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European countries are “vulnerable to adverse shocks” from geopolitical tensions and persistently high interest rates because of their failure to keep reducing their public debt, the European Central Bank has warned.
In its twice-yearly financial stability review, the ECB said many European governments had not fully reversed the support measures introduced to shield consumers and businesses from the impact of Covid-19 and the war in Ukraine.
It argued that the combination of “high debt levels and lenient fiscal policies” could spook investors. This in turn could “raise borrowing costs further and have negative financial stability effects, including via spillovers to private borrowers and to sovereign bondholders”, it said.
It also warned that markets could react to the risks of “fiscal slippage” in the run-up to elections expected this year and next, including in the European parliament, Germany, Austria and Belgium.
The ECB said risks to the financial system had mostly receded in recent months, with household and corporate debt falling below pre-pandemic levels. But it added that sovereign debt was likely to stay high, identifying “lax fiscal policies” as a primary concern.
While economic activity is expected to pick up in the next couple of years, supported by resilient labour markets, lower inflation and expected cuts to interest rates by the ECB from next month, it said “structural challenges . . . remain a drag on productivity and growth”.
Combined with signs of increased losses in commercial property, the ECB said the “outlook remains fragile” and “financial markets remain vulnerable to further adverse shocks”.
It argued that expectations of imminent interest rates had “boosted optimism” among investors but cautioned that the “sentiment could change rapidly”.
The warning from the ECB came after the EU published updated economic forecasts, in which it estimated that Eurozone governments’ net borrowing would decline from 3.6 per cent of GDP last year to 3 per cent this year and 2.8 per cent in 2025.
But it said overall government debt was expected to remain above pre-pandemic levels at 90 per cent of GDP across the bloc in 2024, then tick up slightly next year.
The ECB has attempted to add extra bite to the EU’s new fiscal rules by warning that any countries not complying with Brussels’ debt-reduction recommendations in its excessive deficit procedure could be excluded from the central bank’s new but untested bond-buying programme.
Brussels indicated that as many as 11 EU countries including France and Italy were likely to be reprimanded for being in breach of the 3 per cent budget deficit limit under the revamped fiscal rules, which came back into force this year.
However, ECB vice-president Luis de Guindos said on Thursday that this issue would be considered under its so-called transmission protection instrument, which allows it to buy the bonds of any country judged to have an unwarranted rise in borrowing costs.
“We will go further and beyond the terms of any excessive deficit procedure of any particular country,” he said.
Borrowing costs for European governments have dropped from recent highs as investors anticipate the ECB will soon start cutting rates in response to falling inflation, which is now close to its 2 per cent target.
The spread between the 10-year borrowing costs of Italy and Germany — which is closely tracked as an indicator of financial stress — has fallen close to two-year lows.
The ECB, however, said: “Uncertainties around the exact implementation of the new EU fiscal framework could lead market participants to reprice sovereign risk.”
Commercial property markets have suffered a “sharp downturn”, the ECB warned, adding that prices of office buildings and retail sites could fall further due to “structurally lower demand”.
The ECB sets monetary policy for the 20 Eurozone member states and supervises the currency bloc’s biggest lenders. It said the Eurozone banking system was “well equipped to weather these risks, given strong capital and liquidity positions”.
But it warned that “insufficient cash buffers” could lead to “forced asset sales” by real estate investment funds “particularly if the downturn in the real estate market were to persist or intensify”.
