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

The Sunday Telegraph - Money & Business - - Business -

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

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