projects an overall fiscal deficit of about 3.6% of GDP in 2011, below the deficit target in Belgium’s previous Stability Program submitted to the EU Commission in January 2010 (4.1%). The debt-to-GDP ratio should be stabilized at around 97.5% in 2011. The fiscal effort of the federal government and social security represents around €2.3 billion in 2011, including €1 billion from tax and non-fiscal revenues. These higher revenues are in large part the effect of the cyclical recovery, higher dividends in the banking sector and state enterprises and other reforms (removal of the “banking secrecy” and measures on “amicable settlement”). The remainder consists of containment in primary spending and social security expenditure (notably healthcare). Regional governments are also planning to contain significantly primary spending.

Overall, according to European Commission estimates, Belgium’s structural balance should remain almost unchanged in 2011, around -2.9% of GDP, but after a strong increase in 2010 (+1.4pp of GDP to -2.8%). In fact, the budgetary consolidation in Belgium started last year. The overall fiscal deficit decreased by 1.8pp of GDP to 4.1% in 2010. The decline in the public deficit in 2010 was due to both a reduction in spending and an improvement in revenues. Spending fell, reflecting cost-containment measures, and interest charges fell too, courtesy of the sharp fall in interest rates with the easing of the financial crisis. Moreover, revenues increased, thanks to strong economic growth, which boosted tax revenues.

Planned fiscal consolidation over the medium term. The caretaker government has also been able to prepare the Stability Program for 2011-2014 (SP), based on the recommendations of the High Council of Finance. This new medium-term fiscal consolidation plan aims to reduce the overall fiscal deficit to 2.8% in 2012, and to undertake fiscal tightening of about 1% of GDP per year thereafter, which should bring the deficit to 0.8% of GDP in 2014. Under this fiscal consolidation assumption, the public debt should decline from 96.5% of GDP in 2012 to 92.2% in 2014.

The Challenge of Cutting Public Debt

The key challenge for Belgium is to stabilize its sizeable public debt in the short term and reduce it over the medium term. If fully implemented, the current fiscal consolidation plan should result in sustainable public finances. Nevertheless, considerable uncertainty remains.

1. The political mandate. As the fiscal consolidation plan has been prepared by a caretaker government, can we reasonably expect that it would be fully implemented by the next government? The medium-term fiscal consolidation plan is based on the recommendations of the High Council of Finance, which is an independent body that advises and gives recommendations on budgetary policy. Hence, we believe that the next government is likely to follow its recommendations as well.

Moreover, looking back over recent decades, Belgium’s track record gives us confidence that the fiscal consolidation plan will be effectively implemented. The debt-to-GDP ratio declined sharply, by more that 50pp, from its peak of 135% of GDP in 1993 to 84.2% in 2007. Compared to its peers, prior to the financial crisis, Belgium had delivered one of the largest declines in debt-to-GDP ratio. Even after the crisis, this ratio increased less in Belgium. What’s more, the consolidation in Belgian public finances over this period was mostly structural. During the financial crisis, the cyclically adjusted primary balance fell slightly, but it was again in surplus in 2010. It is among the highest in the EMU – it remains negative in almost all other euro area countries.

2. The fiscal federalism framework. Belgium is a federal state, in which regional governments have constitutional autonomy. The sustainability of public finances over the longer term therefore requires optimal sharing of the burden of fiscal tightening between different levels of government.

In the absence of a new coalition government – essentially because of disagreement on the degree and form of fiscal devolution – the issue of burden-sharing between the federal government (and social security) and the regional governments has not been addressed in the Stability Program 2011-2014. The allocation effort between the federal government and regional authorities in the Stability Program is based on recommendations from the High Council of Finance. It assumes 65% of the burden of fiscal tightening falls on the federal government (35% for regional authorities), which corresponds to the respective weight of the federal government in primary spending in the previous Stability Program.

However, this allocation is not optimal, as under the current Stability Program the trajectories of fiscal balances at the federal government and regional levels steadily diverge over the medium term. The federal budget remains in deficit, while the regional government surpluses continue to rise. This divergence reflects the fact that almost all the costs of an aging population and public debt service fall on the federal government.

The problem is that these costs are likely to remain elevated, and even rise, in the medium and longer term. As age-related costs are likely to keep growing, pressure on the federal government balance (and social security) will continuously increase too. For instance, the Belgian Federal Bureau of Planning projects age-related government expenditure to climb by 6.6pp to 32% of GDP by 2060.

In addition, even if the public debt does decline in the medium term, it will remain large, and so will debt service. The increase in these costs underlines the need for reform of the framework of fiscal federalism, notably safeguarding the revenues of the federal government to allow it to meet debt service and social security costs. In particular, the High Council of Finance suggests structural reforms of the current Financing Law, which would: 1) determine additional revenues at each government level that are consistent with its new responsibilities; and 2) reduce the pace of growth of current transfers from the federal government to regional authorities. This should help the consolidation effort and ensure fiscal sustainability at each level of government in the long term.

3. Our forecasts. Our projections assume that the measures planned by the Stability Program, especially on the spending side, will be effectively implemented. We forecast a significant improvement in public finances over the medium term. Factoring in the main measures of the 2011 budget, we forecast the public deficit to decrease gradually this year. On our estimates, the overall public balance should increase by 0.2pp to -3.9% of GDP in 2011 and more markedly in 2012, to -3% of GDP.

4. Debt sustainability. Assuming plausible growth and interest rate assumptions, along with a continued fiscal effort under the Stability Program, the debt-to-GDP ratio should continue to decline over the long term, to about 65% in 2020. Based on our forecasts, the debt-to-GDP ratio keeps falling too, to approximately 77% in 2020. Under unchanged policy (2010 primary balance remaining stable) the debt-to-GDP ratio rises to 108% in 2020. Overall, these simulations confirm not only that the fiscal consolidation plan has to be fully implemented in the medium term, but also that further structural efforts are needed to bring down public debt as a share of GDP.

Still Reliant on Market Confidence

Even though we believe that the issue of sustainability of Belgian public finances has been addressed – at least for the medium term – Belgium remains reliant on sustained market confidence. Given the sizeable level of public debt, renewed market tensions may cause a spike in interest rates, and hence a sharp increase in debt-service payments. In addition, the reliance on foreign investors to finance the public debt and the large funding needs this year and in 2012 mean that Belgium must maintain market confidence.

Exposure to interest rate risk: With a very high public debt, Belgium is exposed to interest rate risk. Interest charges were about 3.5% of GDP in 2010. On our forecasts, even though we expect a continued reduction in public deficit and debt, the latter should remain sizeable. Debt-service costs will remain high as well (about 3.5% of GDP in 2011 and 2012 – the implicit interest rate is about 3.6%). Given the already high level of public debt, a spike in interest rates would quickly raise debt-service costs, and hence the debt-to-GDP ratio. With interest rates rising from 4.0% to 5.0%, assuming a primary deficit of 1% of GDP and a debt-to-GDP ratio of 97%, the latter would increase by 2pp of GDP.

Exposure to refinancing risk: The total financing needs (maturing debt and budget deficit) for Belgium were 22.4% of GDP in 2010. Belgium’s financing needs are likely to remain relatively stable as a share of GDP compared to 2010, though still sizeable at around 22.6% of GDP and among the largest in the euro area. While the amount of maturing debt should increase, the budget deficit is expected to decrease.

Exposure to funding risk: The share of nonresident holdings of government debt, for both short and long-term maturities, is relatively elevated. For instance, according to the Belgian Debt agency, at the end of September 2010, foreign investors held around 55% of the medium and long-term government bonds (Linear bonds, OLOs), of which almost half are from outside the euro area (24%). The share of Treasury certificates held by non-residents was much higher, around 90.2%, and mostly from outside the euro area (75%).

Rating downgrade risk remains: According to S&P, if unaddressed, the increase in age-related spending would imply downward pressure on Belgium’s current ‘AA+’ long-term foreign currency sovereign credit rating. In particular, factoring in the impact of population ageing on public finances by 2020, S&P expects a weakening of Belgium’s fiscal indicators to levels more in line with those of sovereigns that are currently rated in the ‘A’ categories. S&P expects a further downgrade to the ‘BBB’ categories by 2025 and to speculative grade (‘BB+’ and lower) by 2040. A downgrade of the sovereign rating would cause an increase in the cost of financing of the overall economy.

Source: Olivier Bizimana, Morgan Stanley, May 24,  2011.

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