Italy’s shadow looms large over Europe

Rome’s problems have been decades in the making – but the proposed solutions are high-risk at a time in which Italy can ill afford them

MS5’s Luigi di Maio and Lega’s Matteo Salvini
MS5’s Luigi di Maio and Lega’s Matteo Salvini

This blog was written before the formation of an Italian government Thursday evening.

Italy is known for many things – not least its excellent cuisine, and the contribution it had to the fine arts during the renaissance. In recent years, it has unfortunately become synonymous with economic malaise and political instability, a tumultuous mix. The current Prime Minister, Paolo Gentiloni, is the head of the 65th government which Italy has had in the last 72 years.

For those who are looking for some background on the situation, they need not look further than James Debono’s explainer from mid-week.

Italy’s economic problems are considerable. Italy’s debt to GDP ratio stands at around 132% - second in the eurozone to only Greece’s 180%. However, given that Italy’s economy is €2.4 trillion and Greece’s GDP is just over €348 billion, Italy’s debt in real terms is far larger, and depending who you ask, poses greater threat to the eurozone itself.

When considering the economic perspective, some of the 5Star/League coalition’s proposals appear to add to the problem. One of the proposals which was reported in the media was for Italy to ask the European Central Bank to forgive its debt – something that would cause outrage in countries such as Greece, Spain, Ireland and Portugal, given the considerable economic and political sacrifices they had made to get their debts under control over the past decade. The likelihood of the ECB deciding to forgive any amount of Italian debt is practically zero.

Italy is a core member of the EU but its perennial political stagnation and inability for meaningful economic reform has led people to turn to more radical parties

But the debt forgiveness proposal could effectively be a red herring for the other proposal which was in the same document – the creation of “economic and judicial procedures that allow member states to leave the monetary union.” While the Five Star Movement (M5S) has seemed to be more cautious in expressing Eurosceptic sentiments in public, Salvini’s League has been far more open in recent years of being serious about leaving the euro.

With the potential for another general election looming in the near future, possibly this year, the very notion of a Eurosceptic coalition government was enough to spook the financial markets. Italy’s 10-year bond yield, a good indicator of the risk associated with purchasing the government’s debt, jumped some 19 basis points to 2.13%. Italian stocks fell 2.5% shortly after it became apparent that another general election was on the cards. There was also impacts on the euro itself, with the euro trading at a lower level in relation to the US dollar than it has in six months – and this is simply related to uncertainty in Italy at this point, not a full-blown crisis.

At this point, it remains uncertain as to whether the M5S/League coalition, should it survive beyond the next election, would consider leaving the euro. This is in part due to the changing positions of the two parties over recent months. Whilst popular sentiment in Italy is in favour of retaining the single currency, paradoxically, polls show that support for the Eurosceptic parties is stronger than it was just a few months ago. The chances of the M5S and/or League taking over the reins of power are better than ever.

From an economic perspective, the proposals made by the coalition would increase Italy’s debt through a series of tax cuts and more generous social benefits. This would mean more expenditure and more debt. The tax cuts themselves may stimulate some economic growth, but whether it would be enough to offset the loss in government revenue is uncertain and they would be taking a risk with no guarantee of it paying off. In short, this means that its debt would continue to climb.

As to the impact on the eurozone, economists seem to be split on what the impact would be of a hypothetical Italian default. Some have said that the majority of Italy’s debt is held within Italy, and as such, an Italian default should not spread to the rest of the euro. Others have insisted that a default of such a magnitude would at the very least shake confidence in the euro project, and in one of the potential worst-case scenarios, cause sell-offs on financial markets across the Continent, putting the future of the single currency at risk.

Italy has undergone several crises in past years, to the extent where the lack of a crisis was the exception – not the rule. But with the likelihood of a populist or far-right government on the increase, the ramifications go beyond Italy. Financial markets in Europe, the United States and Asia have already taken a hit in the past few days based upon the unfolding events in Rome. 

Once the UK leaves the European Union (March 2019), Italy becomes the third largest economy within the European Union. If it is led by a party, or parties (as seems likely), whose policies lead them to increase their debt with little thought as to how to bring their spending under control, fewer investors will be willing to buy their debt on the market.

Couple this with the potential for credit rating agencies to downgrade Italy’s sovereign debt if they feel like Rome has no plan to bring its finances under control, and Italy will be facing a situation that Citigroup, a large global investment banking firm feels has been long in coming, saying in an internal note that “We can’t get more aggressive than our long held view that a Sovereign debt crisis is a 100% risk (in Italy), in the long run.”

Italy is a core member of the EU and the eurozone, but its perennial political stagnation, and the inability to engage upon any meaningful economic reform has now led the people to turn to more radical parties who promise to solve Italy’s economic problems through unconventional means.

If 5Stars and the League look to go on a spending spree, they will not find many willing to forgive their debts or to provide the investment they need. At that point, they would need to consider whether to remain within the eurozone as a pariah, or to leave and enter the economic wilderness on their own.

There are no easy solutions ahead for Italy’s politicians. But this has been a slow-burning problem many years in the making. Europe has had one wary eye on London, but it will now turn the other towards Rome. In a world of seemingly increasing political risk, Italy has become the country closest to the political and economic precipice.

More in Blogs

Get access to the real stories first with the digital edition

Subscribe