Back to black: EU states face a budget squeeze as fiscal rules return

The EU has reformed its fiscal rules, bringing in more realistic deficit reduction requirements, but maintaining Excessive Deficit Procedures. We anticipate cuts to government investments in the medium term, after 2024, except in Germany where the 2024 budget was cut by EUR 30bn. In the long term, European states require more public investments, which would benefit insurers by strengthening both their underwriting and investment returns. 

• Updated EU fiscal rules introduce more flexible expenditure reduction paths for countries with excessive debt and deficits.
• Several member countries may qualify for Excessive Deficit Procedures on their 2024 budgets.
• The political timeline implies little fiscal tightening in 2024, outside of Germany (tightening of EUR 30bn), but lower spending from 2025.
• This may soften public-driven demand for commercial P&C insurance in the next few years.
• Long term, structural trends suggest EU states need looser fiscal policy, eg to fund the green transition.
• We see this as a long-term positive for insurance demand, while higher debt issuance and interest rates may sustain strong investment returns.

European Union fiscal policy has been lately in the spotlight: first in Germany, where the government has had to adjust its 2024 budget, and now at the EU level, as it reforms and reinstates its fiscal rules for member states.¹ In question are the expected public debt paths following the large deficits of the COVID-19 era. Governments are caught between constrained fiscal space, growing investment needs for the green and digital transitions, and the need to finance industrial strategies to remain globally competitive. In the near term, fiscal constraints may reduce demand for insurance, but in the long term we expect higher investment to prevail, with positive effects for the insurance industry.

The revised fiscal rules are not expected to materially affect EU governments' spending this year, but from 2025, higher-debt and/or higher-deficit countries could face a squeeze from fiscal consolidation, albeit manageable. The rules maintain the pre-COVID-19 thresholds required of governments, of budget deficits below 3% of GDP and debt/GDP ratios under 60%. Countries that miss these can still be placed in Excessive Deficit Procedures (EDP), but both those and the normal trajectories allow more realistic and flexible multi-year expenditure reduction paths.

Figure 1. EU members' expected budget deficits, % of GDP

We expect to see numerous member states meet the criteria for an EDP in 2024, including France and Italy (see Figure 1). However, in practice several approval steps are still to come in 2024 before the rules will be applied. The European Commission (EC) is unlikely to take any action on EDPs until after the European Parliament elections in June, which would leave little time for the EC to request an in-year fiscal adjustment for 2024 in the second half of the year.

EU countries will likely be required to reduce their deficit spending from 2025 onward, and we anticipate moderate fiscal tightening, though not a severe pullback in governments' spending as a result. We forecast euro area real GDP growth at 1.0% in 2025, up from 0.3% (versus consensus 0.5%) in 2024, reflecting lower inflation and more supportive monetary policy, but we anticipate downside pressure on this from fiscal drag.

Germany played a key role in the EU negotiations, pushing for tougher deficit reduction rules. Germany is also more hawkish at home, already tightening more than originally expected in 2024. The federal government announced a tentative updated 2024 budget,² with a EUR 30bn (~0.7% of GDP) reduction in spending from its initial budget, after a EUR 60bn chunk of funding for the off-budget Climate and Transformation Fund ("KTF") was blocked by the German Constitutional Court last year.

The proposed new, smaller budget would narrow Germany's fiscal deficit to around 1.5% of GDP.³ Yet this is still well above the debt brake limit of 0.35% of GDP, illustrating the challenge of compliance with the EU fiscal rules. We have revised down our 2024 real GDP growth forecast for Germany to -0.1% (0.2% previously) and see potential for negative spillovers to the Euro area. The growth downgrade affirms Germany's underperformance relative to other large EU economies, especially given its very low debt/GDP ratio versus others (see Figure 2).

Figure 2. Government debt to GDP ratio in 2022 (y-axis) and real GDP growth in 2024 (x-axis)

For insurers in Europe, moderate fiscal tightening from 2025 could reduce insurance demand related to public investment. For example, commercial Property & Casualty insurance lines such as liability or surety, which protect infrastructure projects and providers during the construction phase, may see softer demand. The potential for project cancellation or delay resulting from budget reductions is generally symptomatic of the implementation risk facing reindustrialisation initiatives in advanced economies, as noted in our November 2023 sigma.⁴

However, in the long term we expect structural demands for higher government spending to take precedence over the wish for budget discipline. For example, to remain globally competitive, we expect EU countries to require looser fiscal policy than in the post-2008 decade, leading to more public investments that would benefit non-life insurers on a longer horizon.

Higher spending may gradually increase countries' debt-to-GDP ratios over the long term, even if some fall under EDP in the short term. Increased fiscal and debt risks may lead to greater bond market volatility, higher term premiums on bonds, and higher sovereign yields. This would support insurers' reinvestment yields and profitability, particularly for life insurers given their longer asset durations.