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ECB warns virus response could renew fears of euro breakup

Frankfurt - Government spending 'has softened the impact, and is expected to support economic recovery'

A vast fiscal fightback to the coronavirus crisis unleashed by eurozone governments could raise questions about capitals' ability to repay debts and revive the threat of countries exiting the single currency, the European Central Bank warned on Tuesday.

"Should measures taken at the national or European level be deemed insufficient to preserve debt sustainability, the market assessment of redenomination risk might rise further," the ECB said in its biannual Financial Stability Report.

"Redenomination risk" refers to the danger of some countries quitting the euro - or the single currency collapsing altogether.

Indicators of the risk have surged for Spain and Italy in the first half of 2020, while France's have picked up slightly.

The ECB forecasts that eurozone public debt as a share of output will grow by between seven and 22 percentage points in 2020 as governments borrow hundreds of billions to support their economies, driving the total debt-to-GDP ratio in the region from 86 to almost 103 percent.

In normal times, eurozone countries target public debt below 60 per cent, although that boundary has been suspended during the pandemic crisis.

The ECB highlighted that government spending "has softened the impact, and is expected to support economic recovery".

So far, the Frankfurt institution's announcements of over 1 trillion euros ($1.1 trillion) in bond-buying this year alone have kept a lid on investors' perceptions of comparative risk between highly-indebted and fiscally unencumbered nations.

But the so-called "spreads" - differences between the yields on countries' debt - "might increase if investors assess that public debt sustainability has deteriorated," the ECB said .

"A more severe and prolonged economic contraction than envisaged.... would risk putting the public debt to GDP ratio on an unsustainable path," prompting fears to "cascade" to the rest of the economy, the central bank warns.

Market players could question the value of banks' sovereign bond holdings, as well as governments' ability to uphold the state guarantees that have helped keep credit flowing to non-financial firms through the virus crisis.

The ECB reiterated its longstanding message that more joint action at the European level could keep government debt sustainable for individual nations.

More bonds from "highly rated European entities" rather than national capitals "will arguably reduce overall sovereign funding costs and, in some jurisdictions, decrease sovereign spreads," the central bank economists wrote.

Last week France and Germany presented taboo-breaking plans for the European Union to jointly borrow 500 billion euros to foot the bill for rebuilding the economy after the virus crisis has passed, although so-called "frugal" nations like Austria and the Netherlands have resisted.

The European Commission is set to unveil its own proposals on Wednesday.