LONDON: Spanish and Italian borrowing costs have never been lower and yet, in the absence of inflation and stronger economic growth, both countries' debt levels are rising relentlessly.
The problem is particularly acute in Italy, where the economy shrank again in the second quarter and where Prime Minister Matteo Renzi has led calls for greater flexibility in European budget rules to allow it to spend more.
The debt pile-up, both in nominal terms and as a share of economic output, comes amid calls from Germany's Bundesbank to reduce debts "considered unsustainable in some countries".
It is not certain at what point investors would consider debt too high and become unwilling to buy the bonds, but any new economic shock in Europe would re-open that debate. Risks include renewed weakness in the banking sector, a rift in economic ties with Russia or the prospect of higher interest rates in the United States.
A European Central Bank promise in 2012 to buy the bonds of any country that has trouble accessing capital markets has helped cut Spanish and Italian yields by about two-thirds to record lows, though they remain high enough to lure investors.
"Spain, Italy - they're not in a position to withstand the next economic downturn, wherever that may come from," said Chris Iggo, chief investment officer for fixed income at AXA Investment Managers.
Analysts say only a pick-up in inflation would decisively cut debt, by eroding its real value.
This means the European Central Bank's efforts to bring inflation back towards its target of just below 2 percent are key and that it may have to stick to its ultra-easy monetary policy and bond-buying pledge for years to come.
Yet Bundesbank chief Jens Weidmann recently upped the pressure on euro zone governments to tackle indebtedness, saying last month loose monetary policy had "done its bit".
"Many are celebrating these record low yields. It's nice to have, but ... the monthly prints of inflation are, from a debt sustainability perspective, much more important," Commerzbank rate strategist David Schnautz said.
"The ECB is boxed into that corner of keeping the show going, because if yields rise and inflation doesn't pick up, the pain will be way more pronounced. You may question not only are you able to service your debts, but are you willing to service your debts or do you think that a wash-out needs to take place?"
To gauge the market's inflation expectations, analysts look at derivative products which allow investors to bet on where they see inflation in the future.
One-year inflation forwards see euro zone inflation below 0.5 percent for the next three years, below 1 percent for the next five and only hitting the ECB's target in seven years time.
That could be long enough for these too-big-to-bail economies to recover, but it could also be long enough for them to slip into a new downturn or for governments or the central bank to make policy mistakes.
"BASIC MATHS"
For a country to stabilise its debt, the sum of growth and inflation rates must equal the debt-servicing cost as a percentage of gross domestic product unless the country can run a budget surplus before interest payments to cover it.
Italy paid 4.9 percent of its economic output to service its debt last year, while Spain paid 2.9 percent, according to OECD data. Rome partly offset that with a pre-interest budget surplus of 2.1 percent, but Madrid had a deficit of over 4 percent.
Inflation and growth did little to make up the shortfall. Consumer prices grew 1.5 percent in Spain and 1.3 percent in Italy last year. But Spain's economy contracted by 1.2 percent, while Italy's shrank by 1.8 percent.
Their economies are faring better this year, and Spain's in particular is expected to grow 1.5 percent in 2014. But inflation has dropped to zero in Italy and is negative in Spain.
After Italy's poor growth data, traders said some investors used the Spanish auction on Thursday to replace Italian bonds with Spanish ones. But these are short-term trades not necessarily related to the longer term risk of a 3 billion euro combined debt load getting out of control.
"It is a very basic mathematical problem," said Sergio Capaldi, a fixed income strategist at Intesa SanPaolo in Milan.
"The variables in the equation that controls public debt, if you make reasonable assumptions on those, there's not a lot of hope debt will stabilise."
By comparison, Germany's debt financing costs were 1.6 percent of economic output in 2013, which was offset by its budget balance before interest payments of a similar size, OECD data show. That means that Germany would have been able to stabilise its debt even without growth and inflation last year, although growth was 0.5 percent and inflation was 1.6 percent.
Spanish and Italian benchmark 10-year yields hit all-time lows of 2.46 percent and 2.63 percent, respectively, last week.
UBS calculates that if bond yields stay at these levels, the annual cost of financing debt falls by 0.3 percent every year.
Given the limited impact, UBS strategists say that "with low projected real growth rates in both countries, an inflation rate of 1.5 percent would be needed for each year over the next several years were debt levels to stabilise."
It might seem counterintuitive that the market, on the one hand expects inflation to stay at levels that are detrimental to debt dynamics in Spain and Italy and on the other is willing to lend to those governments at record low rates.
The calculation that investors make is that if inflation fails to pick up, the ECB will start printing money to buy bonds. Investors selling the bonds to the ECB make a profit, having bought them when yields were higher and prices lower.
Iggo at AXA says it is likely that because of low inflation and growth, some big euro zone countries may have to impose losses on bondholders and restructure their debt in the next 10 years. But he is quick to predict how bond investors would react to a worsening of the inflation outlook.
"If we do get deflation, the first thought would be that the ECB will do something about it," Iggo said.
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