The consequences of the war in Iran are strengthening financial vulnerabilities/ ECB warning for the Eurozone. Borrowing costs expected to increase
The war with Iran and ongoing trade tensions could harm eurozone economic growth, raise borrowing costs and challenge the ability of some member states to support public budgets, a European Central Bank report has warned.
Financial markets have largely ignored the war in Iran, leaving stocks at high 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.
"A scenario of significantly weaker growth coupled with a more persistent energy shock could trigger a reassessment of fiscal sustainability and an immediate repricing in sovereign bond markets," the ECB said.
Such a revaluation could raise corporate borrowing costs, triggering a feedback loop that could endanger financial stability and hit the real economy. This risk is particularly acute because governments are already financing a long list of urgent projects, limiting their fiscal cushions and their room for maneuver.
"High sovereign financing needs, linked, among other things, to defense spending, the green transition and possible fiscal measures to protect households and firms from rising energy prices, are likely to add to pressures in the medium term," the ECB added.
Compounding the issue is the growing exposure of hedge funds to 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.
Any sell-off in debt markets could also be exacerbated by relatively obscure non-bank financial intermediaries, which tend to be less liquid, have greater leverage and enjoy more relaxed regulation.
Such intermediaries have extensive connections to more traditional lenders and could infect an otherwise healthy banking sector, the ECB argued.
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