Government bond rates and interest expenditure of large euro area member states: A scenario analysis

• Published date: 01 December 2023
• Author: Veronika Grimm,Lukas Nöh,Volker Wieland
• Date: 01 December 2023
• DOI: http://doi.org/10.1111/infi.12434

Received: 10 August 2022

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Accepted: 31 May 2023

DOI: 10.1111/infi.12434

ORIGINAL ARTICLE

Government bond rates and interest

expenditure of large euro area member states:

A scenario analysis

Veronika Grimm

1,2

|Lukas Nöh

3

|Volker Wieland

4

1

School of Business & Economics,

Friedrich‐Alexander‐University

Erlangen‐Nürnberg, Nürnberg, Germany

2

German Council of Economic Experts

(GCEE), Wiesbaden, Germany

3

GCEE, Wiesbaden, Germany

4

IMFS, Goethe University of Frankfurt,

Frankfurt, Germany

Correspondence

Volker Wieland, IMFS, Goethe University

of Frankfurt, Theodor‐W.‐Adorno‐Platz 3

60323 Frankfurt am Main, Frankfurt,

Germany.

Email: wieland@imfs-frankfurt.de

Abstract

This paper assesses the possible development of

government interest expenditures for Germany,

France, Italy and Spain. Until 2021, governments could

anticipate a substantial further reduction in interest

expenditure. This outlook has changed drastically with

the surge in inflation and government bond rates.

Assuming that bond rates remain at the levels implied

by yield curves from December 2022, interest expen-

diture rises substantially. We also examined scenarios

with a further upward shift in yield curves by one or

two percentage points. They indicate major medium‐

term risks for highly indebted member states with

interest expenditure approaching or exceeding levels

last observed on the eve of the euro area debt crisis.

Governments should take action to achieve a decline in

debt‐to‐GDP ratios towards safe levels. They need to

make sure public debt remains sustainable at the

higher interest rates that are required to achieve price

stability in the euro area.

KEYWORDS

bond yield curves, euro area, government interest expenditure,

public debt sustainability

JEL CLASSIFICATION

E43, F45, H68

International Finance. 2023;26:286–303.286

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wileyonlinelibrary.com/journal/infi

This is an open access article under the terms of the Creative Commons Attribution License, which permits use, distribution and

reproduction in any medium, provided the original work is properly cited.

© 2023 The Authors. International Finance published by John Wiley & Sons Ltd.

1|INTRODUCTION

With the rise of inflation expectations and then inflation over the course of 2021 and 2022

medium‐and long‐term interest rates in the euro area have also increased substantially.

Investors want to be compensated for expected inflation and inflation risk. Bond rates also

incorporate the anticipation of a future increase in policy rates. This makes sense. The

European Central Bank (ECB) needs to adjust policy to fight inflation. If it delays it will

ultimately need to raise rates further to contain inflation expectations. In 2022, higher bond

rates apparently triggered new concerns about the ability of highly indebted member states to

service their debt. In fact, spreads relative to bonds of AAA‐rated member states also increased

somewhat. On 14 June 2022, the ECB called an emergency meeting of the Governing Council to

discuss a new selective bond purchase program that aims to control government bond spreads.

By 21 July, it unveiled the new so‐called Transmission Protection Instrument (TPI).

The purpose of this paper is to assess the possible development of government interest

expenditures as a share of GDP for large member states. Interest expenditure is a key

determinant of debt sustainability. This is clear from the simplest version of the debt

accumulation equation,

∆





























big

gbpb=−

1+ −

,

t

tt

t

tt‐1(1)

which shows the crucial influence of the differential between the nominal interest rate i

t

and

nominal GDP growth, g

t

, on the change of the government gross debt‐to‐GDP (Δb

t

) ratio. Here,

pb

t

refers to the primary budget balance and i

t

b

t−1

corresponds to interest expenditure. This

equation is a key element of macroeconomic models that are used to simulate debt

accumulation with endogenously determined GDP growth, interest rates and budget balances.

It assumes that government debt consists of one‐period bonds and i

t

is the one‐period

interest rate.

In practice, however, government debt is characterized by a rich maturity structure that

plays a key role in the development of interest expenditure. Thus, we take a step back and use a

more mechanical approach for calculating the potential path of interest expenditure, which

however makes use of available information on the maturity structure of government debt,

implied future debt redemption payments and the relevant sovereign yield curves. Rather than

using a macroeconomic model to derive nominal growth and short‐term interest rates

endogenously, we employ forecasts by the International Monetary Fund (IMF) for the debt‐to‐

GDP ratio in calculating the path of interest expenditure.

Our analysis focuses on four large euro area member states —Germany, France, Italy and

Spain. In 2021, the latter two states recorded debt‐to‐GDP ratios of 151% and 118%, respectively.

In France, the debt‐to‐GDP ratio stood at 113%, in Germany at 70%. In recent years, these

countries were able to reduce interest expenditure relative to GDP and relative to total

government expenditure. Until 2021, they could anticipate a further reduction of interest

expenditure in the future. Government bond rates in the euro area had been very low for an

8‐year‐period. Thus, member states rolling over debt issued during or before the euro debt crisis

of 2011 and 2012 could expect a substantial further decline in interest expenditure.

Our retrospective calculations show that if the extremely low yield curve from August 2021

(and previous years) had persisted, governments could have anticipated a rapid further decline

in the interest burden of public debt. For example, interest expenditure on German central

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