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Interest rate-growth differentials on government debt: an empirical investigation for the euro area

The interest rate-growth differential (ii-gg) is an important determinant of government debt dynamics and sovereign sustainability analysis. A persistently negative differential could in principle enable lowering debt ratios even in the absence of primary surpluses. Many advanced economies, including in the euro area, had recently - before the COVID 19-crisis hit - exhibited a strong negative inertia in their ii-gg. But to which extent can this be sustained? The focus of our analysis is on the mature euro area economies over the EMU period and the decades before, when the differential was mostly positive on average. We use panel econometric techniques to identify the determinants of ii-gg across euro area countries and then employ a panel BVAR model to forecast ii-gg, while providing various sensitivity analyses. We conclude that the differential is likely to remain negative after the COVID 19-crisis and well below its long-term average for most euro area countries, but several factors will likely push it up. This would warrant caution in the conduct of fiscal policy over the medium term for the high debt countries, where ii-gg is higher on average and the probability of positive values over the medium term is non-negligible. Finally, the on-going crisis, whose duration and economic effects are hard to predict, brings an unprecedented level of uncertainty for both the short and long-run dynamics of the differential.