Italy-EU impasse heading for crisis
THE EU has no legal means to force the capitulation of Italy’s rebel government and the budget showdown is likely to escalate until there is a market crisis, warned a veteran euro fire-fighter.
Vitor Constancio, the European Central Bank’s former financial stability chief, said the high-stakes clash with Italy is extremely difficult to handle and Brussels is effectively powerless against a net contributor to the EU.
This means there is no mechanism to compel compliance by the Lega-Five Star insurgents other than a sobering blow-up in the bond markets. By then there would be serious financial blood on the floor, with revived fears of “redenomination risk”, the technical terms in banking circles for euro break-up.
“Financial markets will dictate the outcome. Italy cannot win against the market,” he told a forum in Brussels. Mr Constancio said there will be no help of any kind until Rome submits to the EU bailout machinery under strict conditions.
Relying on the bond vigilantes to discipline Italy is a gamble for the eurozone. It allows the system to be buffeted around by hedge funds and fast-moving capital flows. The events of 2010 to 2012 showed how quickly
this can spin out of control. There is no sign yet of any truce in the budget fight between Brussels and Rome. The European Commission said yesterday that Italy’s fiscal plans are based on implausible growth assumptions and that the violation of the Stability Pact is even worse than feared.
Its autumn economic forecast said the deficit will hit 2.9pc of GDP next year and 3.1pc in 2020 as costs mount for universal basic income and the rollback of pension reform. The “structural budget deficit” is deteriorating dramatically, from 0.5pc of GDP in 2015, to 1.8pc this year, and 3.5pc in 2020.
The public debt ratio will barely stabilise at 131pc of GDP, a precarious situation a full decade into an ageing global expansion. Debt dynamics could turn toxic in the next world downturn. “This is hugely dangerous. Italy is miles away from the required debt reduction,” said Lorenzo Codogno of LC Macro Advisors.
Finance minister Giovanni Tria dismissed the Commission’s analysis as “technical incompetence”, vowing that his government would stick to the tax and spending plan agreed by the Italian parliament. It looks inevitable that Brussels will activate its “excessive deficit procedure” and take the fateful step of imposing punishment fines on Rome, risking a volcanic political eruption.
Ironically, the enforcer is economics commissioner Pierre Moscovici. He was on the other side five years ago as France’s socialist finance minister, declaring then that elected governments were right to defy the “neo-liberal orthodoxies” of Brussels.
Lorenzo Bini-Smaghi, the chairman of Societe Generale, said Italy has already slipped into recession this quarter and the picture is far worse than the tame Commission forecast, which sticks to the “soft patch” theory of Europe’s latest slowdown. “Italy is going straight into a wall. The crash is going to be violent,” he told Avvenire.
Economic growth stalled in the third quarter. The early-warning PMI indicators point to outright contraction over recent weeks. There are signs of an incipient credit squeeze for small firms as rising bond yields erode the capital buffers of Italian banks, forcing them to curtail lending. A mildly expansionary budget would normally be the advisable policy in such circumstances, at least for wealthy countries with their own
If Brussels takes the step of imposing punishment fines on Rome, it risks a volcanic political eruption
currency and central bank. The perverse logic of Europe’s half-built monetary union is that Italy should tighten fiscal policy “pro-cyclically” into the slowdown. Mr Constancio said the Italian showdown kills off any chance of meaningful euro reform in the foreseeable future. There will be no move towards a eurozone fiscal entity or risk-sharing apparatus. The Macron reform plan lies in ruins.
Germany and the Nordic Dutch-led “Hanseatic League” say open defiance by the Lega-Five Star alliance shows why it would be an error to share debts. Lasting discipline must first be established. Behind this mantra, of course, is the perennial interest of the creditor states. Mr Constancio said the eurozone will have limited tools if there is a global downturn or recession over the next 24 months. It will have to rely on ECB monetary stimulus, meaning further bond purchases, going beyond the 33pc limit on each issue. It will also need a co-ordinated fiscal stimulus, backed by completion of the EMU banking union and the creation of a “European safe asset”, all of which is like pulling teeth.
Mr Constancio says the banks have stronger capital buffers than in the last crisis, while fiscal and current account balances are healthier. “The euro area will withstand and overcome the next crisis,” he insists. It is not clear whether market pressure can be directed surgically against Italy without setting off a chain reaction through southern Europe. Mr Moscovici said there has been no contagion yet. In fact there have been spillovers to Spain and Portugal each time risk spreads on Italian 10-year bonds punch above 300 basis points.
The Commission itself warned that the contagion effect may merely have been “delayed”, while the International Monetary Fund said in its regional outlook yesterday that “contagion from future stress could be notable, especially for economies with weaker macroeconomic fundamentals and limited policy buffers”.
French bank exposure to Italy is equal to 12pc of French GDP. “In a scenario where we go down, France will take the hit too,” said Claudio Borghi, the Lega’s economics chief and an ex-Deutsche Bank trader.
“If I were still trading, the obvious trade would be to go long Italian debt and short French debt, because either Italian spreads are right at 300 points or French spreads are right at 40. They can’t both be right,” he said.
Italy’s finance minister Giovanni Tria: he dismissed the Commission’s analysis as ‘technical incompetence’ and said his government would stick to its tax and spending plan