ECB warns about Italian contagion risk, over-valued property

FRANKFURT (Reuters) – Rising tension on the Italian bond market could affect other indebted countries in the euro zone, the European Central Bank said on Thursday, in a warning about the risk of a disorderly surge in borrowing costs.

Detailing a long list of risks in a regular stability review, the ECB warned that Italy’s high spending, the possible end of the U.S. growth cycle and signs of over-valuation in the euro zone’s property market were among its concerns.

Critics have long warned the ECB itself has sown the seeds of a new crisis by driving down bond yields, inflating asset bubbles and giving banks cheap and nearly unlimited liquidity.

“Sovereign debt sustainability concerns have come to the forefront,” the ECB said. “Pressure on sovereign financing costs, in combination with a lack of sufficient fiscal consolidation efforts, may put the debt ratio on an unsustainable path in highly indebted countries.”

Plans by Italy’s government to increase spending in breach of EU rules has pushed up borrowing costs this year, exposing its vulnerabilities as debt levels are already high and growth is faltering.

“Increased market tensions could spread to other government bond markets in the event of further Italian stress,” the ECB said.

Departing from its long-standing line that overall real estate prices are not stretched, the ECB also warned that housing market momentum was building and there were now “mild signs” of over-valuation, with big differences across countries.

“The main triggers that could unearth a disorderly increase in risk premia relate to both domestic and external factors,” the ECB said in a biannual Financial Stability Review.

“These include disorderly market reactions to political or policy uncertainty in the euro area, further stress in emerging markets with possible spillovers to advanced economies and a sharp turnaround in U.S. macro-financial prospects,” the ECB said.

Fiscal expansion in the U.S. could trigger more turbulence in emerging markets, which have accumulated large U.S. dollar debts and thus face “very high” credit risk, the ECB said.

“A quicker than expected U.S. policy normalization and a subsequent appreciation of the U.S. dollar may trigger an abrupt and broad increase in risk premia on emerging market financial assets,” it said.

The ECB has been dialing back stimulus and plans to end its 2.6 trillion-euro bond-purchase scheme next month but said it would keep rates unchanged at least through next summer and keep policy loose for years to come.

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