Austria and its Creditors: Riding the Business Cycle

Students of Keynesian economics learn that states should save in boom times, and spend during downturns to stimulate demand – if necessary by running up debts. The problem is that since Keynes’ time, bond markets have grown more nervous: As states’ debts rise, so do their interest rates, risking a vicious circle that can drive states into insolvency. "Deficit spending," therefore, has become a question of timing: You’ve got to know when to stop.

When the U.S. credit rating agency Standard & Poor’s (S&P) downgraded Austria’s credit worthiness by one notch from the top, AAA grade to AA+ on 13 Jan., the country’s government took that as a warning shot. On 10 Feb., it announced an austerity package intended to eliminate the state’s annual budget deficit by 2016, from its current level of 3% of GDP.

Yet S&P also justified the downgrade citing Austrian banks’ risky lending to Eastern Europe, and by the on-going Eurozone debt crisis. Austria’s downgrade didn’t happen in isolation: The same day France also lost its triple-A rating, along with downgrades of seven other Eurozone countries.

In all three areas contributing to the downgrade, Austria and its European partners drew the same conclusion: that the time for spending was over. This may satisfy creditors, but will it help Europe’s economic recovery?

Eastern successes

One  area in which the Austrian state risked additional expenses, in S&P’s view, was its financial sector. As Austrian banks have invested heavily in their subsidiaries in Central and Eastern Europe, S&P raised concerns over the banks’ outstanding loans in that region. In the event of serious defaults, the Austrian state could ultimately have to bail out the Austrian parent banks, so S&P reasoned.

But the governor of Austria’s National Bank, Ewald Nowotny told the Financial Times in November that these fears were "wildly exaggerated." Austrian financial regulators had just imposed strict limits on the amount Austrian banks could lend through their subsidiaries in Eastern Europe. As a result, any new loans issued by subsidiaries have to be financed from local deposits. In other words, the credit flow from Austria to its eastern neighbours will slow.

While this limits the risks to the Austrian banking sector – and the Austrian state – it may also deprive it of possible gains in the region; especially as Nowotny said on public radio Ö1 this February that Austria’s banking involvement in Eastern Europe "was, and still is, a success story."

Stefan Bruckbauer, chief economist of Unicredit Bank Austria, agreed that the risks from this exposure were limited. "The main problems come from the Eurozone and are not home-grown," he told The Vienna Review.

Eurozone contagion

Indeed, the fundamental issue behind S&P’s European downgrades was the agency’s dwindling faith in Eurozone policymakers. Given the continuing debt crisis facing Eurozone members, notably Greece, the euro had fallen to a 17-month low against the U.S. dollar early this year. Hence, S&P stated in a press release on the day of the downgrade that current policy initiatives "may be insufficient to fully address on-going systemic stresses in the Eurozone."

The solution proposed by some EU leaders is to impose stricter budget deficit limits on its members, underpinned by new enforcement powers for the European Court of Justice. The new rules are set down in a "fiscal compact" to be signed by EU heads this month.

Yet, uncharacteristically for a credit rating agency, S&P has expressed concerns over the new strictures for fiscal discipline. In a press release last December, the agency noted that "the political agreement does not supply sufficient additional resources… to bolster European rescue operations, or extend enough support for those Eurozone sovereigns subjected to heightened market pressures." In other words, troubled Eurozone economies needed new lines of credit, not more austerity. S&P seemed to be saying that European leaders had got the Keynesian cycle wrong.

Belt tightening

Nonetheless, the Austrian government interpreted its credit rating downgrade unequivocally. "The verdict that S&P reached says very clearly that Austria has a strong, well-performing economy," said Finance Minister Maria Fekter of the People’s Party (ÖVP), "but that reforms to the state have been too long in the making and that debts are a risk if they keep rising."

Similarly, Austria’s business community hoped that the downgrade would kick-start spending cuts by the government. "Hopefully it was the thunder required to get our politicians acting," said senior executive Peter Bazil of Raiffeisen Bank International.

These hopes were not disappointed. After weeks of secret negotiations, the Social Democratic (SPÖ) and conservative (ÖVP) coalition presented an austerity package on 10 Feb., to be passed by the parliament by the end of March.

Austria’s austerity package aims to improve state finances by around €27 billion over a five- year period, in a mixture of tax increases and spending cuts that are supposed to limit structural deficits to 0.35% of GDP by 2016.

New taxes will hit mainly capital gains and top incomes, while plans for a financial transaction tax and a tax deal with Swiss banks are still vague. Cuts will be made to large-scale infrastructure projects, notably by the National Railway, state pensions, and civil servants’ pay. It was a "socially balanced budget," claimed Chancellor Werner Fayman (SPÖ) at the press conference announcing the deal, while averting "enormous interest payments" on Austrian debt.

Doing well for now

The bond markets seem to support Austria’s measures. "Since the downgrade, Austria has issued bonds with reasonable yields," noted Franz Engelhofer, an executive director at Erste Bank. "Further improvement for debt costs can be expected given the current budget consolidation and no further escalation of the Eurozone crisis."

Nowotny agreed: "During the last couple of weeks we have seen a normalisation of the spread, despite S&P’s downgrade," he said.

Moreover, the other two major rating agencies, Moody’s and Fitch, recently confirmed Austria’s triple-A rating, although Moody’s added a "negative outlook" in February due to the on-going euro crisis.

If Austria has been able to satisfy its creditors, the question remains whether its saving measures and financial risk management will stave off economic growth at a vulnerable time. "We still count on GDP growth rates for Austria at 1%, slightly above the Eurozone average," Engelhofer assessed the country’s outlook for this year.

In the end, events will show whether Austria’s leaders judged the Keynesian cycle well.