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| The report warns that higher defense spending, rising interest costs, and aging populations will pressure public finances across the euro area. Photo credit: Wikipedia/Boubloub |
Finance Minister Makis Keravnos says the findings confirm Cyprus' fiscal discipline as the eurozone faces mounting budget pressures.
About half of the euro area countries, including the five member states that received assistance from the European Stability Mechanism (ESM), among them Cyprus, succeeded in reducing public debt and cutting deficits after the pandemic, thanks to the steady economic recovery and growing tax revenues. At the same time, according to the ESM's Euro Area Stability Watch report for 2026, even under the adverse scenario, which takes into account military spending that has not yet been funded, public debt is expected to increase in every country through 2035 except for Cyprus and Greece.
Looking at the Mechanism's adverse scenario, the report says the direct fiscal effects of geopolitical tensions and the secondary effects from the repricing of assets in the United States are relatively limited because inflation offsets much of the impact. Under the adverse macroeconomic scenario, and assuming no policy changes, national deficits and public debt levels change only slightly compared with the baseline projections through 2027. At the same time, weaker economic activity reduces tax revenues, but higher inflation offsets that decline. Primary spending also remains largely unchanged because most major spending categories are not affected by economic conditions. Fiscal effects vary from country to country, reflecting the severity of the adverse scenario, while the euro area's total financing needs rise to 19% of GDP, pushing government bond spreads higher.
According to the ESM, these shocks further destabilize the debt path in most countries, but Cyprus remains an exception.
Over the long term, the report says these shocks make debt paths even less stable in most countries. The adverse scenario affects long-term debt sustainability through permanent effects on economic activity, larger deficits, greater financing needs, and less favourable differences between economic growth and interest rates.
What the Finance Minister told "K"
Finance Minister Makis Keravnos told "K" that the European Stability Mechanism's latest report confirms the steady course of the Cypriot economy during a period of growing challenges for the Eurozone.
Responding to a question from "K," the minister said the European Stability Mechanism, in its latest assessment, expresses serious concerns about the resilience of the Eurozone economy because of significant geopolitical developments. It also points to limited fiscal buffers while not ruling out the possibility of a recession.
Asked to comment on the report's findings, Mr. Keravnos said the European Stability Mechanism expresses strong concern about the Eurozone economy's ability to withstand serious negative geopolitical developments. It also refers to limited fiscal buffers and does not rule out the possibility of a recession.
For Cyprus, the report identifies the country as the major exception because of its steady and significant reduction in public debt and its continued budget surpluses. According to Cyprus' finance minister, the report provides another important confirmation that the government's economic policy and the Ministry of Finance's approach are producing positive results.
NATO through 2035
Unfulfilled defense spending commitments are also placing additional pressure on public finances. Fiscal plans currently provide only partial progress toward meeting NATO's 2035 spending target. Accounting for the remaining commitments adds significant pressure to government spending, although part of those costs could become self-financing over the long term. For this analysis, the benchmark of 3.5% of GDP applies to all euro area countries, including those that are not NATO members.
As mentioned earlier, under the adverse scenario, which includes military spending that has not yet been funded, public debt increases in every country through 2035 except Cyprus and Greece. Compared with the baseline projections, the average debt-to-GDP ratio across the euro area is about 20 percentage points higher.
There is also a positive side. The impact of these shocks on public debt is not directly tied to countries' current debt levels. Instead, the size of the impact depends mainly on each country's economic structure and its specific vulnerabilities to external shocks, including energy dependence and the degree of openness to trade. As a result, the risk of debt divergence is more limited.
Serious challenges ahead
The euro area is dealing with high public deficits and debt after entering a more fragile fiscal position following the Covid-19 pandemic and Russia's invasion of Ukraine. Those events led to decisive fiscal interventions that helped speed up the euro area's recovery. Today, deficits and debt remain above pre-pandemic levels in most euro area countries because of those measures and higher defense spending. At the same time, the recent conflict in the Middle East has renewed fiscal pressures, while higher interest rates make it more difficult to restore public finances to a sustainable path.
The ESM estimates that the five countries that received financial assistance, Cyprus, Ireland, Greece, Portugal, and Spain, have improved their position through credit rating upgrades and a steady decline in government bond spreads relative to German government bonds. By contrast, the other half of the euro area, including several core economies, has struggled to improve public finances because of rising spending needs for defense and infrastructure, along with increasing interest payments.
Fiscal pressures are expected to continue. Under the baseline scenario, existing fiscal pressures gradually become more intense, particularly in areas connected to an aging population, such as healthcare and pensions.
Temporary relief
Higher inflation is expected to provide temporary relief before additional pressures begin weighing on public finances. Government borrowing costs are certain to increase as higher market interest rates work their way into public budgets. By 2035, interest payments are expected to more than double, reaching an average of 5% of euro area GDP and accounting for roughly two-thirds of total fiscal deficits in many countries.
The euro area is unlikely to overcome its fiscal challenges through economic growth alone. After a short-term improvement driven by inflation, the gap between interest rates and economic growth is expected to become steadily less favourable, resulting in weaker debt dynamics.
According to the ESM, debt sustainability risks are already elevated under the baseline scenario. Without policy changes, total public debt across the euro area is projected to rise from about 90% of GDP in 2025 to 103% by 2035. Gross financing needs are expected to increase in most countries, with more than one-third projected to record financing needs exceeding 20% of GDP within 10 years. Several countries that already carry high debt levels are expected to continue posting large deficits while facing substantial financing needs, making them increasingly vulnerable to adverse market conditions. By contrast, several former ESM program countries are expected to keep public debt on a downward path, strengthening their resilience.
