An extended conflict in the Middle East could negatively affect the credit ratings of certain euro-area countries if it led to additional tightening of monetary policy to control renewed inflationary pressures, ultimately resulting in weaker economic growth.
A stagflationary situation resulting from a notable escalation of the Israel-Hamas conflict throughout the region would challenge the financial stability of euro-area countries with limited fiscal flexibility and slower growth. This could occur by abruptly halting the benefits derived from recent declines in energy prices. In this hypothetical scenario, a resurgence in inflation and potential increases in ECB official rates to new highs, or a faster reduction in balance sheets, would highlight the differing abilities of euro-area member states to absorb economic shocks. Depending on the severity of a new price shock and its impact on interest rates, this situation could further strain the credit ratings of certain sovereigns, particularly those already assigned a Negative Outlook by Scope Ratings, including Austria, Belgium, Estonia, France, and Slovakia. While not the primary expectation, diplomatic efforts to prevent a significant escalation in the region's conflicts, including those in Gaza, are ongoing. However, unresolved conflicts and disagreements in the area, such as civil unrest in Libya, Sudan, Syria, Yemen, a political crisis in Lebanon, and Iran's nuclear program, necessitate consideration of the potential significant consequences of any spillover from the Israel-Hamas conflict.
An increase in inflation could hinder economic growth, according to Scope Ratings. The deposit rate for the European Central Bank (ECB) is expected to reach 4% and be reduced by only 25 basis points to 3.75% by the end of 2024. If there is a higher-than-anticipated upside risk for the 2024 euro-area inflation projection of 2.9%, the ECB may need to maintain interest rates beyond 2024 or increase them further. Additionally, the acceleration of the reduction of the ECB balance sheet may be postponed to mitigate risks to financial stability.
In such a tightening funding environment, the growth outlook could be overshadowed especially as long-term Bund yields remain high. In this context, the projected euro-area growth of 1.4% for 2024 might need to be revised downward.
Furthermore, in a crisis scenario, most euro-area countries would have weaker fiscal positions compared to the pre-Covid period, limiting their ability to implement counter-cyclical policies to support the economy and address inflation. The varying fiscal space across the monetary union has further widened since the pandemic due to responses to the cost-of-living crisis driven by high inflation in 2021-22.
The adverse scenario of a broader Middle East conflict could place additional pressure on highly-indebted sovereigns, such as Italy, while Greece may demonstrate more resilience under higher inflation conditions, benefiting from rapid debt reduction. Greece's primary surpluses and compliance with EU fiscal rules ensure its continued eligibility for Eurosystem facilities.
Additionally, other sovereigns like Portugal, Cyprus, Ireland, Germany, and the Netherlands are expected to be more resilient in an adverse scenario due to factors such as strong fiscal flexibility, declining debt, and small primary deficits.
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