What Will the German Release of Trillions of Euros Bring to Croatian Debt?

The decline in the value of German bonds, not seen in 35 years, has not yet caused a shock in the eurozone bond market, but it could have negative consequences if elevated yield levels persist for an extended period. This would, of course, also have repercussions for Croatian debt.

On Wednesday, the yield on the 10-year German government bond jumped by twenty basis points, and such a strong one-day increase in bonds that serve as a benchmark for all other bonds in Europe has not been recorded since the fall of the Berlin Wall at the end of 1989. It is worth noting that yields and bond values move in opposite directions. The reason is a decision that could – from a German perspective – become historic and break with a 16-year-long paradigm of public finance management.

Long Process

Friedrich Merz, the leader of the Christian Democratic Union (CDU), which received the most votes in the recent parliamentary elections and is the most likely new chancellor, has reached an agreement with the Social Democratic Party (SPD) to initiate the process of abolishing the ‘debt brake’. Apparently, the CDU and SPD will form another ‘grand coalition’. The ‘debt brake’ is a constitutional provision from 2009 that prohibits the Berlin government from excessive borrowing. It was introduced in response to the then-global financial and economic crisis, which significantly increased borrowing costs for states, especially those for whom the level of public debt was not a particular problem.

This constitutional provision limits new borrowing by the German government to 0.35 percent of the economy’s value. This is a very narrowly set range considering that the Maastricht rule on the size of the budget deficit allows eurozone members a deficit of three percent of the economy’s value, while the U.S. deficit last year was 6.4 percent. The debt brake functioned excellently during the last decade, allowing Germany to maintain even a slight surplus in the treasury. However, first the pandemic in 2020, and then the Russian invasion of Ukraine in 2022 and the spike in energy prices forced Berlin to temporarily suspend the debt brake due to extraordinary circumstances. The suspension was also introduced in 2023, after which the German Constitutional Court reacted, deciding that the government had gone too far, so the budget for 2024 had to be rebalanced.

The previous government of Chancellor Olaf Scholz fell in November last year precisely due to a dispute with the liberals over the debt brake. Friedrich Merz sees the abolition of this provision as a desperately needed source of funds for fiscal stimulus for the stagnating German economy, but also for spending that is currently at the top of European states’ priorities – military spending. Namely, the abolition of the debt brake frees up one trillion euros for Germany. The proposal still needs to be adopted, and that requires a two-thirds majority in the still old composition of the Bundestag, analysts from Raiffeisen Bank emphasize.

No Impact on Germany

– Although the very likely shift in fiscal policy will increase Germany’s borrowing costs, we do not expect this to negatively affect its creditworthiness as Germany enters fiscal expansion with very stable public finances. The potential adoption of the ‘package’ has been anticipated by the market through higher demanded returns on German bonds – they state in their response.

However, the fact that the aforementioned rise in yields on the 10-year German bond is the largest daily yield jump since the fall of the Berlin Wall illustrates that this is a significant event, claims Mate Jelić, a macroeconomic analyst at Erste Bank.

– The market reaction reflects expectations that other countries within the European Union will also move towards increasing defense spending, where the presented ReArm Europe will play a significant role in relaxing fiscal rules, but also potentially provide joint financing for part of defense expenditures. Thus, the market reaction implies a greater need for financing that comes with a more expansive fiscal policy, but also an expected positive impact on economic activity and potentially on inflation – Jelić believes.

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Mate Jelić, senior macroeconomic analyst at Erste Bank

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Current market expectations show that a strong fiscal expansion could somewhat alleviate the anticipated further relaxation of monetary policy this year, Jelić adds. – Although yields for most other eurozone members, including Croatia, have also risen, the spread (the difference in yield between German and other bonds, ed.) relative to Germany has actually narrowed. At this point, it is too early to say to what extent adjustments will occur among other members and to what extent movements are influenced by the size of fiscal expansion in Germany – Jelić assesses.

Possible Consequences for the Weaker

For southern European members, it is important to note that the differences in yields on Wednesday did not change significantly, meaning that there was not only an increase in yields on German bonds but a general increase in yields on government bonds in the euro area. At Raiffeisen, they say that, generally speaking, the current levels of spreads for the so-called peripheral countries are already at low levels historically. – If yields do indeed remain higher for an extended period, this would obviously have consequences regarding higher interest costs for European countries, with fiscally weaker countries (for example, Italy) being more severely affected – they assess at RBA.

When it comes to Croatian bonds, in the last quarter of last year, yields on Croatian eurobonds (CROATI) followed the sharp decline in yields of the German Bund.

– Given that the rating level is already embedded in prices, current valuations are relatively high compared to comparable issues. Therefore, in our opinion, the room for further convergence of CROATI issues is significantly narrowed at this time. The long-term outlook for Croatia remains supported by membership in the euro area and the actual dynamics of convergence. However, significantly better performance is not expected, as we have already witnessed a strong narrowing of spreads relative to benchmark issues in anticipation of and after Croatia’s accession to the euro area. Accordingly, we expect the spread to remain around the current, as we mentioned, already low levels – analysts at RBA assess.