The war in Ukraine could result in higher borrowing for Europe’s sovereigns but the funding apparatus is more sophisticated than in previous crises. By David Rothnie.
Just when things appeared to be returning to ‘normal’ for Europe’s sovereign borrowers following Covid, with tightening monetary policy and the rolling back of the pandemic emergency purchase programme, the conflict in Ukraine has thrown an unexpected event into the mix that could increase borrowing requirements. But bankers say there are sufficient mechanisms in place to cushion the impact of the conflict, which is not the biggest fear driving bond spreads.
Instead, Russia’s invasion of Ukraine has exacerbated the challenges facing European sovereign borrowers as they formulate a response to geopolitical change, supply chain problems, inflation and an energy crisis. The nature of that response will be political as much as economic.
These challenges were already well established before the invasion. The shift by central banks to raise rates to tackle inflation is underway, while countries have been grappling with supply chain delays and soaring energy prices for several months. Borrowers and investors are already trying to adjust to a world that is unfamiliar to many traders. Central banks are trying to raise rates while avoiding tipping economies into recession, acknowledging that painful solutions are needed as low rates and unprecedented stimulus come to an end.
But there is no question that war, which is by its nature inflationary, has brought all these factors into relief and poses unique challenges to a number of European countries such as Germany, Austria, Greece and Italy, which are most reliant on Russian oil and gas.
Some have responded by announcing bigger funding programmes. For example, Italy has said it will increase funding by €16bn, while, in Germany, Chancellor Olaf Scholz announced a special €100bn to pay for a an increase in military spending and meet the Nato alliance’s military spending goal of 2% of economic output per year. Overall, Germany is looking to increase borrowing by €40bn as it figures out how to reduce its dependence on Russian oil and gas, having wound down its coal and nuclear energy capacity.
Big numbers
Some big numbers have been bandied out – Mario Draghi, Italy’s president, said the EU will need to spend €2trn for relief efforts, the energy crisis and green transition as the bloc accelerates plans to boost its sources of renewable energy.
Bankers say it is too early to see how increased spending as a result of the war will impact sovereign borrowing needs, especially as the problems posed by the conflict are in some cases indivisible from challenges that governments have already begun to tackle with fiscal policy.
“We could expect higher issuance on the back of the war and on the back of supply chain disruption in particular due to the energy crisis, but nothing that the bond market is particularly concerned about at the moment," said Asif Sherani, head of debt capital markets syndicate for Europe, the Middle East and Africa at HSBC.
"Depending on the country and on the response, you could see an incremental increase, but nothing that will lead to undue pressure on bond issuance or yields. Mainly, as the increase will be spread across years of potential issuance.”
While there are some big numbers, the actual impact on bond issuance is likely to be much smaller – and also at this stage hard to quantify. For example, bankers say of Italy’s €16bn increase in funding, €10bn will be accounted for by additional reserves. Meanwhile, Germany’s €100bn budget increase is a multi-year programme and includes funding from a variety of sources.
A report from S&P predicted that 30 developed sovereigns in EMEA will borrow about US$1.6trn in gross long-term paper this year, down by US$263bn compared with 2021. But that was before the conflict in Ukraine.
“We acknowledge upside risks to the total figure, as our projections do not include the higher sovereign borrowing we expect to finance energy subsidies and increased spending on defence and refugee assistance in connection with the conflict in Ukraine,” the report said. This is separate from the cost-of-living crisis that is expected to worsen over the year as energy prices continue to climb, coupled with the spectre of recession in some economies.
Better together?
The question is by how much and whether any additional financing will come from a national, EU or agency level – and whether the response to Europe’s biggest war since 1945 will result in a permanent joint bond issuance programme from eurozone governments.
S&P estimates that roughly half of EU members’ additional funding requirements this year will come from soon-to-be launched EU instruments along the lines of the European Commission’s Support to mitigate unemployment risks in an emergency (SURE) programme.
The EU is already issuing bonds for its €800bn Next Generation EU (NGEU) post-Covid recovery fund, and there is scope to tap into that, as just €74bn has been disbursed so far.
“The impact from the war could lead to higher take-up in the NGEU loans the EU has offered and as such could potentially lead to higher EU funding, but it would still be within that context of around €800bn that had been mentioned in terms of bond market issuance,” said Sherani.
S&P acknowledges its estimates are tentative but calculates that, at a national level, governments will need to raise between €101bn and €173bn in connection with the energy, defence and refugee spending pressures arising from the Russia-Ukraine conflict and that it will add between €86bn and €146bn to sovereign borrowing in the eurozone. Despite this, gross issuance will fall compared to the record highs fuelled by the pandemic.
War in Ukraine has exacerbated the pressures governments are facing as they try to tackle inflationary forces while avoiding tipping their countries into recession, and its impact should be seen as part of a bigger picture. Governments have to make choices on how to tackle the cost-of-living crisis, and the funding solutions they choose will indeed be political as much as economic.
Germany’s Finanzagentur has boosted funding by €40bn as a result of the downturn, even though it might be more efficient for KfW to lend support. Another option could be to provide funding at a multilateral development bank level, but that could be politically difficult because Russia holds a stake in MDBs.
The impact on sovereign supply is expected to be limited and manageable, even given the pressures. A far bigger concern is not related to the Ukraine but to the ending of the ECB’s asset buying programmes this year.
“Net supply is what matters for the market, and I don’t just mean from a redemption cashflow perspective but also in terms of ECB purchases," said Sherani. "The withdrawal of ECB asset purchase programmes presents a bigger shock than a few additional billion euros of issuance from each country."
Bankers fear this could create a supply/demand imbalance that will pose serious questions to the sustainability of some sovereign debt. For example, in 2020, the Kingdom of Spain issued €100bn of debt and the ECB bought €117bn of its government’s bonds. The head of SSA syndicate at one big bank warned: “What’s happening in Spain has a read-across for all EU countries. With the ECB ending its programme, Spain will need to find new buyers for the entirety of its sovereign debt programme. Of course, there was life before QE but, at the same time, we weren’t swimming in debt."
But Sherani argued there is sufficient cash on the sidelines, which, combined with lower levels of supply overall, should help to cushion the blow.
“Investors have high cash balances due to those ECB programmes and there is more than enough to absorb additional supply. While there is heightened risk with the biggest buyer disappearing from the market, I wouldn’t expect that to lead to a huge impact on credit spreads or a sovereign debt crisis. This is not the ECB in isolation,” he said.
The impact of the war in Ukraine on sovereign issuance is yet to play out, not least because European countries are buying Russian oil based on historical pricing contracts. Bankers and politicians agree the situation will worsen irrespective of how much longer the conflict drags on. The war will accelerate energy transition but much of that is already baked into funding pans.
Debt management offices will tackle it as part of seismic shift brought about by the end of unlimited central bank liquidity, rising interest rates and surging inflation. “DMOs are staffed with people who have worked through many cycles and they are well positioned,” said one head of debt capital markets.
Despite a rise in the cost of sovereign funding and the ending of QE, it is too early and perhaps simplistic to predict that a debt crisis would be a logical outcome. Sovereigns have more levers to pull than they did a decade ago.
“We are in a different situation in continental Europe than we were even pre-Covid and certainly prior to the last eurozone crisis, where the institutional framework around the euro is dramatically different and much deeper and thoroughly arranged,” said Lee Cumbes, head of DCM EMEA at Barclays.
“Following Covid, we have EU-wide financing mechanisms in place which could be proposed as a model to meet other challenges. All of that helps with pressure on individual sovereigns. Policymakers and governments are fully aware of the pressures out there early and will be able to work on means to mitigate any problematical outcomes.”
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