Eurozone starting to see ‘light at the end of the tunnel’ – de Guindos

Faster vaccination programmes in the eurozone were “offering a route out of the pandemic”, the vice-president of the European Central Bank, Luis de Guindos, said today (May 19).

Presenting the ECB’s Financial stability review, he warned the uneven effect of the pandemic across countries and economic sectors would be a challenge during the recovery. Additionally, he pointed out corporate insolvencies could rise, should governments withdraw support programmes.

Public guarantees accepted by banks to provide businesses with credit could also reinforce the sovereign-bank nexus at a time when public debt ratios had surged across the region. Nonetheless, de Guindos emphasised that the medium-term outlook was improving, and the pandemic’s worst effects could already be in the past.

“We assess that vulnerabilities for our stability are still quite elevated. But behind that we do see some improvement,” the vice-president said. “We continue identifying relevant risks, but we have started to see light at the end of the tunnel.”

Lower contagion levels would likely allow a progressive reopening of the economy. However, as governments feel more confident about withdrawing emergency measures, businesses may be exposed to new risks. In fact, the report says solvency risk in the corporate sector is set to increase precisely because of this factor.

“The impact of the pandemic on corporates is increasingly concentrated in the services sectors and among [small and medium-sized enterprises],” says the report. “This implies that a sudden tightening of financing conditions or a further delayed economic recovery could have more severe implications for financial stability than the aggregate picture suggests.”

Sovereign outlook

The protection that governments have been granting businesses has also boosted public debt levels. The aggregate sovereign debt-to-GDP ratio in the region rose to 100% in 2020, up from 86% of GDP in 2019. In some large economies, this ratio is even higher.

For instance, in France it has risen from 98% in 2019 to 113% last year, in Italy from 135% to 156%, and in Spain from 96% to 117%, according to the International Monetary Fund. Because of the unprecedented shock created by the pandemic, in March 2020, the European Commission temporarily suspended the Stability and Growth Pact, which requires governments to keep deficits below 3% of GDP and trim public debt ratios to 60%.

This measure, alongside hefty ECB sovereign bond purchases, has allowed governments to finance higher debt issuance at favourable conditions.

“On the sovereign side, we have seen fiscal support continue raising sovereign debt positions. Governments have so far [had] no problems financing this, despite quadrupling debt issuance,” said de Guindos. “We also note that they have taken advantage of conditions that have reduced rollover risk.”

Nevertheless, the ECB’s report points out that the pandemic could push sovereign debt levels even higher if the economic outlook deteriorates again.

Increases in public debt, delays in the implementation of the European Union recovery fund or the emergence of a sovereign-bank-corporate nexus are key risks for the eurozone. The report stresses these could “trigger a reassessment of sovereign risk by market participants and reignite market pressures on more vulnerable sovereigns”.

As a result, the ECB vice-president said governments with higher debt ratios would “have to put in place plans and programmes in order to guarantee in the near term fiscal sustainability”.

Market exuberance

Additionally, the Financial stability review highlights the abrupt market corrections recorded in January and February, when US Treasury yields rapidly increased. This has “revived concerns about the potential for shifts in financial conditions”, the report says: “This could affect indebted corporates, households, sovereigns and those investors that have become increasingly exposed to duration, credit and liquidity risk in recent years.”

These trends have increased concerns about abrupt interest rate hikes, and the potential for future spillovers.

Bank weaknesses

The Financial stability review acknowledges that “market sentiment towards banks has substantially improved” – for instance, bank stock prices have risen since October 2020.

But the sector’s low profitability remains a challenge, in a context where the outlook for credit demand remains uncertain.

“Bank asset quality has been preserved so far, but credit risk may materialise with a lag, implying a need for increased loan loss provisions,” says the report. “Effective [non-performing loan] solutions and full use of available capital buffers are needed to support the recovery.”

Additionally, non-banking financial institutions were heavily exposed to asset price corrections, said de Guindos. The ECB has identified increases in duration in the portfolio investments of insurance companies and investment funds, which could make them more vulnerable.