By Thomas Gillet and Dennis Shen, Sovereign and Public Sector

A stagflationary scenario associated with a significant escalation of the Israel-Hamas war through the rest of the region would test the public finances of euro-area countries with the least fiscal space and weakest growth, not least by bringing about an abrupt halt to benefits from recent declines in energy prices.

This hypothetical scenario of a renewed rise in inflation and further increases in ECB official rates to new highs and/or accelerated balance-sheet reduction would expose the diverging shock-absorption capacities of euro-area member states. Depending on the severity of an additional price shock and its impact on interest rates, such a scenario could place further pressure on ratings of sovereigns we already assign a Negative Outlook, namely Austria (rated AAA), Belgium (AA-), Estonia (AA-), France (AA), and Slovakia (A+).

Such a turn of events in the Middle East and its consequences is not our base case as diplomatic efforts to avoid significant further conflagration continue. Nevertheless, multiple unresolved conflicts and disputes in the region could lead to a potential widening of the Gaza crisis: civil war in Libya, Sudan, Syria, Yemen; a political crisis in Lebanon; and Iran’s nuclear programme. These developments warrant considering the potentially significant repercussions of any spill-over from the Israel-Hamas war.

Figure 1. Wide deficits, high public debt limit space to address a new inflationary shock
Change in the general government balance and change in general government debt, pps of GDP (2023-2019)

Source: IMF data for 2019 and Scope Ratings estimates for 2023

Commodity-price driven inflation would represent the key economic concern from a wider conflict

A new spike in commodity prices is the most significant source of economic contagion in a scenario of a widening conflict. This is due to the vulnerability of Saudi-Arabian energy facilities and transport corridors such as the Strait of Hormuz and the Suez Canal to military action and/or sabotage. Any disruption of oil and commodities markets would add pressure to such markets given termination of the Black Sea Grain Initiative, India’s recent rice-export ban, continued robust demand growth in the United States economy and added stimulus from China. The past two decades demonstrate a close correlation between inflation in the euro area with oil and gas prices (Figure 2).

Figure 2. Euro-area inflation exposed to spikes in crude and gas prices
Headline inflation, % year-on-year and energy prices in USD

Note: last data point, October 2023. Source: ECB, Macrobond, Scope Ratings.

Any return to significantly rising inflation would impair economic growth…

We have expected the ECB deposit rate to peak at 4% and be cut by just 25 basis points to 3.75% by end-2024. Although we have been more hawkish than the market consensus with our long-standing assumption of higher rates for longer, any further upside risk for our euro-area inflation projection of 2.9% for 2024 may force the ECB to hold interest rates steady beyond 2024, or, alternatively, hike rates further. Any acceleration in the reduction of the ECB balance sheet might also be postponed for curtailing risk to financial stability.

Such a scenario of further tightening of funding conditions would cloud the growth outlook as Bund yields rest near decade highs. Our projection for euro-area growth of 1.4% for 2024 would probably have to be revised down under such circumstances.

… and further squeeze restricted fiscal space.

In this crisis scenario, nearly all euro-area countries would be in a weaker fiscal position than immediately before Covid, leaving them less room for counter-cyclical policy measures to support the economy and alleviate inflation. Fiscal space varied considerably across the monetary union before the pandemic but has increased since as governments reacted to the cost-of-living crisis driven by high inflation in 2021-22 (Figure 2).

A renewed and sustained pick-up in inflation could put under pressure select euro-area ratings

Among the euro-area governments using extensive fiscal resources to support businesses and households were France (rated AA/Negative Outlook) and Belgium (AA-/Negative), despite limited budgetary room for manoeuvre compared with highly rated sovereign peers. Both sovereigns benefit from comparatively moderate funding conditions and strong capital-market access, but policy flexibility is hindered by primary deficits estimated at 3.3% of GDP for this year and public debt of around 110% of GDP.

The adverse scenario of a wider Middle East conflict could exert greater pressure on highly indebted sovereigns, such as Italy (BBB+/Stable), with yields on its 10-year government securities standing around 4.4%. Italy could come under heightened market scrutiny should it need to further support its economy. A scenario in which budget deficits widened could increase yields given higher bond supply and investors’ potential re-assessment of the country’s ability to consolidate its public finances to ensure Italy’s eligibility under the ECB’s Transmission Protection Instrument.

Greece (BBB-/Stable) would likely prove more resilient than Italy under this higher-inflation scenario. So far, higher inflation conditions have helped Greece’s rapid debt reduction, which supported our decision this past summer to upgrade the sovereign to an investment-grade rating. High inflation cuts Greece’s high debt stock while higher interest rates roll into Greece’s low-interest debt structure slower than for peer sovereigns after a decade of debt restructuring, including extensions in maturities and reductions in rates. Greece’s primary surpluses ensure its compliance with a forthcoming re-introduction of EU fiscal rules, and thus continued eligibility for Eurosystem facilities. We do not expect Greece’s investment grade to be at risk even in an adverse stagflationary scenario.

Portugal (A-/Stable) and Cyprus (BBB/Stable), which likewise observed upgrades of their long-term ratings in the past 12 months, would similarly prove comparatively more resilient given primary surpluses exceeding 1.5% of GDP and declining debt.

Ireland (AA-/Positive) would be more resilient given a strong fiscal flexibility after enhancing its fiscal position since 2019, with a primary surplus rising to near 4% of modified GNI and debt-to-modified GNI declining under 80%.

Sovereigns holding small primary deficits as well as moderate public-debt stocks, such as Germany (AAA/Stable) and the Netherlands (AAA/Stable), are also better positioned to cope in an adverse scenario.

Brian Marly, Analyst, Sovereign Ratings, contributed to this report.

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