Germany facing rising financial stability risk, Bundesbank warns

FRANKFURT (Reuters) -Germany is facing rising risks to its financial stability from erratic U.S. economic policy, overvalued equity markets, excessive debt levels around the world and souring bank credit, the Bundesbank warned on Thursday.

The German economy, Europe's largest, has been stagnant for the past three years and deeply rooted structural rigidities are holding back its recovery, even if sharply increased government spending on defence and infrastructure will likely provide some boost in the coming years.

Outlining a long list of vulnerabilities, the central bank concluded that overall risk was on the rise as economic weakness was seeping into various corners of the economy, with tariffs exacerbating risks.

ERRATIC U.S. TRADE POLICY, STRUCTURAL CHALLENGES

"The erratic course of U.S. trade policy is weighing on the global economy, not least on Germany’s export-dependent industry," Bundesbank board member Michael Theurer said in the annual Financial Stability Review. "At the same time, structural challenges are weighing on the German corporate sector to an increasing degree."

Even if the EU has already concluded a trade deal with the U.S., the environment remains far too uncertain and this will weigh on German banks' credit quality, the Bundesbank added.

The volume of non-performing loans has been on the rise for some time, mostly because of problems in commercial real estate. Even if credit defaults are still "within manageable territory," banks are increasingly needing to make value adjustments to their loans.

RISING DEBT LEVELS THREATEN STABILITY

The Bundesbank is also worried about rising debt levels both within the EU and outside it, since this raises debt sustainability worries.

"Given how deeply Germany’s financial system is integrated into the European financial system and in light of the sovereign-bank nexus, this could pose a considerable risk to the stability of the German financial system," it added.

"Recently amended national fiscal rules will guarantee neither long-term sustainability nor compliance with EU fiscal rules," it added.

The problem is that Europe needs to achieve persistently stable economic growth to make debt more sustainable but that would require fundamental economic reforms since its potential growth is stuck at around 1.3-1.4% a year, economists say.

The Bundesbank is also worried about equity market and corporate debt valuations, which are above long-term averages, raising the risk of a correction.

"Experience has taught us that markets can change their assessments in an instant," Theurer said. "Market price corrections could then trigger considerable losses among financial intermediaries."

(Reporting by Balazs Koranyi; Editing by Conor Humphries)