The euro-area economy is still facing severe threats even after policy makers took unprecedented measures to tackle the coronavirus pandemic, according to the European Central Bank.
The deep recession has exposed new risks to the financial system and exacerbated pre-existing ones, the ECB said in its Financial Stability Review. That stress on banks could hamper their ability to support the economic recovery.
Significantly higher debt, weaker bank profitability, and market fragility will continue to cast a shadow over the region as nations slowly return to normal, the report showed. The probability of corporate defaults and falling real-estate prices — a key risk for the sector — has also increased.
Just a day earlier, the European Banking Authority warned that lenders could face a €315bn ($345bn) hit to their capital levels due to loan losses and an increase in risky assets on their balance sheets.
The report underscores the challenge politicians and central bankers will face in coming years despite the trillions of euros in monetary support and government spending that have already been deployed. Much still depends on how the outbreak develops and whether lockdowns will have to be tightened again to limit the spread of the virus.
“The pandemic has caused one of the sharpest economic contractions in recent history,” ECB vice president Luis de Guindos said in a statement. “The repercussions of the pandemic on bank-profitability prospects and medium-term public finances will need to be addressed so that our financial system can continue to support the economic recovery.”
The primary response by governments so far has been providing massive financial backstops to keep businesses afloat and workers from losing their jobs.
Problems could arise if the recession turns out to be worse than expected, forcing governments to pay out more aid. Higher debt levels could “reignite pressures on more vulnerable sovereigns,” the central bank said.
The report shows public debt among euro-area member states rising to 103% of GDP from 86% last year because of the support measures and a fall in tax revenue. The economy may shrink as much as 12% this year.
The ECB has already attempted to tackle concerns over debt sustainability. It unleashed a €750bn emergency asset-purchase program after bond yields rose sharply in countries with higher debt burdens, particularly Italy.
Economists expect the program to be topped up as soon as the ECB’s meeting next week.
The ECB acknowledged that ultra-low interest rates — which it flagged in earlier reports as a potential source of financial instability — will now probably be around for longer. Coupled with the drop in asset prices, that’s a risk to bank profitability, and “insurers’ solvency could be significantly weakened.”
Companies are at greater risk of credit-rating downgrades that could push up their funding costs, especially exposing those that loaded up on debt in recent years amid low interest rates.
Likewise, housing and commercial real estate pose a risk, as “high asset valuations prior to the shock probably exacerbated the market correction.”
The ECB report ended with a call to strengthen the bloc’s capital markets to help the recovery and cope with additional risks such as Brexit.
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