ECB Warns Iran War Fallout Increasing Financial Risks Across Europe
ECB Financial Stability Report Highlights Key Risks
Impact of Iran War and Trade Tensions on Euro Zone Economy
FRANKFURT, May 27 (Reuters) - The Iran war and lingering trade tensions could dent euro zone economic growth, push up borrowing costs and challenge some member states' ability to sustain public budgets, a European Central Bank report concluded on Wednesday.
Market Reactions and Investor Complacency
Financial markets have mostly shrugged off the war in Iran, leaving stocks at rich valuations, corporate borrowing costs low and the spread between sovereign bond yields across the 21-nation bloc at low levels, raising fears that investors may be complacent about risks.
Risks of Abrupt Repricing and Fiscal Sustainability
"A scenario of notably weaker growth associated with a more persistent energy shock could trigger a reassessment of fiscal sustainability and an abrupt repricing in sovereign bond markets," the ECB said in a biannual Financial Stability Report.
Such a repricing could then raise corporate borrowing costs, setting off a feedback loop that could endanger financial stability and hit the real economy.
Government Financing Needs and Fiscal Pressures
This risk is especially acute because governments are already financing a long list of urgent projects, limiting their fiscal buffers and their room to manoeuvre.
Medium-Term Pressures from Defence and Green Transition
"High sovereign financing needs related, among other things, to defence spending, the green transition and potential fiscal measures to cushion households and firms from rising energy prices, are likely to add to pressures over the medium term," the ECB added.
Role of Hedge Funds and Non-Bank Financial Intermediaries
Hedge Fund Exposure and Market Liquidity
Compounding this issue is the increasing exposure of hedge funds in government bond markets. While their presence increases liquidity in normal times, hedge funds are often highly leveraged, making price movements more sensitive to changes in sentiment, the central bank said.
Risks from Non-Bank Financial Intermediaries
Any selloff in debt markets may also be exacerbated by relatively opaque non-bank financial intermediaries, which tend to be less liquid, carry greater leverage and enjoy more relaxed regulation.
Interconnectedness with Traditional Lenders
Such intermediaries have widespread ties with more traditional lenders and could infect an otherwise healthy bank sector, the ECB argued.
"The potential for these highly interconnected risks to materialise simultaneously, possibly amplifying each other further, increases the risks to financial stability," the central bank said.
Global Spillover Risks and U.S. Debt Concerns
Pointing to another such interconnection, the ECB also warned that concerns over debt sustainability in the U.S. could infect Europe.
U.S. Treasuries have been a safe haven but concerns over the credibility of U.S. budget policies could lead to an abrupt change in perceptions, which would then have a global impact.
AI-Related Firms and Debt Financing Risks
The ECB also noted that markets are signalling concerns about the increased reliance of AI-related firms on debt financing, which warranted attention.
(Reporting by Balazs Koranyi; Editing by Lincoln Feast.)