Italy, Greece and other heavily indebted eurozone countries risk a financial crunch after the pandemic because of the cost of fighting Covid, analysts have warned.
Mounting debts risk spooking investors and driving up borrowing costs once normal conditions resume, particularly if post-pandemic austerity sparks a new wave of political populism, according to M&G fund manager Eric Lonergan.
Countries have been able to borrow hand over fist because the European Central Bank is buying €1.85 trillion (£1.6 trillion) of bonds under its Pandemic Emergency Purchase Programme, while financial markets have backed spending to get through the lockdowns.
Mr Lonergan said: “Europe is ironically vulnerable to recovery because it seems you only get temporary elimination of credit risk in European sovereigns when you are in an emergency, in which case the ECB underwrites your bond market.
“The problem is that when you come out of an emergency, you are back to market forces in the bond market, and some of these numbers look really, really bad.”
The eurozone’s rules on government borrowing have been suspended to allow countries to run huge deficits through the pandemic. However, the measures are only temporary with the derogation limited to cases of "an unusual event outside the control" of a member state.
The International Monetary Fund estimates Italy’s national debt surged from an already high 135pc of GDP before the pandemic to 156pc at the end of 2020, and expects it to stay above 150pc for the foreseeable future.
Mr Lonergan said Italy was particularly exposed because the interest rate on its debt was higher than its rate of GDP growth, meaning the burden will mount over time.
Other countries could also be at risk as interest rates rise in the US, prompting investors to move their funds from Europe to the faster-growing economy over the Atlantic.
Mr Lonergan said the risk of a sovereign debt crisis was further compounded if post-pandemic austerity measures give rise to fresh wave of political populism, setting the scene for a battle with the ECB.
He said: “In two years’ time, unless something changes it is very difficult to see anything other than fiscal austerity.
"That will mean a huge reliance on monetary policy again, and if you throw in any sort of populism anywhere, there is a material probability of sovereign runs re-emerging. I see absolutely no reason why not, because the fundamental cause has worsened."
Althea Spinozzi, a strategist at Saxo Bank, said any sell-off of sovereign debt was likely to begin with an exodus from Greece.
"Foreign investors hold almost 90pc of Greek debt. Additionally, Greek debt is rated junk due to its serious creditworthiness issues, which the coronavirus outbreak has exacerbated," she said.
“A sell-off in Greek debt would immediately be followed by Portuguese and Spanish debt as foreign investors hold almost half of these countries’ debt.”
However this in part depends on the ECB’s reactions, and analysts hope it will keep policy extremely loose as the economy is fundamentally weak and inflation is expected to stay low.
Fahad Kamal, chief investment officer at Kleinwort Hambros, said: "The ECB has effectively said they are going to be doing yield curve control, without explicitly saying it.
“They are very keenly positioned towards making sure yields remain very low, because Europe is the one area where the economic recovery has been very weak - not just in this cycle but over the last 10 years.”