28th Sep 2023


Reality check: investors don't really care about debt levels

  • German finance minister Christian Lindner wants EU countries to reduce debt ratios (Photo: FDP/Matthias Hornung)
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Something weird is going on in Europe which is hard to explain to anybody that is not…European.

Europe is faced with the contradictory demand to dramatically speed up climate investment while at the same time lowering debt-ratios.

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  • Investor demand for government debt (light blue) vastly outstrips what countries need for climate investment annually (red and pink), which would amount to one to three percent of GDP. (Photo: Ludovic Suttor-Sorrel based)

Increasingly economists are saying that most, if not all, public climate investment in Europe — which numbers in the hundreds of billions a year — can be financed by issuing more debt.

Yet precisely at this moment EU leaders are negotiating new spending limits that prioritise debt-reduction over other goals such as the green transition and competitiveness, setting it apart from its main competitors United States and China.

The question is why?

Money is cheap

First off, it isn't due to a lack of money.

Ludovic Suttor-Sorel, a senior policy researcher at the financial NGO Finance Watch, recently published a report with important figures showing that EU countries can easily afford climate investment needs by issuing new debt.

Annual debt-servicing costs are comparatively low in Europe. According to the World Bank figures, European countries on average spent 2.9 percent of their annual revenue in 2021 on paying back debt.

Even a comparatively high-debt country like Italy has a relatively low debt cost, at 8.4 percent of its revenue, compared to 14.3 percent in the US and 23 percent of total income in India.

Another important factor: people want to invest in European debt. Demand for EU sovereign debt is high among investors and vastly exceeds existing supply.

"Unmet investor demand would easily cover all public debt needed to bridge the climate mitigation funding gap," Suttor-Sorel writes.

Debt financing climate investments could be beneficial in a variety of ways: not all upfront costs would have to be covered by tax-payers today and investments in clean power and heat pumps are actually cost-cutting for people. Finally, and most obviously: it reduces climate risk by preventing further warming.

"Debt resulting from qualitative investments would weigh less on future generations' shoulders than failing to address them," Suttor-Sorel told EUobserver.

EU debt fears

But EU leaders are reluctant to issue more debt.

As Suttor-Sorel argues, the widely-held European fear of over-indebtedness is a hangover from the European debt crisis of 2010-2012. Interest rates in some countries shot up to double-digit numbers, effectively shutting down entire economies. This was driven by panic in sovereign bond markets.

Although too complex to cover in its entirety here, relevant for now is that the preconditions for that panic do not exist anymore today. In contrast to those years the European Central Bank (ECB) now operates as lender-of-last-resort, meaning that even during a crisis investors can always sell the government bonds they own.

This is why sovereign bonds rates of individual member states have remained relatively stable even through recent crises.

Many politicians however haven't adapted to this reality. Last week EU finance ministers meeting in Brussels agreed to "reduce deficits and debt ratios" from 2024 onwards.

Before the end of the year new fiscal rules are set to be reintroduced which would commit countries with higher debt-ratio to reduce debt to 60 percent of GDP — albeit at a slower pace than under the current rules.

The belief is that a uniform debt-ratio — even if deemed "arbitrary" by many economists', including Suttor-Sorel — increases a country's creditworthiness thereby improving financial stability.

"For financial markets, debt is debt and too high debt leads to instability," German finance minister Christian Lindner said in June.

But by analysing what investors actually believe is important when assessing a country's investability, Suttor-Sorel shows that investors actually don't care that much about debt-ratios.

Creditors don't care

For starters: investors outsource sovereign risk assessments to credit rating agencies.

Ratings are important because the higher the rating the lower the interest rate investors charge a country, the easier and cheaper it is for a government to obtain the money it needs to achieve its goals, with the highest rating being AAA and the lowest triple C.

Major credit agencies, including Fitch Ratings, Moody's, S&P and Scope Ratings, all determine a country's creditworthiness along roughly the same checklist: quality of institutions, debt-affordability, GDP growth, GDP per-capita among other criteria.

Debt-to-GDP ratio is also on the list, but has a low priority with every major agency. Fitch ratings for example weighs debt-to-GDP at 8.3 percent, while "institutional strength" (which includes political stability, governance and GDP per capita) determines 53.2 percent of its final credit assessment.

Similarly, the European Investment Bank in a 2022 working paper found no correlation between a country's creditworthiness and its debt-to-GDP stock, whereas the annual cost of debt, GDP-per capita, economic growth and World Bank World Governance indices influenced credit ratings heavily.

Incidentally the high-priority items on the list are mostly things EU countries excel in, which is why all European economies, except Greece, benefit from "investment grade" ratings (BBB and higher).

So while financial markets have developed granular methods of determining the quality of a country's fiscal policies, European fiscal rules are mainly focused on just one variable debt-to-GDP ratio, which as it happens is also the wrong one.

"Whilst financial markets care little about debt-to-GDP ratios, the European economic governance framework made it its main compass," Suttor-Sorel concludes.


Debt reduction or not, the EU has already committed to reducing emissions, as was recently pointed out by Jean Pisani-Ferry, a senior fellow at the Brussels-based think tank Bruegel.

"The question of whether climate action should take priority over debt reduction obviously cannot be ignored," he wrote in an op-ed.

Instead of worrying about increasing debt levels, politicians should perhaps worry more about what to spend it on.

"Future-oriented" investments in climate, education and research should be excluded from arbitrary deficit and expenditure limits, Suttor-Sorel argues.

If done right these investments could improve European countries' debt sustainability and economic strength, leading to better credit ratings and lower borrowing costs.

Incidentally, this could also bypass or at least soften the contradiction between climate action and debt reduction.

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