FRANKFURT (Reuters) – Europe’s coronavirus pandemic has amplified financial vulnerabilities, raising the spectre of further crises ahead as debt levels soar and banks struggle, the European Central Bank said on Tuesday.
With the euro zone economy expected to shrink by a tenth this year, governments have pulled many stops to limit the damage but there is a longer-term price to pay and some countries could struggle to repay their debts, increasing the risk of them crashing out of the euro zone, the ECB added.
Highly indebted companies may also fail to cope while ultra-low bank profitability and the rising risk of a real estate correction are also part of a volatile mix, the ECB said in its biannual financial stability report.
“Even as infection rates fall in many countries, the impact on the economy and markets has unearthed and increased existing vulnerabilities for euro area financial stability,” the ECB said.
The aggregate government euro zone debt level could exceed 100% of GDP this year, well above debt-crisis levels, and could near 160% in Italy, which is already facing rising market bets that it would have to leave the single currency.
“Should measures taken at the national or European level be deemed insufficient to preserve debt sustainability, the market assessment of redenomination risk might rise further,” the ECB added.
Higher debt yields for vulnerable euro zone states could then cascade to the private sector and hit banks that are already facing significant losses.
The first risk to materialize may be a raft of corporate rating downgrades, which could limit the real economy’s access to funding.
Downgrades to non-investment grade status are inevitable, forcing some, like pension funds or insurers, to sell. But the market for high-yield debt is relatively small so this could trigger a bond sell-off, the ECB added.
The ECB is only buying investment grade debt, but is studying options to buy firms downgraded to junk during the current crisis.
(Reporting by Balazs Koranyi; editing by John Stonestreet)