EUROPE: Fiscal positions are deteriorating fast

Analysis

During 2008, short-term economic prospects have worsened dramatically in Europe due to the combination of an economic slowdown leading to likely recession, sharp declines in stock market prices and an unprecedented crisis in financial markets. While compared with the start of the year, Germany's real GDP growth estimated for 2008 remains broadly unchanged (1.5-1.8% depending on the forecaster), this is not the case for the United Kingdom and France: they are now projected to grow by no more than 1.0%.

Growth and deficit. The marked deterioration in the economic and financial outlook will exert a negative effect on government balances in the three largest EU economies:

• Current year .The impact on budgetary outcomes in 2008 should be slight. As in 2007, Germany may achieve a budget close to balance, while the UK and French deficits will probably be around 0.25 percentage points higher than projected at the start of this year by the European Commission. In its spring economic forecast, the Commission estimated that the budget deficit in France would remain broadly unchanged from 2007 at 2.8%, while that of the United Kingdom would worsen from less than 3.0% last year to 3.3% this year. Current data suggest that the 2008 deficits may be around 3.0% in France and 3.5% in the United Kingdom.
• Next year. Prospects are far bleaker for 2009, mainly due to a dramatic downward revision in economic growth forecasts. Current projections generally show economic growth stalling at 0-0.5% in all three countries. While marginally positive growth represents the consensus, some worst-case scenarios project annual declines of close to 1% for 2009. A conservative estimate is that, because of lower growth, deficit-to-GDP ratios next year could be at least 1 to 2 percentage points higher than envisaged by governments a year ago.

Varying vulnerability. Budgetary prospects for the three countries vary widely:

• Germany. As part of its draft 2009 budget, Berlin slashed growth projections from 1.2% to 0.2%. According to Germany's Stability and Growth Pact (SGP) presented in 2007, a reduction of 1 percentage point in growth would translate into a 1 percentage point worsening in the general government balance. Given that the budget was projected last year to be balanced in 2009, the deficit could be between 0% and 1% on the assumption that the economy stagnates next year. The IMF projects a deficit of 0.8%. The deficit is therefore not a source of concern for Germany. Allowing for the impact of the economic cycle, the budget is expected to remain close to balance, and even if the country goes into recession, the general government deficit is set to remain moderate.
• France. France will probably breach the 3% EU deficit threshold in 2009. The government still projects a deficit of 2.7%, revised 1 percentage point upwards from last year due to lower expected growth in 2009. Yet this is probably over optimistic since it is based on an equally optimistic projection of 1% growth (see FRANCE: Economic crisis shapes cautious budget - October 2, 2008). Should the economy stagnate next year, the deficit could exceed 3.5%. The IMF projects a deficit of close to 3.9%. Nevertheless, even at that level, the general government balance, corrected for the impact of the cycle, would still improve on 2007 and 2008.
• United Kingdom. The outlook for the United Kingdom is much bleaker. The 2008-09 budget forecast put growth at 2.0% next year. Under this scenario the (full-year equivalent) deficit would be around 3%. Yet this is extremely optimistic, especially compared with the Commission's spring forecast, which projected higher deficits in 2008 and 2009 than envisaged by London. In July, the Commission considered that the UK public deficit was excessive and asked the government to cut it below 3% by the end of the 2009-10 budgetary exercise. This objective is unlikely to be met. With a deficit of around or slightly above 3.5% in 2008, there is a risk that it could rise to around 5% in 2009, due to lower economic growth, lower tax receipts from financial institutions and the bailout of banks.

Crisis costs. The EU's SGP allows countries to run deficits above 3% under exceptionally unfavourable economic circumstances -- which will probably apply next year. Accordingly, initiating excessive deficit procedures will become less of a Commission priority, allowing for more budgetary leeway. Interpretations of the SGP will probably even take into account circumstances deemed to be outside of national governments' control. More problematic will be the longer-term consequences of increases in government debt linked to the bank bailouts (see INTERNATIONAL: Bank rescue plans are national in focus - October 20, 2008):

• Revenue impact. Due to the importance of the financial sector and to differences in the tax structure, a reduction in tax receipts from financial institutions will have the largest impact on the UK budget. In 2007, taxes on the income or profits of financial institutions amounted to 1.0% of GDP in the United Kingdom, compared with 0.6% in France and only 0.2% in Germany.
• Safe guarantees. European governments have pledged to rescue banks and to guarantee the amount of liquidities available to financial institutions. Most such interventions are designed to ensure the smooth running of the interbank market, which banks use for short-term refinancing operations. Guarantees on very short-term loans between banks are virtual disbursements (as loans are repaid daily or within a very short period of time) and should therefore have no effect on public finances. They aim to restore confidence and, if successful, financial institutions may not even use the full amount of these guarantees.
• Risky recapitalisation. By contrast, the second type of government measures -- the recapitalisation of banks -- will increase general government debt. Governments have earmarked funds, not only to take stakes in troubled private banks to avoid insolvency, but also to reinforce the equity capital of several domestic financial institutions through buyouts of their assets. This amounts to to a full or partial privatisation of the banking sector by the German, UK and French governments.
• Significant stakes. Germany has pledged 480 billion euros (630 billion dollars), including 80 billion euros for the recapitalisation of banks, the latter amounting to over 3% of national GDP. The UK government has pledged up to 635 billion euros, with 63 billion (or 3% of GDP) earmarked for possible recapitalisation. France has indicated that it would commit up to 360 billion euros, including up to 40 billion (or 2% of GDP) for recapitalisation. If actually used, these equity stakes will increase government debt with long-term implications for public deficits through higher interest payments on the new government bonds that will have to be issued.