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The European Central Bank (ECB) has raised the alarm over a potential resurgence of eurozone sovereign debt vulnerabilities, as elevated debt levels, sluggish growth, and fiscal slippage converge into a dangerous cocktail.

In its latest November 2024’s Financial Stability Review, the ECB warns that these factors, coupled with geopolitical tensions and policy uncertainty, could reignite fears of a sovereign debt crisis akin to the turmoil a decade ago.

“Elevated debt levels and high budget deficits, coupled with weak long-term growth potential, increase the risk that fiscal slippage will reignite market concerns over sovereign debt sustainability,” the monetary institution stated.

Rising debt costs heighten financial stability risks

The ECB warns that the era of cheap borrowing is firmly over.

Maturing debt is now being rolled over at significantly higher interest rates, pushing up sovereign debt service costs.

This dynamic poses particular risks for high-debt countries where limited fiscal space could leave governments vulnerable to sudden market shocks.

Geopolitical tensions exacerbate the problem. Energy subsidies and other fiscal measures aimed at mitigating global disruptions are further stretching budgets.

“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.” ECB vice-president Louis de Guindos remarked.

The numbers don’t lie

Debt levels across the eurozone remain a glaring concern, with significant imbalances between member states highlighting the bloc’s underlying fragility.

While the eurozone’s average debt-to-GDP ratio stands at 88.1%, as per the latest Eurostat data, this figure conceals stark contrasts.

Greece leads with a towering debt ratio of 163.6%, followed by Italy at 137% and France at 112.2%. Meanwhile, fiscally disciplined countries like Germany and the Netherlands boast much lower ratios, at 61.9% and 43.2%, respectively.

Looking ahead, the outlook for debt sustainability is increasingly worrying in some of the eurozone’s largest economies. While the broader region’s government debt levels are projected to remain relatively stable, certain member states face a dangerous upward trajectory.

The International Monetary Fund (IMF) in its latest October Fiscal Monitor forecasts that by 2029, France’s debt-to-GDP ratio will climb from 112% to 124.1%, while Italy’s will surge to a staggering 142.3%, up from 136.9%. Belgium, too, is expected to see its debt rise sharply, from 105% to 119%.

These figures underscore growing vulnerabilities that could leave heavily indebted nations struggling to manage fiscal pressures in an environment of higher interest rates and subdued economic growth.

A déjà vu for markets?

The markets, so far, have remained relatively calm, with volatility spikes proving short-lived. However, underlying vulnerabilities suggest that calm may not last. Fiscal slippage in high-debt countries could reignite market concerns, leading to widening bond spreads reminiscent of the eurozone debt crisis a decade ago.

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The ECB acknowledges that “heightened policy and geopolitical uncertainty, weak fiscal fundamentals, and sluggish trend growth raise concerns about the sustainability of sovereign debt in some euro area countries.”

“While financial markets have proved resilient so far, there is no room for complacency. Underlying vulnerabilities make equity and corporate credit markets prone to further volatility,” Frankfurt warns.

The corporate domino effect

The corporate sector is not immune to sovereign vulnerabilities. Rising sovereign bond yields could spill over into the private sector, driving up funding costs for companies.

This would be particularly damaging for small and medium-sized enterprises (SMEs), which are already under pressure from high borrowing costs and weak growth.

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“High borrowing costs and weak growth prospects continue to weigh on corporate balance sheets, with euro area firms reporting a decline in profits due to high interest payments,” the ECB stated.

Banking resilience: A silver lining?

Unlike during the previous debt crisis, eurozone banks are better capitalised and more profitable, providing a buffer against potential sovereign and corporate credit shocks.

However, the interconnectedness of sovereign and bank risks—known as the “doom loop”—remains a concern. A deterioration in sovereign creditworthiness could erode bank balance sheets, potentially triggering a broader financial instability.

The ECB advises regulators to keep banks’ capital buffers strong and uphold rules ensuring borrowers can repay loans, aiming to maintain financial stability and prevent risky lending.

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An old crisis, new risks

The ECB’s warning is clear: the eurozone is not out of the woods. Elevated debt, weak growth, and fiscal slippage are laying the groundwork for potential market turbulence.

For now, the message from Frankfurt is unequivocal: vigilance is paramount, and complacency is not an option.

Without decisive action to address these vulnerabilities, the region risks sliding into a new sovereign debt crisis.