Rome alone? Key questions for the euro

BRUSSELS (Reuters) – A new government is taking shape in Italy which is worrying the EU and financial markets over Rome’s commitment to the euro and the economic rules that membership entails. Here are answers to key questions:

Is Italy ditching the Euro?

Certainly not. After an inconclusive election, the president asked political novice Giuseppe Conte to form a government. He was nominated by two anti-establishment, Euroskeptic parties, The League, far-right and strong in the north, and 5-Star, big in the poorer south. But although critical of the effect the single currency has had on the economy, their joint draft program foresees retaining the euro.

So why all the jitters ?

Because although they say they want to keep the euro, they also want more flexibility to cut taxes, borrow and spend despite Italy already straining at the limits the EU sets on public debt and deficits. An idea to pay some government bills with special new debt sounds to many like recreating the lira. The EU executive and heavyweight partners like Germany and France have lined up to warn Rome not to defy the rules, which they argue are in Italy’s interests if it makes other reforms.

Is Italy ‘the new Greece’?

Greece’s bailout can do little for Italy, whose economy is 10 times Greece’s and whose €2.4 trillion debt is worth nearly the entire national annual income of France. Italy is “too big to fail” – the euro zone simply cannot afford to bail out its third biggest member. The EU believed a Greek default would destroy faith in its currency, driving up costs for other governments. An Italian default would do that easily.

But what if Italy can’t pay?

The Commission polices rules under which Italy is supposed to run budget policies that can reduce its debt. It has not managed to do that in recent years but if it started to let debt balloon, the Commission could reprimand it and issue fines. EU officials acknowledge that such measures are limited and that market and domestic political pressure can be more effective. As happened in Greece, the European Central Bank could curb access to euros for Italian banks if it deemed the Italian public debt they hold as a big part of their capital was of dubious value. That would happen if Italy’s credit rating fell below investment grade, which would either make Italian bonds no longer eligible as collateral for ECB liquidity, or make such financing much more costly for Italian banks. Similar circumstances forced Greece to impose capital controls in 2015, a first step to creating a difference between euros held in Greece and outside. Unable to borrow in euros or other currencies because investors would demand huge yields to compensate for fears of not being repaid, the Italian state could issue money-like instruments to pay, say, pensions or public salaries. A vicious circle of lost confidence could quickly see Italy effectively out of the euro.

And so how likely is that?

Italy crashing out of the euro would massively disrupt, at least in the short term, not just the Italian economy but the whole of Europe, giving politicians, businesses and voters at home and abroad a big incentive to avoid it. It would also be a huge political blow to the EU project as a whole, casting doubt on many other plans and Europe’s standing in the world – the reason Germany, France and others paid up to rescue Greece.