The European Central Bank (ECB) released its half-yearly financial stability review Wednesday, warning that an impending rate hike by the U.S. Federal Reserve and waning growth in emerging economies was "of particular concern" to the financial stability of the eurozone.
The ECB raised its risk-assessment level for global financial-market instability to ‘medium’ and said highly indebted foreign currency borrowers may be vulnerable to the impending rate hike by the Fed.
“A faster than expected withdrawal of monetary-policy accommodation in other major advanced economies could trigger a reversal of global term premia, which may also spill over to the euro area,” the review said.
Term premia -- the extra return that lenders demand to hold on to riskier, longer term bonds -- could face sharp downward adjustments as higher U.S. interest rates would make long term bonds less lucrative.
In such conditions, any negativity amid investors could trigger a sell-off in riskier assets such as equities, ECB warned, as investors would not have enough of an incentive to hold on to a long-term bond, and would instead invest in short-term securities.
Such a reversal would trigger sharp falls in prices of assets, which some economists warn are overvalued, and could lead to a liquidity crunch in financial markets, according to a Financial Times report.
The bank also noted that the loose monetary policy adopted by advanced countries to spur economic growth and inflation had pushed up asset valuations, so they face a greater risk of correction.
“Misaligned asset prices are a key vulnerability in that they could potentially lead, at some point, to sharp adjustments of risk premia,” the report said.
The bank, which controls the monetary policy of 19 European member states, also noted that China remained a cause for concern despite a decline in volatility in its stock markets.
"The slowing of growth in China since the beginning of 2015 has reduced euro area exports, in particular exports of machinery and transport equipment. This has had adverse repercussions, in particular, for exporters of manufactured goods, which account for almost 90 percent of goods exports to China," the bank said in the statement.
“A 1 percentage point slowdown in Chinese real GDP would knock around 0.1-0.15 percentage points off euro area activity after two to three years,” the bank warned.
The review was moderately optimistic on the eurozone economy, saying it had "weathered challenges on several fronts" over the past six months. While significantly higher non-performing loans remained a concern for the region's banks, ECB noted that the risk of Greece leaving the euro -- a key risk at the time of the last report in May, would have lesser effects on the bloc’s economy now.