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The Eurozone risks another debt crisis if the bloc cannot boost growth, lower public debt and fix “policy uncertainty”, the European Central Bank has warned.
In its annual Financial Stability Review, published on Wednesday, the ECB sounded the alarm over a potential return of “market concerns over sovereign debt sustainability”.
It pointed to “elevated debt levels and high budget deficits” as well as tepid growth and uncertainties caused by recent “election outcomes at the European and national levels, notably in France”.
Spreads between French and German 10-year government bonds — a gauge of investors’ concerns — hit 0.78 percentage points this month, close to the 12-year high reached in the run-up to this summer’s parliamentary election.
“Headwinds to economic growth from factors like weak productivity make elevated debt levels and budget deficits more likely to reignite debt sustainability concerns,” the ECB warned on Wednesday.
However Italian spreads against German debt — an indicator of investor worries across the bloc — are at much tighter levels than they were during the Eurozone crisis.
During that crisis, which began more than a decade ago, Greece narrowly avoided a default as concerns about its financial stability fuelled market unrest over the common currency. This only subsided after then-ECB president Mario Draghi pledged to do “whatever it takes” to prevent a collapse of the currency area.
By its nature, the ECB’s Financial Stability Review focuses on risks to the region but its warnings about fiscal risks are more outspoken than in previous editions.
The ECB said sovereign credit risk premiums could be pushed higher by macro-financial shocks, pointing to “weak” fundamentals in several member states and maturing sovereign debt being “rolled over” at higher interest rates.
It added the combination of low growth and high government debt in the 20-country currency bloc could make it more difficult for governments to pay for higher defence needs and investments to fight climate change.
In an indication of the region’s weak growth prospects, the European Commission last week downgraded its 2025 growth forecast for the Eurozone to 1.3 per cent and warned the region is set to fall further behind the US.
The ECB is also concerned that stock and bond markets are exposed to rising risks of “sharp adjustments”, pointing to “high valuations and risk concentration” that had already resulted in “several pronounced but shortlived spikes in volatility”.
It added that “recent market corrections have not dissipated concerns over the overvaluation of equity markets or the potential for an AI-related asset price bubble.”
In a potential economic slump, bank balance sheets could also take a hit as Eurozone consumers and companies are already struggling with higher rates, the ECB said.
The threat of higher losses on commercial real estate “could be significant for individual banks and investment funds”, it added.
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