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Europe’s (public) debt challenge

Economic Report

  • Private and public sector debt is high in a substantial amount of European countries
  • Public debt challenges seem to be the greatest in Southern European countries, Croatia and Hungary
  • Public debt challenges are lowest in the Baltics and Nordics, although Finland faces substantial debt sustainability challenges and Iceland debt affordability risks
  • In Western European countries the risks related to public debt financing and affordability appear to be rather muted (only Ireland faces affordability challenges). Public debt sustainability challenges are larger, especially in Belgium, the UK and Ireland, but also in France

Overall indebtedness

Private and public sector debt is high in a substantial amount of European countries (figure 1). The majority of eurozone countries, as well as the UK, have breached the EU criterion that public debt should not exceed 60% of GDP (figures 1 and 2). Most countries have also triggered an alert in the Union’s macroeconomic imbalances procedure with private debt ratios above 130% of GDP. The Nordics, Switzerland and Luxembourg are within the public debt limits, but breach the private debt threshold. The Baltics, the CEE countries (Hungary excepted) and the SEE countries (Croatia excepted) adhere to both private and public debt thresholds[1].

In the remainder of this piece we will first briefly discuss why debt matters for countries’ economic performance. We then focus on public debt and sovereign default risk. An in-depth analysis of private sector debt is beyond the scope of this piece, but warrants separate attention later on in our research calendar.

Economic growth risks

High levels of gross debt tend to harm economic growth and may generate financial crisis (e.g. Bornhorst and Arranz, 2014).

Financing needs typically increase with indebtedness, lowering the ability of the borrowers to absorb shocks and generally depressing their (perceived) creditworthiness. As a result, high debt levels usually involve higher interest payments, which may restrict consumption and investment spending. Refinancing and servicing debt can become expensive and problematic, feeding back into lower creditworthiness.

Furthermore, high (especially private) credit growth often precedes financial crises, with sometimes long-term negative effects on economic growth and employment. Post-crisis, highly indebted households, firms and governments generally strengthen their balance sheets and pay down debt. This creates a negative cycle of falling demand, economic growth and employment that intensifies or prolongs a downturn. Highly indebted governments are less able to support the economy in such a scenario.

Figure 1: Private and public indebtedness across Europe
Figure 1: Private and public indebtedness across Europe* Maximum public debt ratio permitted in European budget rules: 60% of GDP
**Maximum private debt ratio permitted in macroeconomic imbalances procedure: 130% of GDP
Consolidated private debt except for the UK, Norway, Switzerland and Turkey
Source: Macrobond, IMF, Eurostat, BIS
Figure 2: Net financial wealth changes the picture
Figure 2: Net financial wealth changes the pictureSource: Macrobond, Eurostat

Assets mitigate solvency and liquidity risks

In addition to debt, agents hold assets. Assets mitigate risks stemming from high debt ratios as (at least theoretically) borrowers can sell assets to pay off debt[2]. Accordingly, the level of gross debt could lead to an overestimation of solvency risk. This is particularly the case for public debt in Finland and private debt in the Netherlands and Denmark (figures 2 and 3). That said, net debt may underestimate solvency risk, as assets and liabilities could well be held by different households and firms.

Figure 3: High government debt, low liquid assets
Figure 3: High government debt, low liquid assetsSource: Macrobond

Net debt may underestimate liquidity risk to an even greater extent. Most assets are illiquid, especially public assets (figure 3). Selling assets quickly in times of balance sheet stress might not be possible or lead to a reduction in the realised value. Furthermore, in the case of public assets, sales could be politically challenging, particularly in the case of state-owned companies.

Public debt challenges in Europe

Looking at the challenges posed by Europe’s public debt, we broadly distinguish the following three interlinked criteria:

  • debt financing capacity: the availability of reasonably priced funding for current and future financing needs;
  • debt affordability: the extent to which current and future debt payment obligations can be met without introducing measures that substantially harm growth, welfare or quality of ongoing public services;
  • debt sustainability: the ease with which debt can be stabilised at its current level, or reduced over time if necessary.

A reduction in any of the above increases sovereign default risk, whilst the adjustments needed to mitigate this will likely affect the economy through austerity measures.

Overall, short to medium-term debt challenges seem to be the greatest in Southern European countries, Croatia and Hungary. However, in Southern Europe the risks associated with refinancing and affordability are substantially reduced by the ECB’s quantitative easing programme. Debt challenges are lowest in the Baltics and Nordics, although Finland faces substantial debt sustainability risks and Iceland debt affordability risks. CEE countries are also performing relatively well, except for Hungary when it comes to debt financing capacity and affordability. Among the SEE countries the picture is mixed. Some, like Bulgaria and Romania, face rather low risks, whilst others, like Croatia, face high risks. Serbia and Albania also score relatively poorly. In Western European countries the risks related to debt financing and affordability appear to be rather muted (only Ireland faces affordability challenges). Yet, debt sustainability risks are larger, especially in Belgium, the UK and Ireland, but also in France.

Debt financing capacity

The debt financing capacity can be gauged from, amongst others:

  • the size of government debt: this increases financing needs and generally also financing costs (figure 3);
  • the amount of external debt: this might be more difficult to refinance as foreign investors may be more footloose. Also, shocks and uncertainty in global financial markets in general may reduce access to external funding (figure 4);
  • the amount of foreign currency debt: this creates exchange rate risk, as a result of which debt repayment could become more difficult and refinancing more expensive (figure 5);
  • the short-term financing needs, i.e. maturing debt plus the budget deficit, and the cost of financing this: the larger the needs and the higher the level of bond yields, the greater the risk to liquidity and the lower the debt financing capacity will be (figure 6);
  • liquid financial assets: can be directly used to pay off debt, reducing liquidity risk (figure 7).

Gross government debt
Gross public debt statistics suggest that refinancing risks are highest in most eurozone Member States plus the UK, and lowest in the Baltics, Nordics (Iceland excepted) and several SEE countries (figure 3).

External government debt
The proportion of external debt is highest for the countries that needed financial support during the crisis (Greece, Ireland, Portugal and Cyprus), though also in Belgium, Austria and France (figure 4). Risks relating to high external debt levels in these countries are substantially mitigated by the long maturity. And in Greece, Portugal and Ireland, also due to the fact that public debt is largely in hands of foreign official entities. The latter is a mitigating factor as these entities supposedly are less footloose.

Foreign currency government debt
In most euro area countries and the UK, debt is issued (almost) entirely in the national currency (figure 5). In Lithuania foreign currency debt as a percentage of GDP is quite large, though, and it is also present to some extent in Ireland and Portugal. Overall, Croatia, Hungary, Romania and Lithuania are most prone to exchange rate risk.

Figure 4: Risks related to high external debt are mitigated
Figure 4: Risks related to high external debt are mitigatedSource: Macrobond, ECB, Rabobank, IMF.
Data on debt held by foreign officials is not available for CY, HU, LT, SK, RS, IS, LV, XK, PL, AL, RO, MK, MD, MT, TR, LU, BG, EE.
Figure 5: Few countries exposed to exchange rate risk
Figure 5: Few countries exposed to exchange rate riskSource: Eurostat, World Bank, ECB, IMF

Short-term financing and liquidity risk
Government financing needs in 2015 are especially high in Italy, but also substantial in Spain and Hungary, amongst others (figure 6). By contrast, they are very low in Switzerland and Iceland. Currently, risks related to high financing needs are subdued as the quantitative easing program of the ECB substantially increases the availability of funding (and lowers its cost), with liquidity spilling over into the wider European sovereign debt markets. In fact, only Greece, Turkey and Iceland face high interest rates. Under current circumstances Greece[3], Hungary and Croatia seem most prone to liquidity risk in 2015. Taking account of liquid financial assets (figure 3) does not change this picture.

Figure 6: Greece, Hungary and Croatia most prone to liquidity risk
Figure 6: Greece, Hungary and Croatia most prone to liquidity riskSource: IMF, Macrobond, TradingEconomics
Figure 7: Large differences in debt affordability
Figure 7: Large differences in debt affordabilitySource: Ameco, IMF, Rabobank

Debt affordability

According to the credit rating agencies, debt is affordable when interest payments constitute less than 10% of total government revenue. To calibrate affordability, however, the ease with which governments can raise revenue or reduce other spending must be included as well. If this can be done rather easily, a high or higher ratio of interest payments is affordable. Currently, debt affordability is low in Albania, Portugal, Ireland and Iceland (figure 7) and only marginally better for Italy. Greek affordability is suppressed by high indebtedness and low government (tax) revenues, despite artificially low interest rates on Troika loans.

Public debt sustainability

Public debt is sustainable as long as the issuing government is able to service all accumulated government debt at any point in time. In the short run, this depends on the government’s liquidity and in the medium to long run on the government’s solvency. Thus, in the short run public debt is basically sustainable if the government is able to maintain access to capital markets to refinance maturing debt.

The solvency requirement is met if the government can be expected to continue to be able to afford and (re)finance debt over the medium to long run. Assessment of this ability and thus of debt sustainability depends on whether the criterion used is that the government can, within a certain time span or over an infinite horizon: (i) bring down its debt ratio to a specific level and/or (ii) stabilise it at its current level.

In any case, keeping debt sustainable is easier if, among other things, the budget deficit is low and nominal GDP growth is high (see Annex 1 for the decomposition of public debt to GDP). The latter results from the fact that in such a climate the income from which debt has to be serviced grows, thereby obviating austerity measures. To understand the expected average long-term budget balance (in an unchanged policy scenario) we look at the structural budget balance[4] (table 1). We also take potential GDP volume growth as an estimate of average real GDP growth over a longer period (based on currently expected productivity and labour market developments). As each assumption adds uncertainty to the final result, we look at a range of sustainability measures from the EC and the IMF.

Both the EC and the IMF calculate the scale of austerity measures necessary to reach a debt ratio of 60% of GDP by 2030 (or 40% of GDP for emerging market economies in case of the IMF). See annex 3 for further details of the calculations. The larger the effort required, the lower the medium-term debt sustainability. The EC also calculates the fiscal effort required to stabilise the current debt ratio over an infinite horizon (indicator of long-term sustainability risk). Both the initial budgetary position and the (expected) increase in age-related spending are taken into account.

Table 1:  Debt sustainability indicators
Table 1: <strong> </strong>Debt sustainability indicatorsSource: Macrobond, AMECO, IMF, IMF (2014), EC (2014)
*According to the European Commission medium-term sustainability risk is:
(i) low if the required improvement is lower than 0 (ii) medium if it is between 0 and 2.5, and (iii) high when greater than 2.5.
** According to the European Commission long-term sustainability risk is:
(i) low if the required improvement is lower than 2 (ii) medium if it is between 2 and 6, and (iii) high when greater than 6.
The outcome of the indicators of the IMF and the EC sometimes differs substantially. The differences in outcome between the two indicators stem from both calculation differences and difficulties in the calculations (see Annex 3). It is therefore useful to take both indicators into account when assessing medium-term public debt sustainability.

Overall, the Southern and Western European countries, Croatia and Finland perform rather poorly on debt sustainability in the medium term, apart from Luxembourg, Germany and Switzerland. Although, potentially, risks in Finland are mitigated by large public assets. Belgium and the UK are the weakest performers of all. The Baltics and the Nordics (Finland excepted) are among the best performers. In Norway, the potential risk posed by the high structural deficit are substantially mitigated by strong potential GDP growth and the sovereign’s extremely large sovereign wealth fund. Sustainability risks appear to be muted in the CEE countries as well. Most SEE and CEE countries, as well as Turkey, have the advantage that potential GDP volume growth is relatively high (except in Croatia), while debt ratios are still fairly low (except in Albania, Croatia, Serbia and Hungary) and social security arrangements are limited in scope. The structural deficits in these countries are also high, however, meaning that debt ratios could increase rather rapidly when growth starts to slow and fiscal policy does not adjust.

The European Commission deems long-term debt sustainability risk to be high in Belgium, Malta, Slovenia, Finland and Luxembourg[5]; high future age-related expenditure is mainly to blame (for more information on age-related expenditure, see the chapter on Population trends in Europe elsewhere in this publication). Most CEE and SEE countries perform worse on long-term debt sustainability than they do on medium-term debt sustainability, but none of them face high risk in this respect. At the same time, long-term debt sustainability risks in Spain, Portugal, France and Italy and Hungary, Latvia and Estonia are low, due to beneficial or less negative developments in age-related expenditure.

Importantly, it may prove very difficult for some countries to reduce public debt sustainability risk. Historically there are almost no examples of countries that have been able to run large government budget surpluses over a long period, especially in times of low nominal GDP growth (IMF, 2013).


[1] The regions are defined as follows: Nordics (Denmark, Finland, Iceland, Norway, Sweden), Western Europe (Austria, Belgium, France, Germany, Ireland, Luxembourg, Netherlands, UK, Switzerland), Southern Europe (Cyprus, Greece, Italy, Malta, Portugal, Slovenia, Spain), Baltics (Estonia, Latvia, Lithuania), CEE (Czech Republic, Hungary, Poland, Slovakia), SEE (Albania, Bosnia and Herzegovina, Bulgaria, Croatia, Kosovo, FYR Macedonia, Moldova, Montenegro, Romania, Serbia), and Turkey.

[2] While not strictly within the scope of this paper, the presence of a central bank mandated to act as a lender of last resort may also mitigate the financial stability risks of high debt levels.

[3] Greek liquidity risk depends on its adherence to the agreement with the European Commission, ECB and IMF (the Troika) under the current support programme. It remains our base scenario that Greece will do this.

[4] Government cyclically adjusted budget balance + one-off expenditures – one-off revenues

[5] Note that this specifically means that it will be difficult for Luxembourg to maintain its public debt ratio at 24% of GDP over an infinite horizon. In addition, low Italian long-term sustainability risk means that Italy is expected to be able to keep its public debt ratio at 137% of GDP over an infinite horizon due to falling age-related expenditure over the coming years, owing to large-scale pension reforms in the past few years.


Bornhorst, F. & Arranz, M.R. (2014). Jobs and Growth: Supporting the European Recovery. Chapter 2. Washington: IMF.

European Commission (2014). The 2014 Stability and Convergence Programmes: An Overview, European Economy. Occasional Papers, No. 199. Brussels: EC.

International Monetary Fund (2014). Fiscal Monitor - Back to Work: How Fiscal Policy Can Help. Washington: IMF.

International Monetary Fund (2013). Fiscal Monitor - Fiscal adjustment in an uncertain world. Washington: IMF.

Pescatori, A., Sandri, D. & Simon, J. (2014). Debt and Growth: Is There a Magic Threshold?. IMF Working Paper, No. 14/34. Washington: IMF.

Rabobank Special (2010), Demystifying the paths towards debt sustainability, Appendix 1, 1 May 2010.

Annex 1: The build-up of debt

The analysis of sovereign debt sustainability starts with the identification of the factors that drive the build-up of public debt:


where Dt is the public debt-to-GDP ratio in year t and Dt-1 is the public debt-to-GDP ratio in the previous period. B­t denotes the public budget balance-to-GDP ratio and SFt is the stock-flow adjustment-to-GDP ratio. Stock-flow adjustments (deficit-debt adjustments) capture the elements that alter the government debt-to-GDP ratio, but have no impact on the public budget balance (e.g. changes in financial liabilities, changes in real assets due to privatisation, but also changes in the value of debt in foreign currencies as a result of exchange rate fluctuations, and statistical discrepancies).

Equation (1.1) can be rewritten as[6]:


where rt is the implicit (i.e. average) nominal interest rate to be paid on the outstanding stock of debt, gt is the nominal GDP growth rate and PBt is the primary balance-to-GDP ratio (for definitions see annex 2).

The equation for the change in the debt-to-GDP ratio (ΔDt) can be derived from equation (1.2):


Accordingly, the interest rate (rt) is positively related to the change in the debt ratio and nominal GDP growth (gt) negatively.

Low nominal GDP growth, due to low inflation and / or low GDP volume growth, thus hampers stabilisation and reduction of the public debt ratio. Likewise, high nominal GDP growth makes it possible for a country to grow its way out of debt. This means that a government might be able to stabilise or reduce the public debt ratio without actually introducing austerity measures.


[6] For further detail, see: Rabobank Special (2010), Demystifying the paths towards debt sustainability, Appendix 1, 1 May 2010.

Annex 2: Commonly used definitions

Government budget balance: Total government revenue – Total government expenditure

Government primary budget balance: Government budget balance + net interest payments

Government cyclically adjusted budget balance: Government budget balance adjusted for the economic cycle

Government cyclically adjusted primary budget balance: Government budget balance adjusted for the economic cycle + net interest payment

Government structural budget balance: Government cyclically adjusted budget balance + one-off expenditures – one-off revenues

Government primary structural budget balance: Government cyclically adjusted budget balance + net interest payments + one-off expenditures – one-off revenues

Annex 3: Required adjustment calculation — differences between EC and IMF and difficulties

European Commission

Medium-term sustainability risk – S1
The European Commission calculates how great the improvement in the structural primary balance as a percentage of GDP (annex 2) needs to be in the short term in order to reach a debt-to-GDP ratio of 60% by 2030. The outcome is known as the S1 indicator. The reported S1 indicator indicates by how much the structural primary balance as a percentage of GDP needs to be improved between 2015 and 2020.

Long-term sustainability risk - S2
To define long-term sustainability risk, the European Commission (EC) calculates by how much the current structural primary balance has to improve in order to stabilise the debt ratio at its current level over an infinite horizon. The outcome is known as the S2 indicator.

Calculation basis
Calculations are based on (i) the government debt and structural primary budget balance forecast for 2014 and 2015 in the EC 2014 Spring forecast and (ii) the increase in age-related expenditure up to 2030 (S1) and 2060 (S2) as projected in the 2012 Ageing Report of the European Commission. The effects of pension reforms enacted between the 2012 Ageing Report and the 2014 Spring Forecast are also incorporated.


Debt target adjustment needs
In its Fiscal Monitor of October 2014, the IMF calculates the adjustment needed to the cyclically adjusted primary balance (CAPB, annex 2) between 2014 and 2020, to:

  • reduce debt to 60% of GDP by 2030 for advanced economies and to 40% of GDP for emerging market economies if at present public gross debt exceeds these thresholds, or
  • to stabilise debt at end-2014 ratios if these are presently below these thresholds.

Calculation basis
Calculations are based on (i) the government debt and cyclically adjusted budget balance forecast for 2014 in the IMF fiscal Monitor of October 2014 and (ii) the increase in age-related expenditure up to 2030 as projected by Clements, Eich, and Gupta (2014).

Calculations of required fiscal adjustment to meet debt target differ between the IMF and the EC

  • Use of a different parameter to calculate the necessary fiscal effort;
  • the IMF calculates the required adjustment over six years and the EC over five years;
  • the IMF calculates the adjustment needed to stabilise the debt ratio for countries with below-threshold debt ratios, while the EC in this case allows debt ratios to rise to the threshold;

Difficulties in calculations
Calculations are based on expectations of the implicit future interest rate on government debt and nominal GDP growth. Obviously, if interest rates turn out to be higher or lower than expected, the required improvement in the balances increases or decreases respectively. The same holds in case future growth is lower or higher than currently expected. In the Sustainability Report 2012, the European Commission performed some sensitivity analyses, including a calculation of the S1 indicator if interest rates were to increase by one percentage point. The impact depends on the size of the debt ratio and medium-term financing needs, but on average the S1 indicator increases by multiple percentage points.


This study is a publication of Economic Research (KEO) of Rabobank.

The views presented in this publication are based on data from sources we consider to be reliable. Among others, these include Macrobond. The economic growth forecasts are generated from the NiGEM global econometric structure models.

This data has been carefully incorporated into our analyses. Rabobank accepts, however, no liability whatsoever should the data or prognoses presented in this publication contain any errors. The information concerned is of a general nature and is subject to change.

No rights may be derived from the information provided. Past results provide no guarantee for the future. Rabobank and all other providers of information contained in this study and on the websites to which it makes reference accept no liability whatsoever for the content or for information provided on or via the websites.

The use of this publication in whole or in part is permitted only if accompanied by an acknowledgement of the source. The user of the information is responsible for any use of the information. The user is obliged to adhere to changes made by the Rabobank regarding the information’s use. Dutch law applies.

Abbreviations for sources: AMECO: Annual Macro-Economic Database, BIS: Bank for International Settlements, DOTS: Directions of Trade Statistics, EC: European Commission, ECB: European Central Bank, OECD: Organisation for Economic Co-operation and Development, EIU: Economist Intelligence Unit, IMF: International Monetary Fund, WEO: World Economic Outlook, UN: United Nations

Abbreviations used for countries: AL: Albania, AT: Austria, BE: Belgium, BG: Bulgaria, BA: Bosnia and Herzegovina, CH: Switzerland, CY: Cyprus, CZ: Czech Republic, DE: Germany, DK: Denmark, EE: Estonia, ES: Spain, FI: Finland, GB: Great Britain (UK), GR/EL: Greece IE: HR: Croatia, Ireland, IS: Iceland, HU: Hungary, IT: Italy, LU: LV: Latvia, Luxembourg, LT: Lithuania, MD: Moldova, ME: Montenegro, MK: Macedonia, FYR, MT: Malta, NL: The Netherlands, NO: Norway, PL: Poland, PT: Portugal, RO: Romania, RS: Serbia, SI: Slovenia, SK: Slovakia, TR/TK: Turkey, XK: Kosovo, SE: Sweden, EA17: Euro Area-17, EU27: European Union.

Economic Research is also on the internet: www.rabobank.com/economics

For more information, please call the KEO secretariat on tel. +31 (0)30 – 216 2666 or send an email to economics@rn.rabobank.nl

Allard Bruinshoofd, head of International Research, Economic Research

Graphics: Selma Heijnekamp and Reinier Meijer

Production coordinator: Maartje Wijffelaars and Christel Frentz


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