Italy and the Euro

Italy seems to be heading for new elections in autumn 2018 or early 2019. These elections may well shape up as a de facto referendum on the rules of the EU and the euro.

That is why we need to consider the “what if“ scenarios. In particular, could Italy trigger a new euro crisis?

A radical government in Rome — or the fear thereof ahead of new elections — could well plunge Italy into a deep crisis with significant financial and economic spillovers to its neighbors.

Consider that Italy is a founding member of the EU and the euro and accounts for 15.4% of Eurozone GDP and 23.4% of the bloc’s public debt. It also has linkages through the banking system that tie Italy closely to its European partners.

Given those circumstances, there is rampant talk that a radical government in Italy may try to blackmail the other EU and Eurozone members to ensure it can see through its demands on debt forgiveness, pension reform and the like. The EU and the Eurozone are unlikely to give in to such tactics.

In reality, though, while countries with close links to Italy would be severely affected for some time, it is important to remember that this would still be an Italian crisis — rather than a “euro“ crisis.

In an unlikely worst-case scenario, Italy may go bankrupt, leave the euro and face a prolonged period of chaos.

Beyond losing big Italy, the euro itself would not be at risk, though. Just like Brexit strengthened pro-EU sentiment across the EU-27, a hypothetical messy Italexit would likely make other countries more rather than less eager to stay in the euro.

A matter of contagion

The difference between a regional crisis within the Eurozone and a genuine euro crisis (as occurred in 2011/12) is contagion. The Eurozone today has the tools it needs to contain contagion risks, notably the European Stability Mechanism (ESM) and the ECB’s OMT program.

The latter is de facto a tool to massively scale up any ESM program, if required. The EU may add a further instrument to its toolkit at the upcoming June 28-29th summit by spelling out under which conditions the ESM could be the backstop for national bank resolution schemes.

With these tools, any country that accepts the rules of the euro and wants to stay in the euro can be defended against any financial panic.

As most investors know that, the risk that these tools will actually be needed to protect, say, Spain or Austria from any Italian fallout seems small.

In addition, the ECB could easily employ its standard monetary policy tools, injecting liquidity and adjusting its interest rate guidance in order to lower bond yields in the Eurozone, if Italian turmoil were to impact the outlook for Eurozone GDP and inflation significantly.

A repeat of the 2011/12 euro crisis marked by rampant contagion looks highly unlikely. The issue is how bad a potential Italian crisis could be.

Is Italy too big to support?

Many observers worry that Italy would be too big to bail out in a crisis. However, that is not really the issue at stake.

The question for Italy is whether or not it musters the political will to accept the rules of the euro. Consider three cases:

1. As long as Italy continues to play roughly by the rules of the euro, as it has done since late 2011, and credibly commits itself to staying that course, the country will not descend into a crisis.

2. If Italy, in an acute crisis sparked by concerns that it may want to leave the euro eventually, changes tack and reverts to the course of prudence, it would probably need very little if any outside support.

Italian paper would actually turn into an attractive buying opportunity. At most, a precautionary ESM credit line might be needed as a de facto stamp of approval for a return to sensible policies in Italy.

3. If Italy flouts the rules of the euro badly, descends into crisis and refuses to reverse that course, it would neither qualify for nor receive support. In such a case, the EU/Eurozone/ECB would focus on shielding other Eurozone members from contagion risks.

Italy would face the choice of either doing a Tsipras-style U-turn from radical populism back to sanity in the end — or bearing the consequences of a messy Italexit. It stands to reason that, in such a case, even Salvini would choose to stay in the euro, as Tsipras did in Greece.

Italian politics

That the EU and the euro rather than immigration may now become the top political issue in Italy is a double-edged sword.

If the radicals frame a new election as a de facto referendum on EU/euro issues and win, they would have a mandate to seek a confrontation with Brussels and Frankfurt.

However, a more intense discussion about EU/euro issues during the election campaign may also weaken support for the radicals, notably for the 5Stars.

A comparison to the UK might be instructive here. One key reason why the Brexit referendum succeeded was that neither the real costs nor the likely “day after” scenarios were spelled out in any meaningful fashion.

And in France, Marine Le Pen found out the hard way last year that many voters, even if they are very unhappy with the status quo and look back with nostalgia at supposedly “good old times” when their country had fewer immigrants and its own money, do not really want to leave the euro.

Specifically, French voters did not like the thought that their salaries and pension may in the future be paid not in euros, but in a much-devalued national currency. Neither did they like the prospect that part of their savings might have gone down the drain in an exit from the euro.

How badly would Europe be hit?

In the unlikely case of a messy Italexit, Eurozone growth (outside Italy) may stall for a couple of quarters, while the authorities deploy their tools to contain contagion risks and shore up the most affected banks if required. Thereafter, growth would likely recover back to a healthy pace, at least outside Italy.

Of course, it would take many years to work out the consequences of an Italian default that could come with a hypothetical Italexit, including the settlement of Banca d‘Italia‘s Target liabilities to the ECB.

Eurozone investors hold about 19% of Italy’s sovereign bonds, Italy’s Target liabilities stood at €447 billion in March 2018. The longer the time horizon for any such workout after an Italexit, the higher the recovery ratio would likely be.

For all these reasons, one would expect that, despite significant Italian turmoil now, the Italian crisis will not get out of hand in coming months.

After all, even if a future government wanted to take Italy out of the euro after new elections, it would still need Mattarella’s approval and be bound by rulings of Italy’s constitutional court.

Nevertheless, the risk that the current tension may escalate is significant. Meanwhile, the risk that Italy may, at some point in the future, decide to leave the euro, is small but not fully negligible.