Soaring government debt levels threaten to make investors reassess European sovereign risk and could “reignite pressures” on more vulnerable countries in the region, the European Central Bank has warned.

Eurozone governments’ budget deficits will rise to 8 per cent of gross domestic product on average this year, far above the levels reached after the 2008 financial crisis, the central bank forecast in its annual financial stability review, published on Tuesday.

Aggregate government debt is set to rise from 86 per cent of GDP to above 100 per cent across the 19-country bloc as member states seek to tackle the economic impact of the coronavirus crisis, the ECB said.

“The pandemic represents a medium-term challenge to the sustainability of public finances,” the financial stability review warned.

Public debt is set to approach 200 per cent of GDP in Greece and 160 per cent in Italy, and will hit 130 per cent in Portugal and just below 120 per cent in France and Spain, the ECB said, adding: “The associated increase in public debt levels could also trigger a reassessment of sovereign risk by market participants and reignite pressures on more vulnerable sovereigns.”

Italy must refinance more than 15 per cent of its debt in the next year, while that figure is more than 10 per cent for France, Spain, Belgium, Finland and Portugal, the ECB said, calling some countries’ repayments in the coming two years “substantial”.

A decade ago, fashionable economic thinking suggested that beyond 90 per cent of GDP, government debt levels became unsustainable. Although most economists do not now believe there is such a clear limit, many still think that allowing public debt to build up ever higher would threaten to undermine private-sector spending, creating a drag on growth.

Debt levels are rising across the world as countries turn to the capital markets to finance public-sector responses to the economic impact of coronavirus. The OECD club of rich countries forecasts that its members will take on at least $17tn of extra public debt as a result of the crisis, increasing average financial liabilities from 109 to 137 per cent of GDP.

The ECB, which is due to update its economic forecasts and review its monetary policy next week, has predicted that the eurozone will suffer its deepest postwar recession this year, with GDP set to contract by between 5 and 12 per cent. 

It warned on Tuesday that a more severe downturn than expected risked putting public finances “on an unsustainable path in already highly indebted countries”, if combined with higher government borrowing costs and borrowers’ defaults resulted in loan guarantees being called in by lenders.

Eurozone governments are set to issue an expected €1.2tn of extra debt this year, although the ECB has positioned itself to soak up a large proportion of that through the €750bn bond-buying plan it launched in March.

Last week’s Franco-German proposal to create a €500bn European recovery fund could provide grants to support countries hit hardest by the pandemic, offering additional financial help.

The ECB said on Tuesday that although countries’ “large fiscal policy response” helps to mitigate the economic cost of the coronavirus crisis and “provid[es] a first line of defence against fiscal debt sustainability concerns”, a more severe and protracted economic downturn “could give rise to debt sustainability risks in the medium term”.

The pandemic risked adding further stress to the eurozone’s existing financial vulnerabilities, it added, citing “overvalued asset prices, low bank profitability, high sovereign indebtedness and increased liquidity and credit risks in the non-bank sector”.

Raising the alarm about the so-called doom loop between governments and banks that hold high levels of their domestic public debt, the ECB said this created “risks of negative feedback loops arising from sovereign or bank rating downgrades”.

“Such a development could reactivate the negative feedback loops of the sovereign-bank nexus, especially for Italy and Portugal, as well as for Spain, where bank ratings are closest to non-investment grade,” it said.

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