Italy Risks Reigniting The Eurozone Crisis

By Michael Collins | More Articles by Michael Collins

Italy’s corruption scandals of 1992 to 1994 that ended its First Republic gave life to the Lega Nord political party that was founded in 1989 to create a breakaway region called ‘Padania’ in Italy’s north. Target of the Northern League party that at 1994 elections helped Silvio Berlusconi become prime minister for the first of three times were the Italian flag, immigrants, Muslims, southerners, the capital Rome, globalisation and Europeanisation, especially the euro, which Italy could adopt only after fudging its finances – public debt had hit 100% of GDP, which was well beyond EU limits, in 1991.

In the early 2000s, Italian comedian Beppe Grillo used to smash computers to end his performances to show the nothingness of the internet. He soon realised the web was good for something. From 2005, Grillo wrote a weekly political blog read by millions. From that momentum, Grillo in 2009 founded the anti-establishment Movimento 5 Stelle that looked to southern Italy for support. At the 2013 national elections only votes from abroad stopped Five Star from becoming parliament’s biggest party.

Over the next five years, Five Star and the renamed League under Matteo Salvini broadened their countrywide appeal. Such was their success at the elections in March this year that two months later the pair formed an unlikely coalition that became the first eurosceptic government to take charge of one of the six founding members of the EU.

Among the first tasks of the League-Five Star government was the need to form a budget for 2019 that revives the economic growth of a country where real GDP per capita is still below the levels of 1999 when the euro was launched. Rome, whose debt amounts to 133% of GDP, chose to push for a budget that breaks the Brussels guidelines for indebted governments, a stance that risks placing Italy at the centre of a renewed eurozone debt crisis.

Italy comes to a showdown with the EU with the belief that as a country of 60 million people and the eurozone’s third-largest economy it is too powerful to be bullied and too big to be allowed to collapse. Rome grasps too that its net contributions to the EU budget and past threats to introduce a parallel currency to ease Italy from the euro bolster its negotiating power.

Rome’s biggest menace is the financial enemy Italians dub ‘lo spread’. This is their name for the higher yield investors demand to hold Italian government debt over their German equivalents – the spread on Italian 10-year sovereign bonds over German bunds has risen from about 135 basis points in March to 290 basis points on November 30. If the gap widens too much, the associated rise in interest rates and tightening in the availability of credit could impede Italy’s economy, possibly to the point of recession. In extremis, higher Italian bond yields could trigger the ‘doom loop’. This is the process whereby declines in the value of Italian government bonds erode the capital buffers of Italian banks that hold much of Rome’s debt, and Italy’s banking system could be vulnerable.

The risk for the contagion-prone eurozone is that the Rome-Brussels battle is broader than just finances – it’s part of a fight over the national power within the EU. Of little comfort during any showdown is that Europe’s rescue mechanisms appear inadequate to cope should Italy expose that the eurozone’s design flaws are still unaddressed. While the pressure on both sides to compromise will likely resolve these disputes in time to limit damage, Italy is likely to trigger a series of crises for the eurozone that will call into question the euro’s durability.

It must be said that no one is intent on taking Italy out of the euro. The economic damage a rising spread might do to Italy means that Rome would be under immense pressure to yield while questions about Italy’s euro membership give Brussels an incentive to compromise. That a resolution is the most likely outcome explains why there’s no sign yet of the contagion spreading beyond Italy.

The wider problem, however, is that Italy’s new rulers have assumed control of the eurozone’s vulnerable point that will need years of micro-economic reform to be made competitive. The country’s economy is so fragile a recession could damage Rome’s finances and Italian banks to the point of crisis. A stagnant and indebted Italy is likely to prove an enduring source of instability within a flawed currency system for the foreseeable future – but not an existential threat.

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About Michael Collins

Michael Collins is an investment specialist at Magellan. Since 2000, Michael has worked as an investment specialist/commentator for money managers, AMP Capital, IOOF/Perennial, Barclays Global Investors (now BlackRock) and Fidelity International.

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