Two decades since the euro began, one of the principal worries of its founders is materializing as the coronavirus rages through the region’s third-largest economy.
The longstanding suspicion that Italy’s profligate borrowing could ultimately become the whole of Europe’s problem was the recurring nightmare of German finance officials throughout the 1990s.
Now, as the crisis forces Giuseppe Conte’s government to jettison a decade of tightly capped Italian budget deficits, the country’s strategy for the future is once again built on piling up debt, sending its public borrowings swelling toward or even beyond 150% of gross domestic product.
The increasing death toll from the virus and the economic fallout from the lockdown leave the government with no option but to spend more to help its people. But it’s having to deal with the unprecedented situation carrying an already huge debt load.
The upshot is that Italy’s finances now depend wholly on the European Central Bank keeping a lid on its borrowing costs. Meantime, the only realistic question for officials in Berlin is how to structure further aid, since the alternative may be a failed state at the heart of the currency union, fatally threatening the euro.
“It all hinges on guarantees at the European level to avoid a market reaction,” said Pietro Reichlin, professor of economics at Luiss University in Rome. “Is the European Central Bank ready to undertake the needed purchases?”
Italy’s patchy economic record means worries have long lingered on in the minds of policy makers. It represents the ultimate test of resolve they might face one day, even after the euro’s existential debt crisis was stemmed in 2012.
The overarching issue is that while successive governments in Italy have kept deficits in check, none has succeeded in denting accumulated debt by recreating its economic miracle of the 1960s in a country that, by now, badly needs another one.
As Conte and colleagues firefight the health emergency, they’re deploying at least 50 billion euros ($55 billion) in economic aid. That will add to borrowings already totaling 135% of GDP, more than twice the ratio of Germany.
Should Italy spend all of the package, its deficit would reach 5%, the highest since 2009, when it was coping with the aftermath of the financial crisis, says Reichlin. Odds are that spending will actually have to be even higher.
“Much higher public debt levels will become a permanent feature of our economies and will be accompanied by private debt cancellation,” the Italian former ECB President Mario Draghi said in an opinion piece for the FT. “The alternative, a permanent destruction of productive capacity and fiscal base, would be much more damaging.”
Eurogroup President Mario Centeno has said the euro zone will exit the crisis withmuch higher debt levels, and governments must prevent this threatening the currency bloc with fragmentation.
What makes Italy’s situation all the more precarious, as seen from bond markets, is that the political determination to play ball with partners, whose goodwill it needs, is cracking.
The populist leader of the opposition League party, Matteo Salvini said in comments released on Saturday that the European Union took too long to respond to its crisis, and that Italians should reconsider their membership of the bloc.
“Heavy issuance in Italy and political risk, with Salvini making threats that can unnerve investors, will likely limit how far Italy can rally,” said Mark Dowding, chief investment officer at BlueBay Asset Management.
Salvini’s salvo was fired against the backdrop of an economy in dire trouble, with its northern heartland locked down, while tourism is also frozen.
Bloomberg Economics forecasts a contraction of more than 6% in the first quarter, while aMorgan Stanley report sees GDP dropping 19% in the quarter on an annualized basis, and by 33% in the next three months.
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European countries have indicated some willingness to help, possibly granting an enhanced credit line by theEuropean Stability Mechanism with minimal conditions.
Meanwhile the ECB has scrapped limits on bond purchases for its 750 billion-euro emergency program, a decision giving it huge firepower to fight the crisis. What those actions underscore is the reality that Italy’s dependence on outside aid will persist for the foreseeable future.
Such measures have helped subdue Italy’s borrowing costs, as well as those of other countries. Ten-year yields are currently back below 1.5% after a surge earlier this month saw them near 3%.
Poul Thomsen, an official at the International Monetary Fund, told Bloomberg Television that Italy does have fiscal space to act but that over time, it will need to reverse course.
“Italy would certainly have, over the medium term, to bring down its debt,” he said. “When it is over, it will have to get back to gradually bringing down deficits.”
What Bloomberg’s economists say…
“Without help and assurances from European institutions, Italy would probably be in a full-blown sovereign debt crisis by now. Fortunately, the ECB has clearly signaled its willingness to extinguish any fires in the country’s bond market with the Pandemic Purchase Programme. In addition, the ESM provides a backstop to assuage the worries of investors.”
–David Powell. Read hisECB INSIGHT
What would really help though, according to former Italian Premier Mario Monti, is if the euro’s richest members such as Germany and the Netherlands were to sign up to joint debt issuance to help poorer countries through a trying time. Speaking on Sky TG24 television, he said that the alternative could mean severe consequences.
“They need to choose between allowing the birth of euro bonds, or allowing the ECB to die,” he said.
Italy’s destiny was perhaps always going to be intertwined with the region, especially when the decision to create a single currency had been taken.
David Marsh, who chronicled its establishment in his book “The Euro,” described there how over time, the country’s membership became so inevitable that no rules could impede it. In his words, “excluding Italy was arithmetically valid, but politically impossible.”
— With assistance by Carolynn Look, Guy Johnson, Vonnie Quinn, Alessandro Speciale, and Zoe Schneeweiss
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