The rising debt levels of eurozone governments and companies have made it more likely that economic aftershocks from the coronavirus pandemic could trigger financial instability, the European Central Bank has warned.
While the economic outlook has brightened recently due to falling infection rates and accelerating vaccinations, the ECB said on Wednesday in its twice yearly financial stability review that the bloc was still far from safe.
“We are optimistic that financial and economic conditions will bounce back,” said Luis de Guindos, vice-president of the ECB. “There is, however, a reality that the pandemic will leave a legacy of higher debt and weaker balance sheets, which — if unaddressed — could prompt sharp market corrections and financial stress or lead to a prolonged period of weak economic recovery.”
The aggregate debt of eurozone governments rose from 86 per cent of gross domestic product in 2019 to 100 per cent last year, the ECB said, although it noted that this was mitigated by current low interest rates, which reduced the cost of financing the debt. Sovereign debt levels will remain elevated next year, when more than half of the 19 eurozone countries will still have budget deficits above 3 per cent of GDP, the ECB forecasts.
“Vulnerabilities from the outstanding stock of debt appear higher than in the aftermath of the global financial crisis and the euro area sovereign debt crisis, although debt servicing and rollover risks appear more benign given continued favourable sovereign financing conditions in terms of both pricing and duration,” it said.
De Guindos said the ECB would continue to maintain “favourable financing conditions” for governments, businesses and households and that any withdrawal of monetary policy stimulus “has to be gradual, it has to be very prudent” and in line with the economic recovery.
But he warned that once the eurozone economy returned to its pre-pandemic level of output — which the ECB expects to happen by the middle of next year — “it is very important for governments to lay out fiscal consolidation plans that are credible” to reduce debt levels.
Government loan guarantees and implicit support for big companies, such as airlines, could increase national debt levels further, the ECB said, warning of a “sovereign-bank-corporate nexus”. It said public sector loan guarantees were potentially worth about 14 per cent of GDP, but so far take-up of these guarantees has been worth 4 per cent of GDP.
The rise in corporate debt levels had been highest at the most leveraged companies, the ECB said. Companies in the 90th percentile of indebtedness have increased their debt-to-equity ratios from 220 per cent before the pandemic to more than 270 per cent by the end of last year.
The number of companies going bankrupt in the eurozone fell by a fifth last year, despite a record postwar recession. De Guindos said bankruptcies would rise this year, but the scale of any increase would depend on how fast government support was withdrawn.
The commercial property market has been hit by a shift to remote working and online shopping during the pandemic and the ECB said that real estate price falls were likely to accelerate, posing a threat to eurozone banks as this sector accounts for 7 per cent of their private sector loans.
Noting that equity markets had “exhibited remarkable exuberance” even after the sell-off in US bond markets which began earlier this year, the ECB said “significant price volatility raises questions about the transparency and degree of leverage in financial markets”.
The central bank also said a recent surge in the price of bitcoin had “eclipsed previous financial bubbles like the ‘tulip mania’ and the South Sea Bubble in the 1600s and 1700s”. But while it called the cryptocurrency “risky and speculative” it concluded that its “financial stability risks appear limited at present”.