The European Central Bank (ECB) has said that challenges to financial stability in the eurozone have risen amid risks to growth from trade tensions, and warned that indebted governments, such as Italy, could run into trouble if they do not heed rules limiting debt and deficits.
The warning in an ECB report released yesterday came as Italy’s populist government is challenging the debt rules, saying they are a hindrance to growth and setting up continued conflict with the EU’s executive commission.
Italy’s borrowing costs in bond markets rose this week — a sign of international investor concern — as Italian Deputy Prime Minister Matteo Salvini repeated his opposition to the rules after his League party came in first in elections to the European Parliament.
“Should downside risks to growth materialize, financing costs for vulnerable sovereigns are like to increase and may increase debt sustainability concerns,” the bank said.
It also said that the banking system faces challenges including weak profitability and the failure to cut costs.
ECB Vice President Luis de Guindos said that the economy performance is key to financial stability.
The central bank still expects growth to pick up in coming months after a period of weakness, but it cautioned that external threats, such as trade tensions, could undermine that.
Weaker growth saps tax revenues, which help governments pay off bonds, and undermines bank profits as well.
Italy’s debt is connected to the banking system, because banks hold Italian bonds and their finances could take a hit from a fall in their value or default. Banks are key to the eurozone economy, as that is where companies get credit to operate and expand.
Troubles over Italian debt played a large role in the eurozone’s debt crisis from 2010 to 2012, threatening to break up the currency union and helping topple the government of then-Italian prime minister Silvio Berlusconi in 2011.
The European Commission, charged with enforcing the debt and deficit limits that come with joining the 19-country eurozone, has sparred with Italy over the government’s push to run larger deficits, spend more and cut taxes.
The ECB report contained a chart showing Italy as an outlier among indebted countries, with high financing needs through next year and low growth compared with borrowing costs, a measure known as the “snowball effect.”
Italy has failed to significantly reduce a heavy debt burden that amounted to 132 percent of GDP at the end of last year, due to years of slow growth.
Salvini, emboldened by his party’s gains in European parliamentary elections, on Tuesday said that his party’s first proposal in Brussels would be to propose a new role for the ECB as a guarantor of government debt.
He is also pressing his proposal for a flat tax and challenging EU budget rules, saying that spending should be loosened to allow more government investment in things like schools.
Salvini also has grown increasingly combative in the face of a prospect of warning letter from the European Commission on Italy’s public debt.
Borrowing costs on Italian debt have risen sharply in the past few days. While still relatively low in historical terms, the rise suggests investors are more cautious about Italy’s economic prospects.
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