Beyond the headlines: Italy

Over the past several weeks we have been bombarded with updates on Brexit negotiations between the UK and EU. However, as one book closes for Europe, another one opens. The big issue, and one that is comparatively undocumented by the mainstream media, is what is happening politically and economically in Italy.

In June of this year a new coalition government comprising two populist parties formed to govern Italy. They entered the political amphitheatre with two key goals in mind; the rejection of EU austerity and renegotiation of Italy’s debt. As of 2017 Italy’s debt to GDP ratio was the second highest of all the EU members at 131.8% (for every £1.00 produced from goods and services in the economy the government owes £1.31). Contributing to indebtedness is the government’s annual budget deficit which last year was running at -2.3%.

Under EU regulations, members with a Debt to GDP ratio greater than 60% must reduce their annual budget as a means of reducing the debt ratio. However, friction between the European Central Bank (ECB) and Italy is growing because their proposed budget is -2.4%, surpassing the previous deficit and thus adding to their debt pile.

Why is the ECB involved?

Simply put, a 131.8% Debt to GDP ratio is not sustainable. Italy, like all other EU members, has no sovereign currency nor control over its monetary policies, and as such it is unable to print money in the same way that the UK could. Instead the ECB assists Italy by buying Italian government bonds. This helps ensure that interest rates in Italy and on Italian bonds are lower than they might otherwise be if the ECB was not effectively underwriting the debt. Without the ECB acting as the “buyer of last resort” international buyers might be more inclined to sell which would push yields up. This aspect matters a great deal because Italian banks, already struggling with bad loans, own lots of Italian government debt. If bond yields rise precipitously it will create losses making the banking sector even more fragile.

The main issue now is that the ECB is keen to ease back on its crisis era quantitative easing policies and this include scaling back their bond buying programmes. This process has already begun, and a further announcement is expected in December. If, as planned, the ECB stops its bond buying programme at the end of the year, this in-turn would leave Italian debt subject to market forces. With an economy that is sluggish and a controversial coalition government intent on spending significantly more than the country is recouping from taxes, problems seem likely to arise.

Italy is not alone in economic and financial woes

Economists and ECB officials have been on edge regarding Italy’s future spending but there are other countries also challenging European fiscal rules. Recently France, Spain and Portugal have all been cautioned by the ECB on their failure to reduce their respective 2019 budget deficits by what was previously forecast.

Most surprisingly, economic growth in Germany, Europe’s largest economy, contracted for the first time in more than three years, shrinking by 0.2 per cent between the second and third quarters on the back of a fall in exports. The amalgam of these factors led to disappointing growth figures for the eurozone, as a whole, in the third quarter. The eurozone’s economy expanded by just 0.2 per cent, down from 0.4 per cent in the second quarter — the smallest expansion in more than four years. Italy’s economy did not grow at all.

How could all this impact Italy?

Germany, Italy, France and Spain are the four largest economies within Europe, excluding the UK. As such they have a significant influence over the EU. Historically, Germany has advocated conservative monetary policies. However, Angela Merkel has recently announced that she is to step down as German Chancellor and her possible successor, Friedrich Merz, has very contrarian views and is regarded as being economically liberal. His candidacy has prompted speculation of a more relaxed approach to fiscal spending rules as a way of spurring economic growth across the bloc.

Ultimately, the ‘power-houses’ of Europe could push for discussions with the ECB surrounding a continuation of loose monetary policies, such as quantitative easing. Whether this extends to renegotiation of legislation relaxing the rules on sovereign budget proposals is yet to be determined.

Italy’s debt situation is what is most problematic for Europe. The EU wants to avoid a repeat of the Greek crisis and yet worries that not sticking to their own rules opens the door to further compromises with a populist Italian government that may push their patience to the limit. Expect sensational ‘debt laden Italian banking sector’ headlines to come your way soon.