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The Euro: No Roman Holiday

A woman walks a dog as the coronavirus outbreak continues in Milan, Italy, April 4, 2020. (Daniele Mascolo/Reuters)

Over on the home page, Ashoka Mody, formerly of the IMF, and now at Princeton, turns his attention to the storm gathering over the eurozone, a ramshackle construction that is still standing largely thanks to the scaffolding put in place during its earlier crisis and which will, I suspect, need much, much more support over the next year.

Unsurprisingly, much of Mody’s focus is on Italy:

 While all European countries can anticipate a terrible economic year ahead, COVID-19 has landed hardest on the weakest of them: Italy. The Italian economy has not grown since the creation of the euro zone in January 1999, and it was in one of its near-perpetual recessions when the virus began raging through Lombardy and the Veneto, the country’s most productive regions. The cracking of the Italian fault line will send financial tremors throughout Europe and the world. Everyone who needed to know did know that Italy did not belong in the euro zone. Saddled with undisciplined politics, the Italian economy depended on the accommodating flexibility of the lira whenever it was in trouble. The fact that the ongoing crisis is so ferocious puts that historical error in even starker relief….

In the euro zone, the northern countries have the money to revive their economies, if just barely. The southern countries do not. Germany, like the U.S., is very likely to end up running a fiscal deficit greater than 10 percent of its GDP as a result of measures to boost its domestic economy, and will probably need additional funds to prop up its banks. Italy and Spain, undergoing much larger economic shocks, have even greater fiscal-stimulus needs, but lack the money to finance them. The Italian and Spanish governments also need to worry about debt — over 20 percent of their GDP — due for repayment this year. Will investors lend them new money to roll it over?

Whichever way you look at the numbers, Italy needs at least €200 billion in stimulus money and possibly another €200 billion as a safeguard in case the markets do not step up to purchase the portion of its government debt maturing this year. Spain will need more than half those sums. The exact amounts are fuzzy, and a moving target, but they are large and neither Italy nor Spain can rustle them up without outside help.

And, right on cue:

The Financial Times:

Fitch has downgraded Italy’s credit rating to a single notch above “junk”, saying the jump in debt levels resulting from the coronavirus crisis will increase doubts about the sustainability of Rome’s borrowings.

In an unscheduled update on Italy’s creditworthiness, the rating agency said it expected the country’s ratio of debt to gross domestic product to rise by about 20 percentage points this year to 156 per cent, as a surge in spending combined with an 8 per cent contraction in the economy.

If anything, those forecasts about Italian GDP may prove to be too optimistic, and the implication of that on an already daunting debt/GDP ratio will not be pretty.

The Italian finance minister has commented that Fitch does not take account of the help that Italy is receiving from the EU, and specifically, the European Central Bank. That’s fair enough, the ECB’s support will be enough, at least mathematically, to keep the show on the road for now, both directly as a buyer of the country’s debt and indirectly for its effect on the interest rate that Italy has to pay on its debt. As a result, absent some sort of crisis, the country’s debt service ought to be fairly manageable.

But however low the interest rate (for now), that debt is still continuing to pile up.

The FT’s report concludes as follows:

Mike Riddell, a bond fund manager at Allianz Global Investors, said Rome losing its investment-grade credit rating was “a matter of when, not if”.

“Italy’s debt is probably heading to somewhere upwards of 170 per cent of GDP next year,” he said. “These are the kind of levels where you get junked; it doesn’t matter how much of your bonds the central bank is buying.”

As a Bloomberg reporter notes:

Prime Minister Giuseppe Conte….now has to contend with the prospect of a mass investor exodus. The biggest bond-tracking indices require at least one investment-grade ranking.

One source of comfort to many investors has been the fact that so much of Italy’s debt is held domestically (and Italy is a country with a good savings rate), but as this report (Note: It’s from last year) by the think-tank CEPS makes clear, that’s less reassuring than it seems:

Italian households own very little government debt directly. All sources agree the direct holdings amount to only about €100 billion, or 5% of total public debt. The explanation is simple: a lot of debt is held by Italian financial intermediaries (banks, insurance companies, etc.) whose ultimate beneficiaries are Italian households…..This was different in the past, when interest rates were much higher and people held large amounts of debt directly in their deposits. However, with today’s lower interest rates, few households own Buoni Ordinari del Tesoro (BOTs) or Buoni Pluriennali del Tesoro (BTPs)….

The bulk of tradable debt is…held by financial intermediaries. About €400 billion is held by banks. The total exposure of the Italian banking system towards all levels of the Italian government is thus €690 billion.

About €400 billion is held by banks. The total exposure of the Italian banking system towards all levels of the Italian government is thus €690 billion. This means that Italian banks are by far the largest source of finance for the Italian government…Bank deposits are supposedly safe. But, in reality, bank deposits are to a considerable degree indirect loans to the government….

There’s much more in the CEPS report that is worth considering, but overall it underlines the extent to which Italy, a country with a massive and ever-increasing debt load and (thanks to the constraints put upon its competitiveness by the euro) little obvious way to grow out of it, is vulnerable not only to the unforgiving math of its situation, but the danger of a sudden panic.

Sooner or later there will have to be a reckoning, which is going to force Italy’s partners in the euro zone to make some very tough decisions, but will a panic, centered on the banks — and their depositors — turn later into sooner?

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