All eyes on fiscal in the Eurozone

The Eurozone is heading into a challenging 2024 with both fiscal and monetary policy turning restrictive as real rates turn more limiting and governments tighten their belts. While analysts expect to the ECB to start cutting rates in mid-2024, the real policy rate, approximated as the policy rate minus inflation, will rise amid ongoing disinflation. Thus, Allianz Trade analysts expect the final real rate to be reached in 2024 as disinflation continues. Therefore, monetary policy will have an extremely restrictive impact going forward. At the same time, after the fiscal stimulus granted in response to the Covid-19 pandemic and the war in Ukraine, the countries of the euro area are now moving towards fiscal consolidation by adopting restrictive budget measures. Analysts forecast a fall in the euro area fiscal stimulus of -0.8% in 2024, slightly more than the -0.5% decline in 2023.

Fiscal consolidation takes time and the risks of slippage should not be underestimated. Thus, the governments of the big four countries in the euro area (Germany, France, Spain and Italy) have already drawn different measures regarding fiscal consolidation.

Germany is pursuing fiscal consolidation by implementing a strict fiscal course in the coming years. In addition, due to current cyclical and structural trends, demand for fiscal stimulus is high and the government has announced an economic package worth €32bn of corporate tax cuts – spread over four years and likely to be financed through cuts budget, rather than by increasing spending. In order to comply with the debt limit anchored in the basic law (“Grundgesetz”), net borrowing is only possible to a very limited extent. At the same time, the budget deficit is expected to drop from 2.6% of GDP in 2022 to around 2.25% in 2023, 1.25% in 2024 and even 1% in 2025, mainly due to a reduction in spending on pandemic and energy-crisis support.

Meanwhile, France is kickstarting a modest fiscal consolidation amid a challenging macroeconomic backdrop. The Ministry of Finance is floating around EUR16bn of savings (around 0.6% of GDP) to target a fiscal deficit of -4.4% of GDP after -4.9% in 2023. France forecasts real GDP growth to +1.4% in 2024, -0.2 pp downgrade compared to the previous period. However, the government’s real GDP growth still looks optimistic relative to Allianz Trade analysts’ forecasts (+0.7%). Most of the savings the government will rely on will come from the phasing out of the tariff shield and other energy subsidies, which should result in around €10 billion less spending than in 2023. In terms of revenue, the government plans to increase or create new taxes to finance the green transition, such as a tax on flights departing from France. Housing policy is also expected to be tightened: for example, the ‘Pinel’ tax credit (subsidy for investment in new rental housing) may be removed, while the scope of the ‘zero rate’ home loan subsidy of interest” could be reduced.

In Italy, tax credit expenses have added clouds to the fiscal outlook. The generous tax credit scheme generated higher spending than originally expected, also producing downward revisions to fiscal deficits in 2021-2022. In light of the likely reintroduction of the Stability and Growth Pact in 2024, the government will have to cover unplanned costs as well as honor election commitments (tax cuts). The latest official estimates published in June predict a public deficit of 4.5% in 2023 and 3.7% next year (compared to Allianz Trade analysts’ forecast of -5% and -3.8% respectively).

Spain has a good fiscal consolidation plan, but its effectiveness remains questionable. Regardless of the outcome of the general election in July 2023, the need to address public finances will be inevitable, limiting any attempt to pursue an expansionary fiscal policy. The stability program for 2023-2026 presented by the government proposes a gradual reduction of the budget deficit, driven by the recovery of the Spanish economy from 4.8% of GDP in 2022 to 3.9% in 2023 and 2.5% in 2026. The IMF estimates that this reform could add 3.2-3.5% to pension spending by 2050, on top of the 1pp increase caused by the aging population. Allianz Trade analysts expect the budget deficit to average 4% of GDP in 2023-2026 and gross debt to improve from 112% of GDP in 2022 to 108% of GDP in 2026.

Romania showed resilience, thanks to the increase in the minimum wage and pensions, while investments remained in the light thanks to the flows of EU funds from the Next Generation EU Fund. In contrast, in Poland and Hungary, tensions with the European Union will prevent payments of EU funds in the short term, limiting sources of investment. Analysts forecast GDP growth in Central and Eastern Europe (excluding Turkey and CIS+) of +0.7% in 2023, +2.8% in 2024 and +3.2% in 2025. For Romania, Allianz analysts Trade forecasts GDP growth of +2.8% in 2023, +3.2% in 2024 and +3.6% in 2025. Public finances are still strained due to the measures adopted to deal with the pandemic, while that financing costs have increased. However, in EU Member States, absorption of NGEU funds will provide fiscal support. With the exception of Romania, current account imbalances from 2022, caused by high energy prices, are on track to be restored. Overall, the risk of a balance of payments crisis remains significant in Romania. However, the risk of an energy crisis in the winter of 2023/2024 has decreased significantly, thanks to reduced dependence on Russian gas and the EU’s large natural gas stocks.

Although it remains slightly more stable in Romania, core inflation is on a downward trend, mostly converging towards core figures. However, core inflation is expected to remain above central bank targets until the end of 2024, weighing on consumer spending and investment. On average, inflation should reach 12% in Central and Eastern Europe in 2023 and decline to 6.2% in 2024 and 3.9% in 2025, respectively, remaining above pre-pandemic levels.

By the beginning of the year, the Czech Republic, Hungary and Romania are expected to gradually reduce monetary policy rates and interest rates to stabilize at 3-4% over the medium term, well above pre-pandemic levels and still below inflation rates, which means that CEE countries will continue to have negative real interest rates for some time. Regarding the nominal increase in wages, they registered an upward trend in Hungary and Romania in 2023, while in Poland and the Czech Republic, the trend was a downward one. In Romania, the salary increase was approximately +14% in the middle of 2023, and for 2024 it is estimated at a 10% increase. This year, Hungary saw wage growth of +16%, while Poland and the Czech Republic saw increases of 11% and 7.7% respectively.

“In Romania, fiscal consolidation measures seem more drastic than in the European Union countries mentioned above. We are still in the excessive fiscal deficit procedure, (and for the end of the year it will most likely remain in the area of 6%), and the interest rates at which we borrow from external institutions to cover the deficit are above the average of the countries in the Union. Although the latest measures to eliminate some tax breaks and introduce turnover taxation for larger companies with low profitability should bring a narrowing of the tax gap, the effect will be short-lived. Eliminating tax evasion as a viable response from the start, the adaptation of companies to the new restrictive conditions would take place on several levels. If in the case of the elimination of some tax facilities, the obvious effect would be to increase prices on the distribution chain, in the case of taxing the turnover, the effects will be more extensive.”, points out Mihai Chipirliu, CFA – Risk Director, Allianz Trade.

In addition to the optimization of group structures (mergers/absorptions) for the elimination of intra-company transactions and, consequently, the sublimation of potential taxable turnovers, analysts estimate that we will witness a period with measures to make internal flows profitable. The elimination or restructuring of positions with lower added value, the closure of work units that were operating in the zero profit area or with positive marginal profit are just a few measures that the companies targeted by the new taxes could adopt. Also, certain products or services marketed in large volumes, but with very small profit margins (including those with a State-regulated price) – although essential for consumers – could become unavailable or marketed in a reduced volume. Last but not least, the taxation of banks’ turnover would induce an increase in the cost of loans, given that the interest expense has already become a disruptive factor in pre-tax profit since the second part of last year. The effect of postponing or canceling some investments will also be important – rare being the cases where an investment brings a substantial profit from the first year – but also fueling the unpredictability in terms of fiscal policy at a time when emerging countries are perceived as a risk country raised.

European sanctions against Russia

Despite efforts to enforce sanctions, EU goods under export ban still seem to find their way to Russia via third countries. Even though the EU issued comprehensive sanctions against Russia following its military invasion of Ukraine in February 2022, the Russian economy has not contracted as much as forecasts in 2022 predicted. One reason might be that the West has shielded energy from sanctions out of fear that a full embargo would cause oil prices to spike and drive the global economy into a recession. Another reason is that sanctioned goods continue to find their way into Russia. Looking at aggregate exports from the EU to Russia, we find a drop of -52% comparing H1 2019 to H1 2023. But trade data indicate that EU-sanctioned goods might be exported to a considerable extent from the EU to third countries and from there to Russia. These are mostly countries that have not sanctioned Russia, such as Turkey, or are historically, politically and economically close, such as countries in Central Asia. Particularly for those that form the Eurasian Customs Union together with Russia, there are minimal checks once goods enter one of the member states.

EU exports to Turkey, for example, increased on average by +58.1% between H1 2019 and H1 2023. The numbers are even more striking for Central Asian economies: EU export values to Kazakhstan are up +100%, to Kyrgyzstan by a striking +800%, to Tajikistan by +151%, to Turkmenistan by +78.5% and to Uzbekistan by +66.6% comparing H1 2019 and H1 2023. This alone is not yet evidence, but Turkey and the Central Asian economies also trade more with Russia. Turkish exports to Russia stood at USD0.4bn in 2019 and increased to USD0.9bn in 2022. Similarly, in Central Asia, exports to Russia increased by +53.8% from USD0.8bn in 2019 to USD1.2bn in 2022. The notable shifts in trade patterns do not necessarily prove sanction evasion but could also be genuine trade diversion. Looking at patterns in trade exposure between Russia and individual countries gives an indication of the circumvention of shipments. Most western countries – with the exception of Croatia, Latvia, Slovenia and Cyprus – have sharply cut their direct exports to Russia, while others such as China, India or Turkey have increased it. But exports to Russia via Central Asia or Turkey have gone up everywhere – except for Cyprus.

European sanctions against Russia

Despite efforts to enforce sanctions, EU goods under export ban still seem to find their way to Russia via third countries. Even though the EU issued comprehensive sanctions against Russia following its military invasion of Ukraine in February 2022, the Russian economy has not contracted as much as forecasts in 2022 predicted. One reason might be that the West has shielded energy from sanctions out of fear that a full embargo would cause oil prices to spike and drive the global economy into a recession. Another reason is that sanctioned goods continue to find their way into Russia. Looking at aggregate exports from the EU to Russia, we find a drop of -52% comparing H1 2019 to H1 2023. But trade data indicate that EU-sanctioned goods might be exported to a considerable extent from the EU to third countries and from there to Russia. These are mostly countries that have not sanctioned Russia, such as Turkey, or are historically, politically and economically close, such as countries in Central Asia. Particularly for those that form the Eurasian Customs Union together with Russia, there are minimal checks once goods enter one of the member states.

Real estate boom and bust in Italy

In Italy, the construction sector saw an impressive recovery in 2021-2022, thanks to the tax credit scheme for house renovation. Thus, construction investments increased by +27.7% and +11.5% in real terms in 2021 and 2022, respectively. Given the much more limited growth in new construction, which decreased in 2022, building permits for new homes registered an increase of only +0.1%. Thus, Allianz Trade analysts predict that 40% of the growth in 2021 and 2022 was due to incentives for renovations and energy efficiency. The increase in construction investment coincided with construction sector costs escalating by +6% in 2021 and around +12% in 2022, which further increased the cost of tax credits.

Paradoxically, the gradual roll-out of the tax scheme (already revised in February 2023) is expected to gradually align future budgets. Thus, a decrease in the dynamics of the construction sector is expected. Monthly data confirms that activity has started to slow, suggesting a reversal of the visible improvements seen in 2021 and 2022. Industrial production fell by -2.6% per month on average in the first quarter of this year (compared to an average increase of + 12.8% in 2022), while construction employment intentions have recently deteriorated. In addition, the latest data on business insolvency for the sector corroborates the halting of the downward trend initiated in 2021.

The easing of fiscal measures, together with the rapid impact of monetary policy tightening on credit supply and demand, has created a dangerous mix for Italy’s housing market. However, the tax credit had minimal impact on prices. Demand for credit fell at a faster pace than in 2012, while mortgage rates reached a record high (Figure 6). While the introduction of the tax credit was expected to increase the prices of existing homes, the effect was imperceptible compared to the problems facing the sector. The price of houses already built has increased less than the CPI or construction costs, leading to lower real prices. Although Italy is emerging from a long housing market crisis, analysts expect new home prices to fall by 3-5% by the end of 2024.

Wage indexation in Belgium

Belgium is one of the few countries in the Eurozone that has an automatic wage indexation system for most incomes. Private and public sector wages, pensions and all social benefits are periodically adjusted to the cost of living as measured by the Health Index. When energy prices rose in 2022, Belgium saw a greater shift from wholesale to retail markets due to lower taxation of energy products compared to similar markets in the euro area. As a result, CPI peaked at 12.3% in October 2022. However, the normalization of energy prices helped CPI fall to 4.1% in August 2023, while underlying pressures remain strong but saw a the third consecutive decrease (to 7.7%). This allowed the government to postpone some indexation tranches.

Belgian firms and the government bear the costs of indexed wages. In 2021-2022, the government made deals with part of the private sector (one-off tax-free bonus between €500 and €750 instead of automatic increases) to keep companies competitive in the face of rising wages. However, corporate profits fell in the third quarter of 2022. However, the labor market remains strong and shows the first signs of recovery. The number of employees, as well as that of the unemployed, decreased, the unemployment rate reaching a rather high 5.5%. Thus, Belgium’s vacancy rate is still the second highest in Europe, although it fell slightly from 4.68% to 4.63% in the second quarter of this year. In addition, according to the European Commission’s latest survey, employment intentions are falling while savings rates are rising, providing support for a slowdown in wage growth. However, if energy prices reverse significantly, more persistent than expected inflation could reinforce concerns about unsustainable wage setting.

Signs of optimism appeared in 2023 and were generally more modest than the growth of 2004-2006. 2022 has brought challenges to financial markets, leaving few safe tax havens. But the strength of the USD contributed to the further underperformance of emerging market fixed income instruments. The growth cycle coincided with a war with global repercussions that fueled the road to safety. In addition, serious doubts have arisen about China’s economic and geopolitical trajectory. Many emerging markets face limited access to financial markets. This is a sign that market participants are not ignoring the risks inherent in the current situation, but benchmark USD spreads are expected to widen by 30-40bp by the end of the year.