(Kitco News) – The amount of debt that countries have been piling on in recent years continues to accelerate amid a rise in geopolitical tensions and the green energy transition. According to the European Central Bank, the Eurozone is at risk of another debt crisis if the bloc cannot lower public debt, boost growth, and reverse course on “policy uncertainty.”
As reported by the Financial Times, the ECB published its annual Financial Stability Review on Wednesday, with the central bank raising alarm bells over a potential return of “market concerns over sovereign debt sustainability.”
According to the report, “Heightened geopolitical and policy uncertainty is exacerbating sovereign vulnerabilities,” with the ECB citing “election outcomes at the European and national levels, notably in France” as forces that “have rekindled concerns about sovereign debt sustainability.”
“Greater policy uncertainties and market concerns about their implications for debt sustainability have resulted in some sovereign spreads widening for some euro area sovereigns with high levels of debt, albeit with limited cross-border spillovers for now,” the report said. “Concurrently, the longer-term trend of rising political fragmentation observed over the past three decades has made it more challenging to form stable government coalitions.”
The ECB warned these developments “may contribute to delays in reaching agreement on key fiscal and structural reforms while also raising economic policy uncertainty.”
“Furthermore, rising geopolitical uncertainty may imply an additional burden for sovereigns in dealing with the consequences of geopolitical fallout (e.g. energy subsidies),” they added. “This would be particularly challenging for countries where public debt levels are high, given their limited fiscal space to support the economy in the event of adverse shocks.”
According to Luis de Guindos, vice president of the ECB, another factor contributing to the problem is the “poor historical compliance with EU fiscal rules” by some member countries’ governments.
“Alongside geopolitical and policy uncertainty, global trade tensions are on the rise, increasing the risk of tail events,” de Guindos wrote. “Financial markets have seen a resurgence of volatility, enduring several notable spikes since the last edition of the Financial Stability Review was published.”
“In the euro area, while inflation pressures are receding, market participants are concerned about the potential for weaker than expected growth,” he added. “So far, financial markets have demonstrated resilience, with episodes of volatility proving brief and having only a limited impact on the broader financial system. However, underlying financial market vulnerabilities – notably stretched valuations and risk concentration – remain significant, making further bouts of volatility more likely than usual.”
He noted that at the same time that this is occurring, “liquidity fragilities in non-bank financial intermediaries, in some cases coupled with high financial and synthetic leverage, have the potential to intensify and render market stress more enduring. Meanwhile, sovereign vulnerabilities are deepening.”
“Despite recent reductions in debt-to-GDP ratios, fiscal challenges persist in several euro area countries, exacerbated by structural issues such as weak potential growth and heightened policy uncertainty,” de Guindos said. “While non-financial sectors appear broadly resilient, there are credit risk concerns for some euro area households and firms, particularly in the real estate sector and among lower-income households and small and medium-sized enterprises which would be most affected should growth slow.”
The report detailed how the borrowing costs of certain countries – including Italy and Spain, which were at the center of the Eurozone crisis – remain well below the high reached in the market turmoil in the early 2010s, but that hasn’t stopped investors from worrying about the rapidly rising debt in other countries, such as France.
During a call with reporters, de Guindos said that markets have started to pay “more attention to fiscal [risks],” pointing out that “the funding costs of countries with debt-to-GDP ratios of more than 100% widened notably during the recent episodes of financial markets volatility.”
According to FT, “The spread between France’s 10-year bonds and Germany’s — a measure of investor concern over the former’s debt — hit 0.78 percentage points this month, close to the 12-year high reached in the run-up to this summer’s parliamentary election.”
This fact led the ECB to warn that “Headwinds to economic growth from factors such as weak productivity make elevated debt levels and budget deficits more likely to reignite debt sustainability concerns.”
The report discussed the various risks the region is facing, and notably, its warnings about fiscal risks were highlighted more than in previous editions, suggesting that the problem is nearing a breaking point. In the 2023 review, the ECB noted a potential resurgence of doubts over the sustainability of public debt but said, “risks to sovereign debt sustainability appear to be manageable in the short run.”
The ECB should state “very clearly that there are potential threats ahead of us,” de Guindos said, including potential “contagion from other jurisdictions,” referring to the effects that policies enacted by the incoming U.S. president Donald Trump, along with rising U.S. government debt, could have on global markets.
The report also suggested that government funding costs could be pushed higher by macroeconomic shocks, including weak fundamentals and maturing sovereign debt being “rolled over” at higher interest rates.
“Interest costs are set to rise further and weigh on government finances for many years to come, raising the need for timely fiscal consolidation,” the report warned. “Even though ECB policy rates and borrowing costs for euro-area governments are expected to decline further, interest payments on sovereign debt relative to GDP are projected to increase in the medium term and beyond for most euro area countries.”
“This is because, at eight years, the average maturity of sovereign debt is relatively long, as a result of which maturing public debt is still being rolled over at interest rates that are higher than they were a few years ago,” it added. “Higher interest payments will limit the remaining fiscal space further and make timely fiscal consolidation even more important.”
As an example, the report cited EU estimates that interest payments by France would more than double to exceed 4% of GDP by 2034, while Italy’s would rise nearly a third to 6% of GDP.
“Overall, while euro area sovereigns have benefited from the easing of global financing conditions since the end of 2023, their debt service costs are set to rise in the near term, particularly for sovereigns with higher debt-to-GDP levels,” the report said. “In this context, implementing the EU’s revised economic governance framework fully, transparently and without delay will help governments bring down budget deficits and debt ratios on a sustained basis.”
The ECB also warned that the combination of low growth and high government debt could make it more challenging for governments to pay for higher defense needs and investments to tackle climate change.
Regarding financial markets, the report warned that they “remain vulnerable to adverse dynamics which could be amplified by non-bank liquidity fragilities.”
“High valuations and risk concentration render financial markets susceptible to sudden, sharp adjustments, notably in equity markets,” the ECB said. “While stock markets have recently absorbed tail events swiftly, underlying vulnerabilities make them prone to similar episodes in the future. There are signs that investors may be underestimating and under-pricing the likelihood and impact of adverse scenarios, as indicated by record low equity risk premia and relatively compressed corporate bond spreads on both sides of the Atlantic.”
“Also, concentration of equity market capitalization and earnings among a handful of single names, notably in the United States, has increased greatly in recent years,” they added. “This concentration among a few large firms raises concerns over the possibility of an AI-related asset price bubble.”
The report warned that with “deeply integrated global equity markets,” this concentration “points to the risk of adverse global spillovers, should earnings expectations for these firms be disappointed.”
“As such, there is a greater likelihood that negative surprises – including sharply deteriorating economic growth prospects, sudden changes in monetary policy expectations, or further escalation of ongoing geopolitical conflicts – could trigger abrupt shifts in investor sentiment, resulting in spillovers across asset classes,” the report said.
If a major economic downturn were to occur, the ECB warned that bank and investment fund balance sheets could also take a hit as Eurozone consumers and companies are already struggling with higher rates, which could lead to an increased risk of higher losses in commercial real estate.
“In addition, several cross-cutting structural issues remain critical for financial stability and could interact with and amplify existing cyclical vulnerabilities,” the report said. “These issues are associated with climate-related risks − both transition and physical − on the way to a low-carbon economy; cybersecurity weaknesses, including outages of systemic IT providers, and the rise of AI; and geopolitical fragmentation sending global economic, trade and financial integration into reverse.”
“The potential for these cyclical and structural vulnerabilities to materialize simultaneously and amplify one another raises the risks to financial stability, potentially creating adverse feedback loops across various sectors,” the report concluded.
