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The eurozone's Italian nightmare

Arthur Sullivan
August 27, 2019

Political talks are ongoing in Italy which could avert a snap election and see Matteo Salvini's League party ousted from government . But an economic shadow hangs over the chaos and that's a worry for the eurozone.

Symbolbild | Italien nach Referendum
Image: imago/R. Peters

With new British Prime Minister Boris Johnson having apparently scheduled a no-deal Brexit for October 31 this year, Halloween is already shaping up to be more ghoulish than usual for the EU.

But there's an even more terrifying story spooking Eurocrats in 2019, and it comes from Italy.

Do you know what a mini-BOT is? It might sound like something from a robotic, dystopian future, but it's the informal name given to a prospective "parallel currency" that many in Matteo Salvini's right-wing League party are in favor of bringing into circulation in Italy.

The idea behind these prospective mini-BOTs (literally mini "bills of treasury") is that they could be issued in small denominations and used by the Italian government to pay off some of the mountain of debt it owes to commercial businesses and suppliers.

Whether the mini-BOTs ever come into circulation or not remains to be seen. But several Italian economists and analysts have said they could serve as a stepping stone on the way to an alternative currency in Italy if they do.

Italien Innenminister Matteo Salvini
Matteo Salvini, leader of League and a prospective Italian prime minister, once described the euro as 'a crime against humanity'Image: Getty Images/AFP/M. Medina

Salvini's party, until recently part of a rickety coalition with the left-wing 5-Star Movement, is keen to trigger an election year that it believes it could win outright. The latest political developments suggest an election may be averted but Salvini is not going anywhere and remains a popular figure.

The populist leader has made no secret of his desire for Italy to leave the eurozone one day. So the current political chaos in Italy and the prospect of a League majority government has deep significance for the wider EU — arguably much more significance than the current paroxysms around Brexit.

Why Italy matters

There's a famous line in the Shakespeare play Macbeth, when the mad Scottish king tells the rival he has been warned most about: "of all men else I have avoided thee."

That sums up precisely the way the eurozone's financial doyens have long since felt about Italy, even during the long night that was the Greek debt crisis in the early years of this decade. As bad as that was, nothing sends shivers down spines in Brussels quite like the thought of an Italian debt crisis.

The reason can be understood clearly enough by looking at the following graphic, which shows how much European banks beyond Italy's own shores are exposed to Italian debt, much of it government debt.

European banks' credit exposure to Italian debt EN

Most governments around the world owe a fortune. But the Italian debt pile would make most others blush. Italy owes $2.3 trillion (€2.06 trillion) in public debt. That's around 133% of its GDP — a massive ratio that puts it in the top five in the world.

While the majority of that stock of borrowing is weighing down banks in Rome and Milan, European banks are severely exposed in the event of anything going wrong. France is in the hole for a potential €285 billion according to a study by Bloomberg, while German, Spanish, British and Belgian banks also have cause for concern.

Although Italian government projections see the percentage of public debt as a percentage of GDP falling to 120% in the next decade, the OECD recently forecast that it would rise in that period due to sluggish growth rates, among other things.

Indeed, one looming conflict that adds extra spice to the mix is the prospect of the EU launching a disciplinary process against Rome for breaching EU rules on debt and budget deficits.

Doom loop

As the third-largest economy in the eurozone and one of the top 10 worldwide, the Italian economy will always have an influence on the wider European economy.

But given the extent to which European banks are tied to Italian debt levels, that link is much stronger that it otherwise might be.

During the years of the global financial crisis from 2007-2008, several banks collapsed. When major banks collapse, that has the potential to infect the entire financial system as the knock-on, contagion effect begins to affect other banks and other balance sheets.

One particularly devastating element of this is the so-called sovereign debt "doom loop." This is when banks and domestic governments are so intertwined that a country's indebtedness can lead to doubts over its ability to pay back its debts — in turn, leading to banking chaos.

Given the numbers at stake in Italy, it's easy to see why it turns so many people's blood cold.

Arrivederci euro, buongiorno mini-BOT?

But if Italian banks haven't collapsed yet, why should they ever collapse? After all, the whopping public debt in Italy is nothing new.

The simple answer is political. The prospect of Italy being governed by a party that has actively spoken of leaving the eurozone, and indeed the EU, has only increased since League and the 5-Star Movement hammered out their initial pact just over a year ago.

The debate over mini-BOTs, however serious, feeds into this prospect. Riccardo Puglisi, an economist at the University of Pavia, told the Financial Times earlier this summer that the proposal was "a way to facilitate the exit of Italy from the eurozone."

Were Italy to try to leave the eurozone in the coming years, there could only ever be a disorderly departure, if such a departure were even possible. Although still very much an extreme, hypothetical scenario, a disorderly euro exit would increase the possibility of Italy defaulting on billions of euro debt.

From that rises the specter of what would be the largest default in economic history.

The consequences for Europe in an economic age already jolted by Brexit, the China-US trade war and indeed, the longer-term effects of the Greek debt crisis, hardly bear thinking about.

Yet the increasingly uncertain terrain of politics demands that we do.

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