The euro area in a volatile world: resilience under strain

This chapter assesses the main macro‑financial risks to the euro area and their implications for fiscal positions and sovereign debt markets. It focuses on a selection of risks that could materially affect the euro area’s economic outlook, the channels through which these shocks propagate across the real economy and financial markets, and how they translate into public finances and sovereign financing conditions. 

The global order that underpinned Europe's prosperity since the Second World War has changed. Multilateralism is under strain and economic relationships are increasingly shaped by geopolitical considerations. Adverse shocks are materialising more frequently than in the past: the Covid-19 pandemic, Russia’s invasion of Ukraine, rising tariffs from the United States (US), and the recent conflict in the Middle East, all occurring within a single decade. Episodes of market stress, although short-lived, are increasingly triggered by US policy actions, and responses across US asset classes have deviated from historical patterns. At the same time, advanced economies face high public debt, population ageing, and tepid long-term growth prospects, while transitions related to climate and technological change continue to shape the economic landscape.  

The euro area weathered recent shocks with notable resilience but is not immune to global headwinds. The recent conflict in the Middle East has triggered a significant global energy supply disruption – the second in less than five years – that is testing the euro area’s resilience anew. It has raised energy prices, weakened business confidence, tightened financial conditions, and impaired the outlook, increasing future downside risks (Figure 1.1).  

The baseline outlook for the euro area points to moderate growth and temporarily elevated inflation, but developments in the Middle East add significant uncertainty. Real gross domestic product (GDP) growth is projected at 1.1% on average in 2026–2027, while inflation is expected to rise to 3% in 2026 before easing gradually thereafter (European Commission, 2026). These projections rely on energy markets pricing a swift normalisation of supply conditions, a process that could be accelerated by the recent de-escalation in the region. However, the situation in the Middle East remains fluid, leaving baseline assumptions inherently fragile.  

Sovereign markets remain supportive, but fiscal buffers are thin in many countries. High public debt and deficits from past crisis support measures, coupled with higher defence and other spending pressures, leave limited room for manoeuvring new shocks. Market confidence has held up so far, but it cannot be taken for granted.  

Survey-based evidence points to a risk environment dominated by geopolitical developments, inflation, and spillovers from global financial markets. The European Stability Mechanism (ESM) Sovereign Sentiment Survey (April 2026) shows that market participants view geopolitical tensions and persistent inflation as the main risks for euro area sovereign bond markets, followed by fiscal sustainability concerns and corrections in financial asset prices (Figure 1.2 and Box 1.5).  

This chapter sets out two main adverse risks and how they affect the euro area. Section 1.2 develops the selected risk narratives: a prolongation of geopolitical tensions, including a possible re-escalation in the Middle East, and an abrupt repricing of US financial assets. Section 1.3 examines vulnerabilities in private balance sheets and sovereign markets that could amplify their transmission. Section 1.4 quantifies the impact on the euro area under an adverse scenario. Section 1.5 assesses the fiscal implications for euro area countries. 

This section sets out the main downside risks to the euro area outlook and the channels through which they could materially affect growth, inflation, and financial conditions. It focuses on two external risk narratives that are both plausible and potentially impactful in the current global environment: a prolongation of geopolitical tensions, including a re-escalation in the Middle East, and an abrupt repricing of US financial assets. While distinct in origin, these risks could reinforce each other, amplifying their macroeconomic and fiscal consequences for the euro area. 

1.2.1 Prolonged geopolitical tensions in the Middle East: Europe under pressure  

The recent military confrontation in the Middle East has returned geopolitics to the centre of the global macroeconomic outlook. The turmoil affected global energy markets, supply chains, and confidence. Accordingly, geopolitical risk indices rose significantly, reaching levels comparable to past episodes of acute geopolitical tensions (Figure 1.3). What distinguished the recent episode is not merely the severity of the immediate shock, but also the likelihood that elevated geopolitical risk would persist. The military intervention in Iran also raised security concerns across important maritime chokepoints and lowered the threshold for future confrontations elsewhere. 

The conflict is the most acute manifestation of a broader and more lasting shift in the global geopolitical environment affecting the euro area. The euro area faces several open fronts that could independently or jointly challenge its growth and financial stability: an unresolved war in Ukraine, structural uncertainty over the future of the North Atlantic Treaty Organization (NATO), continued tensions between major powers’ territorial ambitions, vulnerability at critical maritime chokepoints, and the renewed use of tariffs as geopolitical leverage.  

Current developments also highlight the euro area’s vulnerability to disruptions in global energy markets. The Strait of Hormuz, a chokepoint for a significant share of global oil and liquefied natural gas flows, stood at the centre of recent tensions. Direct exposure to the region is limited. Since the energy crisis of 2022, the euro area has also reduced its dependence on Russia as a single gas supplier and improved energy efficiency. But the move to liquefied natural gas and its overall strong energy import dependency leaves it structurally exposed to disruptions in global energy markets, with varying degrees of vulnerability across euro area countries (Figure 1.4). The Strait is also a critical route for fertilisers and industrial gases, broadening the potential impact of any supply shock, both globally and for the euro area. 

Prolonged geopolitical tensions and a possible re-escalation in the Middle East would raise energy prices and keep uncertainty elevated. While recent de-escalation efforts have eased immediate supply concerns and driven energy prices down, renewed tensions under fragile or non-binding ceasefire agreements, including further structural damage to energy infrastructure, could push prices up again. Elevated geopolitical tensions also raise uncertainty, as perceived threats weigh on activity as heavily as realised events (Caldara and Iacoviello, 2022). Planning and decision-making become more complicated for households, companies, and governments. Higher energy prices coupled with uncertainty affect the economy through several mutually reinforcing channels:  

• Higher energy prices weaken real incomes and terms of trade. They reduce households’ purchasing power and consumption, while raising production costs and compressing firms’ profit margins. The resulting deterioration in the euro area’s terms of trade, reflecting its energy dependence, erodes firms’ competitiveness at a time when global trade costs are already on the rise.  
• If higher energy costs feed into wage formation and price‑setting dynamics, inflation could remain elevated for longer. With the 2022 energy shock still fresh in memory and unemployment at historically low levels, workers may seek higher wages to offset real income losses. Firms facing squeezed margins may attempt to pass higher labour costs on to consumers if demand remains sufficiently resilient. 
• Uncertainty weighs on confidence and delays investment. Persistent geopolitical tensions and supply disruptions increase uncertainty. High uncertainty weighs on consumer and business confidence, encouraging precautionary behaviour and delaying investment decisions.  
• Financial conditions tighten as risk appetite deteriorates. When geopolitical tensions and economic uncertainty intensify, investors demand greater compensation for risk, equity valuations fall, and volatility across asset classes rises. This channel was already activated in the immediate aftermath of the initial US-Israel intervention in Iran (Box 1.1). Tighter financing conditions amplify the impact of the other channels, particularly on investment. 

More broadly, an environment with high geopolitical tensions may generate non-linear economic dynamics. 1 Higher energy prices and greater uncertainty can tighten financial conditions and increase macroeconomic damage non-linearly. Investment and exports would be disproportionately affected. A simulation comparing two recent episodes of geopolitical shocks shows that doubling the size of the shock is associated with a sixfold decline in investment and a sevenfold reduction in exports (Figure 1.5). These non-linearities are a key feature of the adverse scenario (Section 1.4).

Over the longer term, persistently higher energy costs and uncertainty weaken competitiveness, productivity, and, ultimately, long-term output. High energy prices sustained over time further erode the competitiveness of European manufacturers. In addition, elevated uncertainty acts as a persistent drag on investment, as firms delay or reconsider their plans. This is particularly detrimental for the euro area at a time of high and rising investment needs related to defence, the green transition, and digitalisation. 

• 1

  See Capolongo et al. (forthcoming) for the euro area and Brignone et al. (2025) for the US

1.2.2 Sharp US asset price correction spilling over to the euro area

Global investor perceptions of US government bonds are shifting. US policies, including tariffs and military interventions, are increasingly triggering episodes of market stress. As a result, asset price reactions have diverged from historical patterns.2 Recent spikes in market volatility have been accompanied by a widening risk premium on long-term US Treasuries (Figure 1.6a). Foreign outflows from US government bond markets in periods of acute market stress are not unprecedented, but in the past, they typically reflected the liquidity of US Treasuries rather than a weakening of their safe-haven status (Box 1.2). 

In addition, there are signs of a structural decline in investor confidence in the US dollar’s performance during market turmoil. As diversification benefits from US dollar exposure have declined, foreign investors in US assets have increased their exchange rate hedging. Weakened US dollar sentiment can be seen in options pricing. Contrary to the historical pattern, the medium-term cost of hedging against significant US dollar depreciation is now comparable to the cost of hedging against the opposite change (Figure 1.6b). At the same time, many reserve managers intend to diversify away from the US dollar.3

Investor confidence in US assets could weaken if domestic developments prompt a reassessment of US policy credibility or elevated equity valuations.
Three channels appear particularly relevant: 

• Concerns about US fiscal dynamics could crystallise in response to domestic political developments. The federal and general government deficits relative to GDP are projected to remain around 6% and 7.5%, respectively, in the coming years.4 Rising interest payments, higher military spending, and potential fiscal support ahead of the midterm elections later this year are adding upside risks. A broader investor reassessment of US fiscal sustainability could materially raise US Treasury yields.  
• Concerns about US Federal Reserve independence could deepen cracks in the safe-haven status of US Treasuries and the US dollar. Since 2025, political pressure on the US Federal Reserve has pushed investors to question the durability of its inflation mandate. Should doubts about central bank independence intensify again, particularly if inflation rises while the Federal Reserve is perceived as constrained, investor confidence in US Treasury holdings may falter, leading to higher long-term interest rates and potentially a depreciation of the US dollar. 
• Stretched US equity valuations could adjust abruptly, if optimism around artificial intelligence (AI) investments dwindles. Expectations of exceptional AI-driven earnings growth have contributed to rising equity valuations (Figure 1.7a). Capital expenditure by the largest US firms on AI infrastructure has been substantial, and AI-related news is seen as more market-moving than conventional macroeconomic data releases (Figure 1.7b). However, the ultimate returns on AI investments remain uncertain, especially given growing competition in developing this technology. Hence, the assumption that large technology firms’ profits will continue to offset broader market pressures could be challenged.5If earnings expectations are revised downward, prices would correct sharply and broader market volatility would soar, reflecting heightened concentration.

• 2

  Jančoková et al. (2026).

• 3

  Official Monetary and Financial Institutions Forum (2026).

• 4

  Congressional Budget Office (2026), International Monetary Fund (2026a).

• 5

  This assumption is currently reflected in the low implied correlation of individual stock performance. See Goosen et al. (2024

A financial shock originating in US asset markets would transmit to the euro area through a combination of channels: 

• Falling US asset prices would rapidly and directly reduce investors’ wealth and tighten financial conditions in the euro area. The euro area has large and increasing holdings of US portfolio investments. At end-2025, the US accounted for nearly half of the euro area’s total global portfolio holdings – 59% of equity positions and 36% of debt, compared with roughly one-third in 2013. Measured against euro area GDP, this exposure reached 46% in 2025, up from 18% in 2013. Therefore, a material repricing of US assets would bring substantial direct losses for European investors. It would also lead to higher global risk aversion, with investors requiring higher risk premia across different asset classes and jurisdictions, tightening financial conditions in the euro area as well.  
• The spillover to financial markets may be asymmetric across euro area sovereigns. Capital reallocation away from US Treasuries could compress yields on higher-rated euro area sovereign bonds (Figure 1.6a), offering a partial offset to tighter financial conditions.6 However, sovereign bond spreads may widen for lower-rated sovereigns. Over the short term, a weakening of the US dollar could erode euro area export competitiveness. Over the longer term, a more structural shift away from global US dollar dominance could strengthen the international role of the euro, benefitting the safest euro area assets.   
• A correction in US equity prices would also affect the US economy, with spillovers to Europe. US equity market capitalisation now stands above 230% of GDP (compared to 150% in 2000), and equities account for around 33% of US household wealth (compared to 26% in 2000). While the concentration of equity ownership among more affluent consumers has increased in recent years, so has the concentration of consumption (the “K-shaped economy”). In addition, a high share of AI-related capital expenditure could lead to a more abrupt decline in investment. Therefore, the overall wealth and investment effects of a significant correction could be larger and more consequential than in previous episodes. A slowdown in US growth would spill over to the euro area through weaker external demand.  

• 6

  See Cornevin and Peppel-Srebrny (2026).

This section examines how existing financial vulnerabilities could heighten the impact of the downside risks described in Section 1.2. It focuses on vulnerabilities in private-sector balance sheets, including financial intermediaries, and in euro area sovereign bond markets that could amplify the transmission of external shocks to the real economy. While firms, households, and banks are entering this period with buffers, rising uncertainty and tighter financial conditions could test the resilience of parts of the non-bank financial sector and of sovereign markets given the growing share of price-sensitive investors. 

1.3.1 Corporates, households, and banks have financial buffers

Households enter this period with meaningful financial buffers, although unevenly distributed. Households appear broadly resilient, supported by accumulated savings, robust income growth, and historically low debt-servicing burdens. However, rising energy prices, elevated uncertainty, and tighter financial conditions weaken real incomes, while wealth and confidence effects likely reinforce precautionary savings and weigh on consumption. Low-income households are particularly vulnerable, reflecting more limited savings and a higher share of energy expenditure. 

Firms have benefitted from strong nominal profit growth in recent years and retain solid fundamentals overall,11 but financial pressures are mounting. Higher energy costs compress margins while weaker demand can limit firms’ ability to pass on increased production costs. This contrasts with the 2022 energy shock, when strong demand and extensive fiscal support sustained firms’ pricing power. Elevated uncertainty and tighter bank credit standards further weigh on firms’ debt-servicing capacity and investment decisions, encouraging firms to postpone capital expenditure and scale back production. Energy-intensive and demand-sensitive sectors, such as manufacturing of household goods, automobiles, and machinery, are particularly vulnerable to these conditions. 

Banks’ risk aversion appears to be on the rise, despite solid financial positions and limited direct exposure to US assets. Capital and liquidity positions are sufficient to absorb the effects of the two external risks considered in this chapter. Banks’ direct exposure to US assets is modest overall: US credit risk accounts for about 4.9% of total credit risk, while holdings of US government securities amount to roughly 1.2% of total assets. However, when geopolitical risks intensify, banks tend to rebalance portfolios towards sovereign bonds and away from private-sector lending. A prolonged energy shock combined with heightened risk aversion could therefore constrain credit supply, particularly to energy-intensive sectors (Box 1.3). The impact would likely be uneven across countries, reflecting differences in banks’ exposures to the shock (Figure 1.8) and in non-performing loan ratios in the most affected sectors. 

• 11

  On aggregate, non-financial corporations’ debt service ratio (interest payments over gross operating surplus) is stable at 7.8% and consolidated debt declined to 65.6% of GDP in Q4 2025.

1.3.2 The non-bank financial sector could amplify market stress

Non-bank financial institutions have substantial US exposures. Insurers and occupational pension funds together have about €710 billion in US exposures (7% of invested assets) on their balance sheets, mostly in US equities and corporate bonds. Euro area bond and money market funds have invested around €1 trillion in US issued bonds, about 37% of which (or 4% of total net asset value) are US government bonds.12Asset price corrections in the US combined with negative market sentiment would cause losses for insurers and pensions. For funds, redemption shocks could trigger large asset sales, exacerbating negative asset price dynamics in a volatile market and potentially spilling over to other markets and asset classes. Illiquid investment fund portfolios could amplify these effects.

Euro area equity funds are particularly exposed to US equity markets. Assets under management of euro area equity funds have increased more than sevenfold since 2009, reaching €6.1 trillion by end-2025, while the share invested in US assets has risen from 19% to almost 45% (Figure 1.9a). Given the significant exposure, a correction in equity prices would have a meaningful impact and generate substantial losses for the sector. Illustratively, a 25% correction in US equity prices could reduce euro area equity fund net asset values by around 14%. Losses would arise not only through direct valuation effects on US holdings, but also from spillovers to European equity markets, and additional losses on unhedged dollar positions could materialise if the US dollar does not appreciate. A correction comparable to those that occurred during the Covid-19 pandemic or the global financial crisis, would have substantially larger effects (Figure 1.9b).13 Losses would transmit to the real economy through negative household wealth effects, higher equity financing costs for firms, and declining collateral values, leading to tighter bank lending conditions. 

• 12

  Non-bank financial institutions partially hedge their currency exposure through FX derivatives. Data indicate that hedging increases when the dollar depreciates and vice versa and generally tends to be higher for fixed income assets than equities.

• 13

  For comparison, the US equity price fall during the global financial crisis was almost 57%.

The rapid expansion of opaque private credit markets, and the leverage increasingly embedded within them, represents a further vulnerability. Limited data availability hampers quantification and may obscure correlations with public markets, complicating risk assessment. Liquidity mismatches in private credit funds that allow for redemption (primarily a US phenomenon) could trigger withdrawal pressures that exceed available liquid assets. Measures have been designed to mitigate this pressure, such as liquidity gates or swing pricing. Nevertheless, under extreme stress conditions, such measures may amplify rather than contain investors’ reaction.  

Growing interdependencies between funds and banks increase banks’ exposure to potential liquidity stress in the fund sector. Global investment funds held around €450 billion of euro area banks’ long-term debt in 2025 (10% of total outstanding), about a fifth of which was provided by asset managers affiliated with euro area banks (Figure 1.10). These close linkages increase banks’ exposure to potential liquidity stress in the fund sector, which could disrupt funding conditions and force the sale of bank bonds, creating rollover and regulatory pressures.14 The widespread bank ownership of euro area funds raises additional step-in risk should parent banks need to support distressed affiliates.

• 14

  Long-term bank debt is required to comply with loss absorption and stable funding regulatory requirements.

1.3.3. Sovereign markets: benign pricing of sovereign risks and changing investor landscape exposes bonds to price corrections

Sovereign spreads in the euro area continue to reflect benign market pricing of risks. Between late 2023 and early 2026, euro area sovereign spreads compressed, supported by declining interest rate uncertainty (among other factors), and the dispersion of spreads declined (Figure 1.11a). Recently, sovereign spreads have widened somewhat in response to the conflict in the Middle East, but on average remain contained by historical standards. 

Relatively compressed spreads suggest that investors trust the euro area institutional framework. The additional risk premium required by investors for purchasing riskier euro area sovereign debt has fallen below historical averages (Figure 1.11b). This partially reflects progress in fiscal adjustment by some countries, particularly former ESM beneficiary Member States (Section 1.5).15 On aggregate, the compression of spreads outpaced the improvement in underlying fiscal fundamentals. This indicates investor trust in euro area backstop mechanisms, as also confirmed by market participants (see Box 1.5).

An adverse global risk environment, signs of weakening political cohesion in the EU or deteriorating fiscal fundamentals could prompt investors to reassess sovereign risks. Risk premia could re-align with historical patterns. To sustain the current benign view, compliance with the fiscal framework as a guardrail to fiscal sustainability is essential. The ECB’s Transmission Protection Instrument reduces market-driven fragmentation risk but is not designed to insulate sovereigns from spread widening related to country-specific economic imbalances.16ESM support provides a safety net that includes precautionary instruments, but it serves to safeguard financial stability – rather than as a substitute for healthy public finances. Investor trust in the European institutional framework should not be taken for granted. The more market participants doubt countries’ budgetary sustainability and resilience, the more likely sovereign bond spreads are to widen again, potentially triggering financial instability. 

The greater role of more price-sensitive investors, including hedge funds, makes euro area sovereigns more vulnerable to changes in global risk sentiment. Amid ongoing ECB balance sheet normalisation and elevated US policy uncertainty, the footprint of non-euro area investors, including hedge funds, has increased substantially (Figure 1.12a).17 Box 1.4 shows that in countries where these investors hold a high share of sovereign debt, negative demand shocks can meaningfully widen spreads.  

• 15

  See Gnewuch (2026).

• 16

  See ECB (2022).

• 17

  Hedge funds active in the euro area government bond market are mostly domiciled outside the euro area and now account for over half of electronic trading volumes (up from around a quarter in 2018). See ECB (2025). 

Hedge funds tend to be particularly sensitive to changes in yields and funding conditions, due to the high leverage deployed. 18 In non-stress periods, their presence may support liquidity. However, in periods of stress, if forced to unwind exposures, hedge funds could strain dealer intermediation capacity and amplify price swings (Box 1.5).19 In addition, if non-euro area hedge funds face liquidity stress from their large exposures to US Treasuries, they may also transmit the shock by unwinding positions in the euro area sovereign bond market.20  

Banks have returned to sovereign markets but reduced their home bias, while the role of other price-insensitive investors is shrinking. Banks have increased their holdings of sovereign bonds since the beginning of the ECB’s monetary policy normalisation with a reduced home bias, thereby diminishing – though not eliminating – doom loop risks (Figure 1.12b).21 Meanwhile, insurers’ sovereign bond holdings have fallen, with the share of total invested assets decreasing from 26% to 20% over the past five years. Over the medium to long term, pension funds are expected to follow suit as defined-contribution schemes expand, as exemplified by the Dutch pension reform.22This narrows the stable, less price-sensitive component of investor demand and increases reliance on investors whose behaviour under stress is harder to predict.   

• 18

  See Alquist, R. and R. Yamarthy (2022).

• 19

  See Ferrara et al. (2024).

• 20

  See Bassi et al. (2024), Barth et al. (2025), and IMF (2026b). 

• 21

  As of December 2025, the average share of domestic bonds over total assets in the euro area was 3.1%, though with some countries, including Slovakia, Italy, Greece, Spain and Malta, well above the euro area average. In recent years, banks have increasingly placed their sovereign holdings in their amortised cost portfolios. This practice mitigates the risk of unrealised losses stemming from short-term volatility pressures in sovereign bond markets but increases balance sheet opacity.

• 22

  Under a defined-contribution scheme, pension funds have less need for long-term government bonds to hedge
  interest rate risk.

This section translates the risk narratives and financial vulnerabilities discussed in Sections 1.2 and 1.3 into a quantified adverse macro-financial scenario for the euro area. The scenario combines two mutually reinforcing external shocks: prolonged geopolitical tensions, including a re-escalation in the Middle East, and a rise in US policy uncertainty that triggers a sharp repricing of US financial assets. It assumes no economic or monetary policy responses beyond the operation of automatic stabilisers. The model-based approach and details are described in Annex A6. 

The impact of the adverse scenario is assessed relative to a baseline consistent with the European Commission’s spring 2026 economic forecast. Under this baseline, euro area GDP growth is projected to slow to 0.9% in 2026, while inflation is expected to pick up to 3.0%, reflecting the impact of the current energy shock. In 2027, growth is projected to recover to 1.2%, and inflation to moderate to 2.3%. Notably, these projections are underpinned by energy price assumptions derived from futures markets, which at the time of the forecast were consistent with a relatively swift, albeit partial, normalisation of energy supply conditions. 

1.4.1 Risk layers, assumptions, and transmission channels

The first risk layer assumes prolonged geopolitical tensions in the Middle East. This is captured by a renewed surge in geopolitical risk indicators and wholesale oil and gas prices. This scenario is consistent with a re-escalation of US–Iran tensions, halting any incipient reopening of the Strait of Hormuz. The resulting disruptions in energy supply extend into late 2026. Consequently, geopolitical risk indicators and oil prices are assumed to reach levels close to those observed at the peak of the war in Ukraine (Figure 1.13). Gas prices also increase significantly, but remain well below the peaks observed in 2022, reflecting the different nature of the episodes. After the initial shock, these indicators gradually fade but remain above baseline levels over the medium term (Figure 1.13). 

The second risk layer assumes a material repricing of US assets and a rise in global risk aversion. In the model, these are triggered by a sharp increase in US policy uncertainty24 to levels close to the April 2025 peak, when reciprocal US tariffs were announced. Investor appetite for US assets deteriorates, pushing US Treasury risk premia to late-2016 highs. Elevated US equity valuations adjust downward, while risk aversion in corporate bond markets also rises. The excess bond premium surges to pandemic‑era levels and credit spreads widen.

The interaction of these two risk layers leads to a substantial tightening of global financial conditions. The S&P 500 declines by almost 20% and the EURO STOXX by nearly 30% over 18 months, while equity market volatility rises by around 60% relative to the baseline. US 10‑year Treasury yields increase by more than 50 basis points, whereas euro area risk-free yields rise by a more modest 30 basis points, partly cushioned by portfolio rebalancing into euro area assets. Over the same period, the euro appreciates slightly, by around 2%, against the US dollar. 

The adverse scenario also incorporates amplification effects stemming from some of the financial vulnerabilities discussed in Section 1.3. In particular, it allows for mild amplification through higher bank risk aversion and a deterioration in non-financial corporations’ balance sheets (see Section 1.3). The exercise does not quantify amplification effects linked to vulnerabilities in the non-bank financial sector. They are considered tail risks that could further aggravate the disruption caused by an adverse scenario.  

1.4.2 Short-term impact: inflation rises sharply while the euro area enters recession in 2027

In the adverse scenario, growth slows sharply as investment adjusts disproportionately and inflation rises materially: 

• GDP growth moderates to 0.6% in 2026 and -0.4% in 2027. By the end of 2027, GDP levels are 2.4% below the baseline scenario (Figure 1.14). The geopolitical shock dominates in 2026, weighing on consumption and investment. The US repricing channel and second round effects compound the drag in 2027 as tighter financial conditions and higher cost pressures for firms transmit more forcefully to the real economy. 
• Exports see the largest adjustment, falling almost 7% below baseline by end-2027 as global demand weakens. Investment falls around 4.5%, as firms delay capital expenditure under uncertainty and tighter credit conditions. Consumption declines more moderately by around 1%, as wage growth is not enough to stabilise households’ purchasing power. 
• Inflation rises to 3.7% in 2026 and 3.4% in 2027, driven initially by energy prices. Later on, spillovers to core inflation and second-round effects to wage settings contribute to a more persistent inflationary shock (Figure 1.14), further impairing growth. Monetary policy is assumed to not respond to inflationary pressures.  

• 24

  US policy uncertainty index. ESM calculations based on Baker, Bloom, and Davis (2016) using Factiva data (the US Economic Policy Uncertainty index measures the frequency of newspaper articles discussing economic and policy-related uncertainty). 

1.4.3 Long-term economic scars from energy prices and uncertainty

Under the adverse scenario, prolonged uncertainty and higher energy prices result in a persistent loss of output in the euro area (Figure 1.15a). Higher-for-longer oil and gas prices raise production costs across the economy, eroding the international competitiveness of European manufacturers and weighing on activity well beyond the initial shock. Elevated uncertainty reinforces these effects by discouraging investment and impairing innovation. The two effects weigh on economic activity for a prolonged period, causing persistent losses in actual and potential output under the adverse scenario. While firms and households gradually adapt to the new environment and productivity recovers over time, the adjustment remains incomplete. By 2035, real GDP remains around 2% below baseline levels. 

Over time, inflation gradually shifts from reflecting upside cost pressures to demand-driven disinflation. As demand weakens and investment remains subdued, inflationary pressures gradually recede, offsetting earlier energy‑driven price increases. 

1.4.4 Uneven impact across countries reflects different economic structures and shock exposures

The impact of the adverse scenario varies across euro area countries, reflecting differences in economic structures and exposures to the shock (Figure 1.15b). While all member states face common headwinds, three features are associated with the cross-country differences in the impact on growth, inflation, and overall financial conditions: 

• Energy import dependency and intensity. Countries with higher reliance on fossil fuel imports and a greater energy weight in production and consumption face stronger and more persistent headwinds, amplifying the impact of the adverse scenario. 
• International trade integration. In more open economies, higher energy costs transmit rapidly through imported inputs and global production networks, magnifying the impact on domestic prices and competitiveness. Elevated geopolitical uncertainty weighs on global demand, disproportionately affecting countries with stronger international linkages. 
• Sovereign market dynamics. Country-level financial conditions are also shaped by sovereign spread dynamics, which respond to both the rise in global risk aversion and domestic macro and fiscal fundamentals.  

The exercise does not account for country-specific exposures to US financial assets.  

Inflation paths also differ across countries. Economies with greater exposure to energy inputs face stronger short-term inflationary pressures, while more open economies experience faster pass-through from import prices to inflation. Price pressures ease and inflation moderates as demand weakens over time. Inflationary forces are more persistent in those economies with more rigid price- and wage-setting mechanisms. 

This section analyses the fiscal consequences for euro area sovereigns arising from the risks and vulnerabilities discussed in Sections 1.2 and 1.3. It assesses how weaker growth and tighter financial conditions affect the trajectories of public finances and analyses the required fiscal adjustments under the EU fiscal framework. The analysis zooms in on the short-term fiscal effects and longer-term implications for debt sustainability, while emphasising the role of market confidence in times of increasing political constraints.  

1.5.1 A fragile starting position with serious challenges ahead

The euro area is grappling with high government deficits and debt. The region moved onto a more tenuous fiscal trajectory in the aftermath of the Covid-19 pandemic and the Russian invasion of Ukraine. These shocks prompted determined fiscal responses, which helped accelerate the euro area’s recovery. Deficits and debt today remain above pre-pandemic levels in most euro area countries due to these measures and higher defence spending. The most recent conflict in the Middle East has renewed fiscal pressures, and higher interest rates complicate efforts to place public finances on sustainable paths. 

Aggregate numbers mask diverging fiscal performances across countries in recent years. About half of all euro area countries, including the five ESM beneficiary Member States (Cyprus, Greece, Ireland, Portugal, and Spain), have successfully pared back public debt and contained deficits since the pandemic, propelled by the solid recovery and rising tax receipts (ESM, 2026). These improvements are reflected in rating upgrades and sustained declines in their sovereign bond spreads relative to German government bonds. In contrast, the other half, including several countries of the region’s core, struggled to improve public finances, due to rising defence and infrastructure expenditure needs as well as growing interest payments (Figure 1.16). 

Fiscal pressures look set to persist. Under the baseline, fiscal pressures that have already emerged will gradually gain momentum, particularly in areas related to population ageing (such as healthcare and pensions). Higher inflation will temporarily provide some respite before additional factors start weighing on the public purse:  

• Government financing costs are bound to rise as higher market interest rates permeate public budgets. By 2035, interest payments will more than double, averaging 5% of euro area GDP, explaining about two-thirds of overall fiscal deficits in many countries (Figure 1.17). 
• Subdued outlook for growth: the euro area will struggle to grow out of its fiscal challenges. As a consequence, on the heels of an inflation-driven improvement in the short run, the interest-growth differential will steadily worsen, leading to less favourable debt dynamics.  

Risks to debt sustainability are hence already elevated in the baseline. In a no-policy-change scenario, aggregate public debt in the euro area would rise from levels close to 90% of GDP in 2025 to 103% of GDP by 2035. Gross financing needs will increase for most countries, with more than a third of all countries recording financing needs in excess of 20% of GDP in 10 years. Several countries with already-high debt are projected to continue running large deficits and have high financing needs, leaving them increasingly vulnerable to adverse market shocks. By contrast, several of the former ESM programme countries are projected to keep public debt on downward trajectories, strengthening their resilience.  

1.5.2 The adverse scenario: large fiscal adjustments only feasible if markets grant time

The immediate fiscal effects of geopolitical tensions and spillovers from US asset repricing are relatively contained, mitigated by inflation. Under the adverse macroeconomic scenario (Section 1.4) and no policy changes, national deficits and public debt levels change only marginally relative to baseline projections by 2027 (Figure 1.17b). Weaker economic activity dampens tax revenues, but this effect is offset by higher inflation. Primary expenditures are broadly unchanged, with most large spending categories unresponsive to economic conditions. Across countries, the fiscal impact is uneven, mirroring the severity of the adverse scenario (Section 1.4). Aggregate euro area financing needs climb to 19% of GDP, pushing up sovereign spreads. 

Over the longer run, however, the shocks further destabilise the debt trajectory in most countries. The adverse scenario affects debt sustainability risks over a longer horizon, through permanent scarring of economic activity, larger deficits and financing needs, and less favourable differentials between growth and interest rates. 

In addition, unmet defence spending commitments weigh on the public purse. Fiscal plans so far specify only partial progress towards the NATO target by 2035. Factoring in the remainder adds significant expenditure pressures, although a fraction of these could be self-financed in the long term (Chapter 2). For the purpose of this exercise, the 3.5% of GDP benchmark applies to all euro area countries, including those that are not NATO members. 

Under the adverse scenario, accounting for unmet military spending, public debt increases for all countries by 2035, except Cyprus and Greece. Compared to baseline projections, the average debt-to-GDP ratio in the euro area is about 20 percentage points higher. There is one silver lining: the impact of the shocks on public debt is not systematically related to the countries’ current debt levels; instead, the magnitude of impact is mostly related to the countries’ economic structures and specific vulnerabilities to external shocks such as energy dependency and trade openness. By implication, risks of debt divergence are more contained (Figure 1.17). 

Warding off the threat to debt sustainability requires large and sustained adjustments (Figure 1.18). The EU fiscal rules are crucial in helping keep fiscal stress at bay under the adverse scenario: they buy flexibility and time. If markets remain patient, they will give countries access to financing on reasonable, though more expensive, terms. Under these conditions, countries can adjust their fiscal positions gradually, postponing the moment of reversing their debt trajectories for several years. Under the adverse scenario, putting debt on a plausible downward path by 2035, as stipulated by the rules, requires cumulative adjustments that exceed what has historically been achieved in around half of the countries.25 The bulk of the adjustment would occur in the period 2030–2035, if the overall fiscal effort is backloaded. 

Large cumulative adjustments can spread over a long horizon, but at the risk of running into consolidation fatigue. In annual terms, and over the maximum horizon allowed by the EU’s Stability and Growth Pact, the average improvement in fiscal balances is about 0.6 percentage points of GDP in countries with non‑stabilising debt paths. Most countries have a track record of successfully delivering annual adjustments of this magnitude. But countries have typically recorded these over shorter time periods. Extending fiscal adjustments over long periods raises risks of consolidation fatigue, amid political resistance and electoral cycles.  

• 25

  This result is obtained from a comparison between the ‘maximum realised’ adjustment in each country and the required adjustments under the adverse scenario (Figure 1.18). ‘Maximum realised’ is calculated as the largest positive cumulative change in the cyclically adjusted primary balance (CAPB) in the period 1995–2025 over a qualifying consolidation episode (see Annex A7 for details).

1.5.3 Upholding market trust under economic strain and political frictions 

Sovereign market conditions remain benign, but foundations are fragile. Despite significant fiscal risks, market sentiment towards euro area sovereign debt has so far remained broadly favourable (Box 1.5). Investors seem confident in the effectiveness of the existing fiscal framework. However, this relative stability is vulnerable (Section 1.3), not least because of the greater role of more price-sensitive investors in several euro area sovereign bond markets. 

In this setting, policy mistakes can incur disproportionate costs. The adverse scenario with elevated global risk aversion, combined with large and back-loaded fiscal adjustment needs, creates fertile ground for disproportionate market reactions to relatively small changes in domestic policies. If markets were to begin doubting countries’ commitment to the rules – because of policy steps that raise the likelihood of breaching spending limits or because of waning political capacity to deliver – investors may demand proof of willingness to consolidate on a much shorter timeline. In that case, the required fiscal adjustments become front-loaded and unfeasible if required over one or two budget cycles. This shift could move countries into sovereign stress territory much more quickly. 

Scope for new fiscal support under the adverse scenario is limited. Governments may be tempted to cushion the impact of the shocks, particularly that of higher energy prices, through broad-based support measures similar to those used in 2022. But repeating this type of fiscal response under adverse conditions involves complex trade-offs and would expose countries to new risks. 

• The economic environment in 2022 was special, enabling broad fiscal support packages. Euro area countries’ growth was relatively fast after the pandemic, interest rates were lower (though rising), the Eurosystem was a major investor in euro area sovereign bonds, and the general escape clause of the EU’s Stability and Growth Pact was active. The adverse scenario in this report explores a very different economic environment. 
• Most euro area countries have limited leeway for discretionary policy action. This constraint can be captured by an index that measures several metrics typically associated with room for fiscal manoeuvring: (i) debt levels and dynamics, (ii) deficits, and (iii) budget composition under adverse conditions (Annex A8). According to this index, lower growth and tighter financing conditions in the adverse scenario (leading to worse interest-growth dynamics) militate against broad-based fiscal support in response to the adverse shocks (Figure 1.19).  
• Countries with the least fiscal space also confront the largest long-term needs (Annex A8). Higher military spending is increasingly important in a more volatile geopolitical environment and can generate positive growth spillovers in the long term (Chapter 2). Managing these long-term spending needs, including defence, will require clear prioritisation of large expenditure categories and, most likely, difficult choices. Maximising the growth impact of reprioritised spending can help to preserve fiscal space and maintain room to manoeuvre.  

Domestic political factors could further constrain effectively available fiscal space. Fiscal support is often easier to roll out than to unwind. The experience of the 2022 energy crisis reinforces this concern: countries were more likely to maintain support measures for longer and rely more on broad-based energy price suppression where electoral pressure was stronger and political fragmentation greater (Figure 1.20). Price caps are particularly inefficient and untargeted, generally diminishing their stabilising effects.26

Upholding market confidence is key. The credibility of delayed consolidation hinges on markets believing governments are politically capable of course correction. Maintaining market trust will require prudent fiscal policy choices, including avoiding costly and inefficient price subsidies like those in 2022. More generally, markets are likely to look favourably upon temporary deviations from planned adjustments if discretionary fiscal support is both temporary and tailored to a well-identified need (e.g. temporary income support for the poor). Plans must be backed by transparent public outreach, grounded in prudent economic assumptions, and subject to independent monitoring (End, 2023; IMF, 2026a and 2021; OECD 2025).  

• 26

  See Gabriel et al. (2026) for evidence on smaller fiscal multipliers under political fragmentation.

The euro area is confronting a structurally less cooperative global environment with more frequent and mutually reinforcing adverse shocks. Geopolitical tensions, recurrent energy-price shocks, and the risk of abrupt market repricing have become persistent features of the macro-financial landscape. The euro area’s resilience to these shocks so far is remarkable, but policy space is limited. The risks examined in this report – prolonged geopolitical tensions raising energy prices, and spillovers from a sharp correction in US financial markets – could boost inflation, tip the euro area into recession, derail fiscal paths, and challenge benign pricing in euro area sovereign markets. Non-bank financial intermediaries and sovereign bond markets with a growing share of price-sensitive investors can amplify transmission and disproportionately tighten financial conditions.

Debt sustainability will deteriorate when risks materialise. High public debt, rising interest expenditures, and mounting structural spending pressures restrict room to cushion new shocks. The short-term fiscal impact of the adverse scenario considered appears contained, but medium-term debt dynamics place almost all euro area countries on upward debt trajectories, requiring sustained fiscal discipline over an extended period. In this environment, governments’ capacity to respond to shocks will be further constrained. This makes the ability and willingness of governments to face such adjustment requirements an important financial stability issue.  

A credible fiscal outlook preserving market trust is central to maintaining fiscal and economic resilience. Fiscal frameworks provide flexibility and buy time only if markets trust governments’ capacity to comply and deliver sustained adjustment. When fiscal room to manoeuvre is limited, targeted and temporary support is warranted under economic stress. Broad-based measures are costly. Where political fragmentation is larger, fiscal measures have proven more difficult to unwind, complicating the policy calculus. Rebuilding buffers, credible well-specified medium‑term fiscal plans that command broad support, and spending efficiently – embedding rising defence expenditure in a growth-friendly strategy to reduce its fiscal cost (discussed in Chapter 2) – could set in motion a virtuous cycle of stronger confidence, lower risk premia, and greater fiscal room to act.  

A strong EU institutional framework remains a critical source of collective resilience. Progress towards strategic autonomy, deepening the single market, and pursuing the green and digital transitions will reduce external vulnerabilities and strengthen the euro area’s position in the new global order. However, these take time to deliver, and the credibility of the European institutional setting needs preservation throughout. Current decisions to use the flexibility of the existing framework will affect future fiscal dynamics. The focus of the euro area safety net remains on safeguarding financial stability by preserving investor confidence, containing liquidity stress early, and ensuring that credible insurance mechanisms are ready before they are needed.  

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