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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”. Luis de Guindos, ECB vice-president, also pointed to “poor historical compliance with EU fiscal rules” by some EU governments.
The borrowing costs of countries such as Italy and Spain, which were at the centre of the Eurozone crisis, remain far below the peaks they reached in the market turmoil more than a decade ago. But investor worries have recently risen over debt in countries such as France.
De Guindos told reporters during a call that markets have started to pay “more attention to fiscal [risks]”. He pointed out that “the funding costs of countries with debt-to-GDP ratios of more than 100 per cent widened notably during the recent episodes of financial markets volatility”.
The spread between its 10-year bonds and Germany’s — a measure of investor concern over its 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.
“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 ECB warned.
During the Eurozone 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.
The Financial Stability Review focuses on risks to the region but its warnings about fiscal risks are more outspoken than in previous editions. While the ECB mentioned a potential resurgence of doubts over the sustainability of public debt, it noted in 2023 that “risks to sovereign debt sustainability appear to be manageable in the short run”.
De Guindos said the ECB should state “very clearly that there are potential threats ahead of us”, including potential “contagion from other jurisdictions,” pointing to US president-elect’s Donald Trump unclear fiscal plans and high US government deficit.
The ECB said government funding costs could be pushed higher by macroeconomic shocks, highlighting “weak” fundamentals and maturing sovereign debt being “rolled over” at higher interest rates. It cited EU estimates that interest payments by France would more than double to exceed 4 per cent of GDP by 2034, while Italy’s would rise a third to just under 6 per cent of GDP.
The combination of low growth and high government debt in the 20-country bloc could make it more difficult for governments to pay for higher defence needs and investments to tackle climate change, the central bank said.
The European Commission last week downgraded its 2025 growth forecast for the Eurozone to 1.3 per cent, warning the region was set to fall further behind the US.
The ECB also pointed to “high valuations and risk concentration” that threaten “sharp adjustments” in the equity and bond markets.
It added that “recent market corrections have not dissipated concerns over the overvaluation of equity markets or the potential for an artificial intelligence-related asset price bubble”.
In a potential economic slump, bank and investment fund balance sheets could also take a hit as Eurozone consumers and companies are already struggling with higher rates, the ECB said, noting the heightened risk of higher losses on commercial real estate.
