Italy appears to be heading for new elections in autumn 2018 or early 2019. These elections could well take the form of a de facto referendum on EU and euro rules.
This is why we need to consider the âwhat ifâ scenarios. In particular, could Italy trigger a new euro crisis?
A radical government in Rome – or fear of it ahead of new elections – may well plunge Italy into a deep crisis with significant financial and economic benefits for its neighbors.
Consider that Italy is a founding member of the EU and the euro and accounts for 15.4% of the euro area’s GDP and 23.4% of the bloc‘s public debt. It also has links through the banking system which closely link Italy to its European partners.
Given these circumstances, it is widely said that a radical government in Italy could try to blackmail other members of the EU and the euro zone to make sure he can see through his demands on debt cancellation, pension reform and the like. The EU and the euro area are unlikely to give in to such tactics.
In reality, however, while countries with strong ties to Italy would be badly affected for some time, it’s important to remember that it would still be an Italian crisis – rather than a crisis. “Euro”.
In the unlikely worst case, Italy could go bankrupt, exit the euro and face a prolonged period of chaos.
Beyond the loss of the great Italy, however, the euro itself would not be threatened. Just as Brexit strengthened pro-EU sentiment in the EU-27, a hypothetical messy Italexit would likely make other countries more than less willing to stay in the euro.
A case of contagion
The difference between a regional crisis within the euro zone and a real euro crisis (as in 2011/12) is contagion. The euro zone now has the necessary tools to contain contagion risks, in particular the European Stability Mechanism (ESM) and the ECB’s OMT program.
The latter is de facto a tool to massively extend any ESM program, if necessary. The EU could add an additional instrument to its toolbox at the next summit on 28 and 29 June by specifying under what conditions the ESM could be the safety net for national banking resolution systems.
With these tools, any country that accepts the euro rules and wants to stay in the euro can defend itself against any financial panic.
As most investors know, the risk that these tools are actually needed to protect, say, Spain or Austria from any Italian fallout seems low.
In addition, the ECB could easily use its standard monetary policy tools, injecting liquidity and adjusting its interest rate forecasts to reduce bond yields in the euro area, if the Italian turmoil were to have a significant impact on the outlook for euro area GDP and inflation.
A repeat of the 2011/12 euro crisis marked by rampant contagion seems highly unlikely. The problem is how serious a potential Italian crisis could be.
Is Italy Too Big To Be Supported?
Many observers fear that Italy will be too big to save itself in the event of a crisis. However, that is not really the issue.
The question for Italy is whether it has the political will to accept the euro rules. Consider three cases:
1. As long as Italy continues to respect roughly the rules of the euro, as it has done since the end of 2011, and credibly commits to maintaining this course, the country will not sink into crisis.
2. If Italy, in an acute crisis triggered by concerns about its willingness to exit the euro eventually, changes course and returns to caution, it would likely need very little or no external support.
Italian paper would in fact become an attractive buying opportunity. At most, an ESM precautionary line of credit might be needed as a de facto seal of approval for a return to sensible policies in Italy.
3. If Italy seriously flouts the rules of the euro, sinks into the crisis and refuses to reverse this trend, it would be neither admissible nor supported. In such a case, the EU / Eurozone / ECB would focus on protecting other Eurozone members from contagion risks.
Italy would have the choice between turning around Tsipras of radical populism and coming to its senses in the end – or enduring the consequences of a messy Italexit. It stands to reason that in such a case even Salvini would choose to stay in the euro, as Tsipras did in Greece.
Whether the EU and the euro rather than immigration can now become the main political problem in Italy is a double-edged sword.
If the radicals see a new election as a de facto referendum on EU / euro issues and win, they would have the mandate to seek a showdown with Brussels and Frankfurt.
However, a more intense discussion on EU / euro issues during the election campaign could also weaken support for radicals, especially the 5-star.
A comparison with the UK might be instructive here. One of the main reasons the Brexit referendum was successful is that neither the actual costs nor the likely ‘day after’ scenarios have been spelled out in any meaningful way.
And in France, Marine Le Pen discovered the hard way last year that many voters, even if they are very unhappy with the status quo and remember with nostalgia the so-called “good old days” when their country had fewer immigrants and their own money. , I don’t really want to exit the euro.
Concretely, French voters did not like the idea that their salaries and pensions could in the future be paid not in euros, but in a strongly devalued national currency. They also disliked the prospect of some of their savings being lost when exiting the euro.
How would Europe be affected?
In the unlikely event of a messy Italexit, growth in the euro zone (excluding Italy) could stagnate for a few quarters, as authorities deploy their tools to contain contagion risks and support the most affected banks if necessary. Thereafter, growth should return to a sustained pace, at least outside Italy.
Of course, it would take many years to determine the consequences of an Italian default that could come from a hypothetical Italexit, including the settlement of Target’s debts from Banca d’Italia to the ECB.
Eurozone investors hold around 19% of Italian sovereign bonds, Italy Target’s liabilities stood at 447 billion euros in March 2018. The longer the time horizon for such an operation after an Italexit is long , the higher the payback ratio is likely to be.
For all these reasons, one might expect that, despite the current significant Italian turbulence, the Italian crisis will not degenerate in the coming months.
After all, even if a future government wanted to pull Italy out of the euro after new elections, it would still need Mattarella’s approval and would be bound by the decisions of the Italian Constitutional Court.
However, the risk that the the current voltage may intensify is important. Meanwhile, the risk that Italy will decide at some point to leave the euro is low but not entirely negligible.