Italy’s debts could break the eurozone
Europe is facing up to a crisis whose consequences could dwarf the bailout given to Greece, writes Anna Isaac
On June 1, the European Central Bank turned 20. It was an eventful anniversary. The same day there was an epic sell-off of Italian debt, with yields on its two year bonds spiking the most in a single trading session since 1992.
Credit ratings for everything from utilities to banks were thrown into doubt. For a while, carmaker Ferrari could borrow money at better rates than the Italian government.
The reason why the eurozone’s third largest economy shook world markets last week was seemingly simple: the possibility of a Eurosceptic government that would spend big while slashing taxes and maybe even quit the single currency.
Recent political developments might have helped to ease some of those immediate concerns. The prospect of a fresh coalition line-up has emerged. New elections this year which would be an effective referendum on Italy’s future relationship with the euro are now less likely.
However, the rise of populism in the southern EU state has laid bare the economic gulf between the three main cornerstones of the eurozone: Italy, France and Germany. The two Italian parties in charge – the Five Star Movement and the far-right League – are still no fans of the euro. Matteo Salvini, the League’s head, says the
fiscal rules of the EU have “enslaved” Italians.
There is already plenty of economic ammunition to help advance an anti-euro agenda. Italy’s GDP is growing at half the rate, 0.3pc per quarter, of its larger eurozone counterparts. Since 1999, German productivity levels have outgrown Italy’s by a staggering 20pc.
As a working paper from the world’s lender of last resort, the International Monetary Fund, reiterated in January, the promise of the 1992 Maastricht treaty was that by giving up monetary autonomy, eurozone countries would gain greater economic stability and higher growth. This would come “as the elimination of exchange rate uncertainty and lower borrowing and transactions costs would lead to more trade, labour, and capital flows”.
Stark differences in economic growth have called that premise into question. Benoît Coeuré, a board member of the ECB, has warned that trust in the institution has become “fragile”, with 47pc of eurozone citizens saying they have no confidence in the central bank. No longer is it “enough for central banks to deliver low and stable inflation for people to trust them,” he says.
Ignazio Visco, head of Italy’s central bank, says the trust that investors and businesses have in Italy “must not be frittered away in actions that will not affect growth potential and may even risk reducing it”.
Markets have calmed slightly as a new government has been put together. Paola Savona, a vehement Eurosceptic who spooked markets as a potential finance minister because he had advocated quitting the euro, has been moved to European Affairs Minister. He is replaced in the finance ministry by Giovanni Tria, an obscure academic who has been critical of the EU in the past but is not thought to be in favour of leaving the single currency.
A decidedly anti-eu leadership with plans for massive public spending remains, however. Some plans, including the introduction of a basic income of €780 (£685) a month – which could drive Italy’s budget deficit to 6pc – are particularly reminiscent of the 50pc increase in public sector wages seen in Greece between 1999 and 2007. This drove it over the 3pc budget deficit rule for eurozone members and led to a sovereign debt crisis. The Greek bailout is still unresolved. The world’s lender of last resort is looking to the EU to agree to increased debt relief. Some €200bn from other eurozone states has been spent on trying to help it recover.
Other governments may not have learnt from its lesson. They have not fixed the roof while the sun has been shining on the global economy. This makes Italy’s spending plans particularly disturbing.
“The weakest countries have not used this time [of economic recovery] in an optimal way,” says Nicola Mobile of Oxford Economics. “Italy has only made some liberal market reforms. There is still diversity between the weakest countries and the strongest. If another crisis comes there is more fiscal room overall [in the eurozone] but there is huge disparity. There isn’t much appetite for this [another bail-out] in Germany.”
Following the eurozone crisis all eyes are on Italy’s debt. As a far bigger economy than Greece, any problems it could have will be of a different order of magnitude.
Italy has a 132pc debt to GDP ratio, second only to 180pc in Greece. However, Greece only just slips into the top 50 of world economies by GDP, ranked 48th in 2016, whereas Italy is one of the world’s biggest, ranked 8th. An Italian meltdown would be far more damaging and wide-reaching.
Moody’s, one of the credit ratings agencies that added to the market panic by placing a range of Italy’s credit ratings under review, has made a revealing move – by not budging. It has stuck to its review despite the fact Italy may now avoid new elections.
It said: “Italy’s sovereign rating would likely be downgraded if we were to conclude that whoever emerges as the next government will pursue fiscal policies that will be insufficient to place the public debt ratio on a sustainable, downward trajectory in the coming years. A failure to articulate and present a credible structural reform agenda which would enhance Italy’s economic growth prospects on a sustained basis, would be similarly negative for the rating.”
There is considerable pressure on both the populist partners in the likely coalition government for a spending spree. So far, mooted policies have included a reversal of pension reforms, and an introduction of considerable tax cuts, to a flat rate of 15pc.
Currently, Italy’s sovereign debt rating is two notches above junk, within investment grade territory. A downgrade therefore presents serious risks for its financial stability, and importantly, that of its banks which still hold twice the level of non-performing loans of other eurozone counterparts.
At the end of April, 10.8pc of the Italian banking sector’s balance sheet was made up of government bonds. This was up from 9.9pc at the end of November.
“The fate of the Italian banking sector remains entwined with that of the sovereign [debt], something that the market understands only too well,” says David Owen of Jefferies.
It’s a problem revealed by Moody’s own rules, which mean that banks can only be two notches above their nation’s sovereign bond rating. If Italian treasuries are downgraded, banks will follow suit.
Fears of a schism between EU states, and resultant threats to their currency, have not disappeared. Neither have concerns that it is only a matter of time before another country needs significant financial aid. For the euro to survive future crises, there must be greater eurozone integration, many economists argue. But the bloc will first have to tackle the political headache of persuading member states that some countries’ taxpayers will have to underwrite others.
Soon after the debt sell-off began, questions about whether Italy’s populists would accept the strings attached to any ECB assistance, such as its mechanism for buying back bonds in secondary markets, loomed large. The ECB’S quantitative easing, or money printing programme, is set to come to an end this year, and worries are mounting that Italy’s finances might weaken further once this support is removed.
Such fears have provoked Brussels into trying to find a solution that will add to the stability of the eurozone, but which all members can accept. This won’t be easy – Emmanuel Macron’s plans for closer monetary and fiscal union were severely criticised by other finance chiefs, including those of Ireland and the Netherlands.
While the nature of its elaborate and vast rescue mechanisms are hotly debated, if it is to see in another 20 years, the eurozone’s central bank has some big problems to solve.
‘The weakest countries have not used this time [of economic recovery] in an optimal way’
‘The fate of the Italian banking sector remains entwined with the sovereign [debt]’
‘Change or you die’ says the banner at this Five Star Movement rally last week in Naples, Italy. Carlo Cottarelli, below, named as Italy’s new prime minister designate by the president, has been rejected by the populist parties