The EU Commission yesterday warned that growing household indebtedness in Ireland would put the economy at serious risk of a downturn.

In its latest quarterly report on the euro-zone economy, the commission expressed optimism for the euro-zone economy as a whole, but singles out several countries where it says the economic situation is "less benign" as a result of soaring debt and house prices.

As a share of economic output, euro-zone household debt has risen from 44 per cent in 1995 to 56 per cent in 2004, with lower interest rates only partly explaining this, the report found. Longer mortgage repayment periods, higher loan-to-value ratios and interest-only mortgages have allowed borrowers to take on more debt, while debt securitisation has allowed banks to source funding beyond their deposit base, the report finds.

While manageable for the euro-zone as a whole, it warned of a serious divergence between some member states, including Ireland, Spain, Greece, the Netherlands and Portugal.

Demographic trends and higher inflation, which gives rise to lower real interest rates, were mainly to blame for this difference the report said, but it also warned of excessive expectations for future house price growth

"One cannot exclude the possibility of excessive optimism among households, implying an overestimation of long-term income prospects and an underestimation of future debt burdens," it states.

Data contained in the report shows Ireland to have the highest growth in household debt in the euro-zone.

The report predicts that a gradual cooling in housing markets was more likely than a crash, but added that countries with high levels of household debt could face economic difficulties even if house prices remained stable. "Rapidly rising house prices can leave an economy vulnerable to a subsequent price correction with ensuring negative wealth effects," the report stated. "Irrespective of whether such a correction occurs or not, high levels of debt leave households vulnerable to adverse shocks to disposable income and interest rates."

The commission predicts economic growth will rebound this year, despite poor growth last year, but that growth in private consumption would be critical.

Klaus Regling, head of the commission's directorate general for economic and financial affairs said it was more important for EU governments to secure employment growth than wage growth.