After four successive days of increasing risk spreads, and after a prominent politician, Claudio Borghi, said there was an advantage to having your “own currency,” Italy is back squarely on both public and private radar screens as a potential source of systemic economic and financial disruptions. This has led to suggestions that the country could become “a new Greece.”
While there are similarities between the Italian and Greek cases, the differences are big enough to suggest that investors in Italy should focus on a different set of factors.
In less than two weeks, the risk spread on 10-year Italian bonds has climbed about 60 basis points to around 3 percent, a level not seen since 2014. This has spilled over onto the equity market in Italy, and to a lesser extent, elsewhere in Europe. It has also put pressure on the euro.
The immediate trigger for the widening risk spreads was the government’s announcement of a budget deficit target that exceeds the European Union’s guideline. The gradual reduction in purchases of Italian bonds by the European Central Bank is also an issue for some investors. But the deeper contributors to the turmoil are the medium-term mix of high public debt, some unsteady banks and persistently sluggish growth.
Market worries have been exacerbated by some unhelpful public remarks, and not just from euroskeptic Italian politicians such as Borghi. European Commission President Jean-Claude Juncker told a television interviewer that “We have to do everything to avoid a new Greece — this time an Italy — crisis.”
The parallel with Greece of a few years ago is understandable. The two cases share at least three important similarities.
On debt: a fragile mix of sizable public liabilities relative to GDP, lots of the related government bond issuance residing in the domestic banking system and medium-term debt sustainability concerns.
On the real economy: a growth model that has repeatedly failed to produce high and inclusive prosperity.
In politics: the emergence of anti-establishment movements that do not shy away from politicizing the issue of the euro zone.
Yet there are also important differences suggesting different dynamics governing the extent of the systemic threat in the two countries.
Unlike Greece, Italy is one of the largest economies in Europe and an original member of the European economic integration project. Because of its size, its gross funding needs in euro terms are sizable relative to the regional safety nets put in place to deal with troubled countries. As such, a big problem with Italy would constitute a much larger and more durable source of systemic risk, economically and financially. It is no exaggeration to say that, if it were to stumble very badly, the southern European country could present an existential threat for the euro zone.
But also unlike Greece, Italy doesn’t have a current account deficit (it has a surplus), and the average duration of its outstanding debt is longer. With lower risk of financial default in the short term, the main determinant of possible disruptions resides in dislocations originating from domestic and regional politics. That is the most important factor for investors to monitor closely.
What ultimately saved Greece’s membership in the euro zone a few years ago was the imminent threat of default. Fearing a shock that would tip the economy into a multiyear depression and fundamentally alter many of Greece’s regional economic and financial relationships, the Syriza government opted for an orthodox approach, even though it had won both the election and the referendum by backing a political agenda that advocated doing the opposite.
The hope of many investors — as well as EU officials, ECB officials and several policy makers in European capitals — is that the Italian government will perform a similar pivot, even though the immediate default risk is lower. In doing so, Rome would need to design a more comprehensive program aimed at generating high, inclusive and sustainable growth.
By Mohamed A. El-Erian