Europe on Edge as Two Countries Face Debt Crisis Risks

Europe is increasingly concerned about sovereign debt risks. After France, Italy is now in the spotlight.

Plans to increase government spending and widen the budget deficit have raised fresh concerns about Italy’s fiscal position. Goldman Sachs warned that a higher deficit and rising bond yields could drive the country’s debt-to-gross domestic product (GDP) ratio upwards through 2028, potentially making it the highest in Europe.

Prime Minister Giorgia Meloni’s government approved an additional €28 billion (about US$31 billion) in funding on 2 October for defence and energy spending over the next two years. The increase takes Italy’s deficit targets to 3.4% of GDP in 2027 and 3.2% in 2028.

Those figures are above the projections made in April, which were 2.8% and 2.5%, respectively.

Filippo Taddei, Goldman Sachs’ senior European economist, said the revised targets were a significant surprise that could put further pressure on Italian government bonds. In a note on Thursday, Taddei said the combination of looser fiscal policy, tighter financial conditions and a closely contested election could worsen Italy’s debt outlook after four years of fiscal consolidation.

Goldman Sachs expects Italy’s debt-to-GDP ratio to rise through 2028 before stabilising at around 137%. If that forecast is borne out, the ratio would be the highest in Europe at that time.

The risks would increase if yields on Italian 10-year government bonds remained above 4%. Taddei said a structural shift towards yields above that threshold could cause Italy’s debt ratio to continue rising thereafter.

Shadow of France’s debt crisis

Concerns about Italy have emerged as European bond markets remain under pressure because of France’s fiscal position. On Friday, yields on French 10-year government bonds stood at about 4.85%, while those on Italian bonds of the same maturity were around 4.55%.

The yield spread between Italian bonds and Germany’s benchmark bonds was about 108 basis points. Rising bond yields reflect investors’ demand for greater compensation to hold government debt.

This can increase government borrowing costs, particularly for countries with heavy debt burdens. Italy also faces political uncertainty ahead of its next general election, which must be held no later than 22 December 2027.

Goldman Sachs said a closely contested election could make it harder for the next government to pursue fiscal consolidation. Parties on both the right and the left could seek additional spending to build a governing coalition.

Meloni’s government, however, has previously won market approval after reducing Italy’s budget deficit, which stood at 3.1% of GDP in 2025. Political stability under her leadership has also helped improve investor sentiment towards Italian bonds.

The additional defence and energy spending is permitted under the European Union’s National Escape Clause, which gives member states temporary budgetary flexibility to respond to shocks, including the effects of the Russia-Ukraine war and conflicts in the Middle East.

Is Italy still stronger than France?

Despite the risk of rising debt, some investors argue that Italy’s position is not necessarily worse than France’s. Konstantin Veit, a portfolio manager at PIMCO, said Italian government bonds have relatively supportive characteristics because most are held by domestic investors.

That could help stabilise the market during periods of stress. By contrast, the broader foreign ownership of French bonds is considered to make the market more vulnerable to shifts in global sentiment.

Veit also pointed to factors supporting Italy, including a stronger primary budget balance, a relatively favourable fiscal direction, political stability and the government’s track record of making difficult fiscal decisions. Nevertheless, Italian bond risks remain a concern for investors.

Reinout De Bock, head of European rates strategy at UBS Investment Bank, has previously taken a short position on Italian government bonds, known as BTPs. The strategy reflects the view that Italian debt could become the next weak point in Europe’s sovereign bond market.

De Bock said investors could pay increasing attention to Italy’s risks as bond yields remain high, despite the country having implemented various reforms. Although Italy retains several fundamental supports, widening deficits, a heavy debt burden and political uncertainty could combine to pose risks for markets as 2028 approaches.