In a recent report Goldman Sachs warned Italy risks falling into a new recession, suggesting financial markets could end up forcing the government to change its economic policy. Investors are far from reassured by the political instability created by the Italian populist government, which has engaged in a “budget saga” with the European Commission for months. Brussels said that Italy’s budget plans were in “particularly serious non-compliance” with the rules, raising doubts about the solidity of Italy’s public finances due to its massive public debt pile. This has led some commentators to make a comparison with a Greece-like crisis. However, the circumstances that put Rome under the European Commission radar are very different from those that brought Athens under the Trioka’s supervision. Italy’s problem is so not much of a financial nature, but in its absence of political will in observing the rules of the European Monetary Union (EMU).

The row between Brussels and Rome has had a direct impact on Italian banks, which are the main buyers of Italian sovereign bonds, while investors’ demand for Italian debt has slowed down considerably and the sale of bonds dropped. A bigger selloff in two-year debt prompted deep concerns about the nation’s near-term financial solidity, mixed with the European Central Bank’s decision to tweak capital key and adjust the capital shares of national central banks in 2019, cutting Italy’s share in bond-buying. Moreover, it’s still unclear how the ECB will deal with its holdings of Italian securities as it rolls back gradually its loose monetary policy.

Niall Walsh, an analyst at Oxford Analytica, says “market optimism is unlikely to last for long” if the Italian government doesn’t respond adequately to EU’s demands the equity market could fall again and the spread could widen above 300 basis points. If interest rates on debt repayment were to grow to levels over 4%, the write downs of Italian banks on their government bond holdings would be so high that they would have problems with their capital ratios. Walsh noted “if the spread widens to 400 basis points, they will likely require fresh capital injections”.

Mario La Torre, a finance professor at the Sapienza University in Rome, also agrees that higher spread will impact first on the value of banks’ government bond portfolios, which lastly will put pressure on their free capital. However, he points out “Italy does not face any risk of a new banking crisis as the Italian banking system has put in place a significant effort in cleaning their balance sheets from non-performing loans”, while its largest banks have performed well at the last European Banking Authority (EBA) stress test.

Overall the Italian banking system doesn’t show any particular deviations that could trigger fears of a new crisis. According to figures from the Italian Banking Association (ABI) in October 2018 the spread between the average lending rate and the average rate on household and non-financial corporations funding remained at 188 basis points, showing a sharp decrease from more than 300 basis points prior to the onset of the previous crisis.

The Italian financial system, unlike the Greek one, can count on current account surplus and its debt has a longer debt maturity profile. Moreover, private savings and deposits offer a significant cash buffer, which makes it very unlikely that Italy would run out of money or miss its debt obligation, as instead was the case for Greece. The Italian national debt is about eight times larger the size of Greece’s debt, but over 70% is held by domestic creditors, and contrary to Greece, has yet no difficulty in refinancing its debt. Domestic savings can easily be used to cover for even a bigger fiscal deficit. Iain Begg, a Professorial Research Fellow at the European Institute of the London School of Economics (LSE), argues “we are still quite a way from a scenario equivalent to Greece because Italy is not insolvent, and unlike Greece, much of Italian debt is owned domestically by Italians”.

The nature of the Italian populist government, led by Eurosceptics forces, suggests that tension between Rome and Brussels is likely to continue in the upcoming months in the run-up to the European elections in May. However, the worst-case scenario of a possible “Italexit” is far from materialising anytime soon as that would have unquantifiable political and economic negative ramifications on Europe and the rest of the world.

The post Too big to fail but big enough to trigger a financial crisis appeared first on International Finance.

James Newell, professor of Italian politics at the University of Salford, notes “what is more likely to unsettle investors is less any plan to leave the Euro than policies in relation to the public debt which might result in Italy being forced to leave the Euro against its will”. The new government has indeed failed to give any specifics over the timing and the costs of the core economic and fiscal measures contained in its programme, including a new flat-tax, universal basic income scheme and roll-back of pension reform. “I think that investors and the markets are for the moment adopting a wait-and-see attitude, we shall have to wait and see what happens in the light of more specific plans when they emerge”, Professor Newell added.

Undoubtedly, Italy’s high public debt combined with a weak growth and persistent structural problems of its economy due to the lack of needed reforms justify mistrust by some of its European partners. Professor Newell’s views are shared by Mario La Torre, an economist and finance professor at Rome’s La Sapienza University, who said: ‘the government has announced an aggressive fiscal policy but it is now explaining that not all the goals will be reached in the short term’. However, he expects a new set of goals to be unveiled before the end of summer.

The new government’s spending plans have rattled markets, although the risk of a Greece-style crisis doesn’t currently seem to be on the cards at least yet, it cannot be totally ruled out in the near future due to growing financial pressure Italy has come under. Robert Sinche, chief global strategist at Amherst Pierpont, notes the markets are ‘well aware’ of the pitfalls in the programme. He said: “the markets realise the programme is not sound and, if actually implemented as proposed, would likely cause a further widening of spreads”. In his view, a full implementation of all the outlined proposals could push the spread between Italy’s BTP 10-year bonds and the 10-year German Bunds into the 400-500bp range.

This risk could be further exacerbated by the end of European Central Bank’s quantitative easing (QE) programme as the bank’s policymakers have given their strongest hint that they are preparing to phase-out its bond-buying programme later this year. Italy has undeniably been a beneficiary of the QE, and its end combined with the end of Italy’s Draghi’s era as the Bank’s President could cause further problems for the country. Moreover, Draghi’s likely successor, Germany’s Bundesbank President Weidmann, has widely criticised the effectiveness of the programme and has a different stance on what type of monetary policy Europe needs.

The Centre for Economic Policy Research (CEPR), in a recent paper, suggested that “in normal times, debtors have a stronger incentive to default to induce more expansionary monetary policy”. This could be well the case of Italy, which new government has unofficially called on the European Central Bank to cancel the repayment of the €250 billion it holds in Italian debt. On the other hand, the CEPR also highlights “constraints on monetary policy, may act as a disciplining device to enforce repayment of sovereign debt”, something Germany has constantly insisted on with its demands for a more market discipline policy. The question is would sovereign default risk induce countries with a preference for tight monetary policy to accept a laxer policy stance?

Another important factor to watch in global markets is the sustainability of Italy’s highly-indebted and fragmented banking sector. Trust in the country’s banking sector has once again been undermined by a self-reinforcing and contagious cycle of financial pressure stemming from banks’ large holdings of government bonds and non-performing loans (NPLs), which could deeper existing problems during periods of market turmoil.

The banking sector has already gone through some dramatic and controversial bailouts, in particular the government-led recapitalisation of Monte dei Paschi, the world oldest bank and Italian third largest lender. The other two biggest lenders, Intesa and Unicredit, have €130bn of non-performing loans among their assets. Professor La Torre, however, notes “Italian banks have put in place important actions in order to clean their balance sheets from NPLs and have increased significantly their capital”. According to the Italian Banking Association (ABI), NPLs stood at around 14.5% in December 2017 and its ratio is expected to be further halved to around 7.9% by 2020.

Nonetheless, these figures are likely to be revised under the new administration which has already unveiled plans to undo or change some of the measures implemented by the previous government, for example a much debated cooperative banks reform. The government has pledged to present new economic forecasts and goals in September, meanwhile its. ‘hazardous’ fiscal policies coupled with the end of quantitative easing and a vulnerable banking sector could pose a serious threat to Europe as the continent’s economic future and financial stability face unprecedented challenges.

The post Italy, a test for the European Union and its financial stability appeared first on International Finance.