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Eurozone nations' lower spending flexibility limits policy options as growth slows

Publication Date: 25 Oct 2018 - By ReachX Team By ReachX T.

Environmental, Social & Governance Macro FX & Rates FX Fixed Income/Credit EU


Rising mandatory spending and slowing economic growth have left a number of eurozone governments with less budget flexibility than before the financial crisis a decade ago, according to a new report. 

In a note to clients, rating agency Moody's said for governments with already high debt burdens, a combination of increased social care spending and a slowdown in revenue from cyclical direct taxes will reduce their policy options to respond to adverse conditions in the future.

Spain (Rated Baa1 stable by Moody’s), Greece (B3 positive), Ireland (A2 stable) and Cyprus (Ba2 stable) have seen their mandatory or "sticky" spending rise the most. Only Malta (A3 positive), Germany (Aaa stable) and Luxembourg (Aaa stable) have seen an improvement since 2008.

“An increase in mandatory spending on interest, wages, subsidies and social benefits since 2008 means a number of government budgets are more rigid than before the financial crisis," said Evan Wohlmann, Vice President and Senior Analyst at Moody’s.

"Higher social spending and a slowdown in tax revenue will constrain the policy options available to euro area governments and present credit risks to those with already elevated debt burdens."

The report notes that a government's ability to respond to difficult conditions and prevent - or limit - the deterioration of its credit profile is partly driven by its spending flexibility. In Moody's view, spending flexibility is heavily determined by the structure of government spending because some spending areas are more difficult to adjust than others.

Although nominal budget deficits have fallen, the aggregate share of mandatory spending in euro area budgets has actually risen to 76.3% of total spending from 74.5% in 2008. This increase mainly reflects a rise in spending on social security and assistance, pensions, education and healthcare to 23% of GDP in 2017 from 21% in 2008.

Eurozone governments' increased reliance on more cyclical direct tax revenue like income and corporate taxes since 2009 is likely to intensify budget challenges as the economic cycle turns.

Moody's expects eurozone growth to slow to 1.5% in 2021, while the structural fiscal position is likely to deteriorate in the coming years.

If revenues underperform, some governments may be faced with the challenging task of trying to find savings from a relatively rigid expenditure structure. As "sticky" spending is slow to adjust in a downturn and is politically sensitive, eurozone budgets have by and large become more rigid.

Belgium (Aa3 stable), Spain and Italy (Baa3 stable) will hold the highest shares of mandatory spending by 2021. Those sovereigns whose spending flexibility worsened the most between 2008 and 2017 will see broad improvements, but not sufficiently to offset the deterioration witnessed since 2008.


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