The deceleration of economic growth, increase in borrowing costs and reversal of the European Central Bank's accommodative monetary policy threaten to throw the eurozone into another debt crisis.

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Government debt-to-GDP levels fell in 2021 as economies rebounded from the COVID-19 lows, but with that bounce now past, six eurozone countries have swollen government debt-to-GDP levels of over 100% including France, Italy and Spain, the economic bloc's second-, third- and fourth-largest economies, respectively.

The eurozone is in a technical recession following two consecutive quarters of 0.1% declines in GDP. Rising interest rates are likely to put further pressure on the economy at a time when borrowing costs are increasing, raising the question of debt sustainability and rekindling memories of the debt crisis in the region in the early 2010s, when Portugal, Ireland, Italy, Greece and Spain all flirted with default as government borrowing costs soared.

"Weak growth, higher rates and more pressure to step up public investments are enormous risks to debt sustainability," said Carsten Brzeski, global head of macro at ING. "Markets are currently ignoring it as they are more focused on central banks. But this can change quickly."

Anemic growth

Recent economic indicators suggest continued economic weakness. Retail sales were down 2.6% in April and industrial production remained sluggish in Germany, the region's manufacturing heavyweight. Growth in industrial production was just 0.3% in April with energy-intensive production still struggling under the weight of high energy costs. Across the whole eurozone — excluding volatile data in Ireland — industrial production contracted by 0.8% in the month.

"On the growth side we are a bit concerned that we may see growth struggling, at least for a year," said Diego Iscaro, senior Europe economist at S&P Global Market Intelligence. "We haven’t seen the full impact of borrowing costs and there the impact is likely to peak in late 2023 to early 2024."

The German economy grew by 1.8% in 2022, but the International Monetary Fund forecasts that to decline to a 0.1% contraction in 2023 and not return to 1.8% growth until 2026. Italy has an even worse prognosis with a peak growth rate of 1.1% in 2026.

The ECB increased rates by a further 25 basis points to 3.5% on June 15 — up from -0.5% a year ago — as the bank battles to return inflation to its goal of around 2%. This increased tightness in lending is likely to further squeeze economic activity and may be prolonged if inflation proves to be sticky.

The strength in rates will likely push up yields on sovereign debt, raising borrowing costs further for heavily indebted countries such as Italy and France, where yields on 10-year debt have already reached 3.98% and 2.87%, levels last seen a decade earlier during the region's debt crisis.

"We have a bias to wider spreads as the full economic impact of the very aggressive hiking cycle has not yet fully filtered through in our view," said Matt Cairns, head of credit strategy and regulation at Rabobank.

The ECB's attempts to unwind its quantitative easing program in the face of inflation are adding to the stress. The bank's decision to stop reinvesting the proceeds of its asset sales from July effectively accelerates the pace of quantitative tightening from about €15 billion per month to roughly €25 billion per month, according to HSBC. The ECB's balance sheet peaked at more than €8.500 trillion in 2021 after years of purchasing government bonds and other securities to keep long-term interest rates low and stimulate economic activity.

"The main upward risk on yields comes from the ECB withdrawing from bond markets," Iscaro said. "The private sector will need to step up and replace the ECB and that is likely to lead to a further increase in bond spreads and borrowing costs."

The demand on private investors will also be tested by the volume of maturing debt. While the typical average debt maturity among eurozone countries is between seven and nine years, some nations have a large amount maturing in the next two years, most notably Italy and France at 39.1% and 25.9%, respectively, according to Oxford Economics.

"Our view is we are not out of the woods yet in terms of pressure on spreads," Cairns said. "More signs of stress may well emerge in the next quarters."

Fiscal consolidation

Government spending is likely to increase rather than decrease in the near term to counteract the threat of recession, putting further pressure on government balance sheets.

"With energy transition, derisking and demographics, all governments will be confronted with a huge push for more spending. In such an environment, stabilizing rather than reducing debt ratios is probably the best we could get," Brzeski said.

While government debt-to-GDP fell in 2022, the weak projected growth outlook may eventually force highly indebted governments such as Italy and France to make tough spending decisions. Eurozone countries broadly pursued austerity measures following the debt crisis in the 2010s, which were largely viewed as harming economic growth.

"It's a problem that a quite strong rebound in activity last year masked," Iscaro said. "There will be some degree of fiscal consolidation but then we look at the past track record in Europe, it's quite mixed. The picture is quite complex and quite fragile."