Is the eurozone on the brink of a new crisis?
The eurozone is once again facing fragmentation risks, as it did a year ago and ahead of the French presidential elections. Several countries are openly critical of the EU (such as Austria, the Czech Republic, the Netherlands, Hungary, and Poland) and openly anti-EU political parties are standing in elections.
Nevertheless, the risks should be limited as long as no party or government requests a referendum on the euro or on a country’s membership of the eurozone; this kind of referendum appears to be illegal in several countries, as a referendum cannot alter an international treaty, but this fact is doing little to mitigate risks.
What could elections change?
Elections in Italy, and also probably in Spain, could refuel political risks in the eurozone, as these elections have the potential to turn into an implicit referendum on the eurozone.
However, Italian political parties could be reluctant to adopt such an extreme stance, as Italians generally seem to be in favour of the eurozone and the euro, even if the European Commission faces criticism about its decisions and governance. In Spain, the possible replacement of the PP by a Ciudadanos government (based on recent polls) is unlikely to affect Spain’s membership of the eurozone.
What is the future for the Italian economy?
Italy lagged behind the eurozone rebound in 2016-2017, and it has still not recovered to the levels of growth and activity reached before the financial crisis. Reforms under a common currency are taking their time to restore Italian competitiveness, but the external position has improved significantly: Italy has a current account surplus and a positive primary surplus. This gives any government little or no room for manoeuvre, and any move away from a policy of austerity has to be negotiated with the EU and other EU members. If uncertainties surrounding elections last a long time, confidence may weaken and growth could slow from its current 1.5%.
Is there any visibility on a political way out of the crisis?
For the time being, Italy is in a political crisis and there is also the potential for an institutional crisis, as the role of the president is under discussion. There are several different political scenarios that could develop depending on the reaction of the president and the two main political parties. The risk of a political stalemate is emerging and there is no visibility in the short term.
Could the ECB support the Italian bond markets?
The ECB’s QE programme has already been used to ease tensions on the markets; the ECB can temporarily deviate from its capital rules guiding QE, and it can provide support to any country which faces specific trouble.
Other measures (such as OMT and EMS) require an official request from a government and that government accepting the conditions that come with them; in the current environment, rising spreads are clearly a financial constraint, but markets are still working. Soft and discreet support for Italy could be put in place for a short period of time, unless Carlo Cottarelli (Italy’s technocrat prime minister) submits an official request to the ECB. Otherwise, it will be difficult for the ECB to support an anti-EU government that explicitly refuses to follow EU guidance and recommendations.
Will Italy default on its debt?
Public debt has reached 135% of GDP and it has not stopped growing since the crisis. Debt servicing has been buoyed by unusually low interest rates (thanks to the ECB’s QE programme) and by an existing primary fiscal surplus (1.5% of GDP; the budget deficit before interest payments) which gives Italy some scope to continue paying down its debt in the medium term.
The average cost of Italian debt is about 3%, which means that the recent rise in Italian bond yields has not yet put Italy’s finances in jeopardy. The main risk, just as in the European crisis, is of seeing a rising risk premium required from investors on BTPs, as political risks are on the rise. This could generate a negative spiral, as real rates will exceed growth.
As Italian political parties do not have an explicit programme to leave the eurozone, the risk of a new government defaulting on its debt or deciding to take a haircut on it (the scenario that is once again being seen in Greece) is still remote at this time, but it nonetheless represents a major tail risk.
Does Italy have any systemic risks?
Public debt is mainly held by domestic investors (such as banks, pension funds and retail investors) with foreign investors holding around 35%. Another main holder is the ECB, through QE. As long as Italy does not hold a referendum on the euro, any redenomination risk is low.
The banking sector in Italy is still vulnerable, as further consolidation is probably needed. If growth stabilises on its current trend, the rise of non-performing loans will remain contained and the effects of the rising cost of capital would also be limited; the ECB will be able to see if banks have specific needs in terms of liquidity during this delicate political time and could potentially offer extra liquidity in the short term should the markets encounter increased constraints.
Are contagion effects possible?
Generally, the eurozone is in better shape than in 2007 and imbalances have been reduced; spreads in peripherals have increased, and the German Bund looks like a safe haven in the eurozone, with 10-year yields below 0.5%. Although the political situation in Spain looks uncertain, the situation in other countries is less worrying, and reforms have restored growth and some fundamentals. Confidence on the markets remains the key to avoiding contagion.
Will the euro weaken further?
The eurozone growth outlook has moderated since the beginning of the year and the ECB has maintained its accommodative monetary policy, as the inflation outlook was still fragile. A crisis of confidence could further weaken the euro at a time when the US dollar is still holding firm against other developed and emerging countries. The current account surplus and the balanced budget situation at eurozone level may not be sufficient to compensate for renewed fragmentation risks and political uncertainty in a major country. Volatility should remain high as long as there is reduced visibility.