The financial world’s eyes remain on Italy as the country suffers from very low growth and an uncompetitive economy, which paired with the eurozone’s second-highest debt after Greece makes it a potential target for speculators. It is hard to think of a scenario where an Italian debt default would not trigger a European banking crisis, which would subsequently have tremendous global economic and financial consequences. Although Italy is simply too big to fail, the country has all the stormy economic conditions to trigger a devastating financial crisis.

In a recent report Goldman Sachs warned Italy risks falling into a new recession, suggesting financial markets could end up forcing the government to change its economic policy. Investors are far from reassured by the political instability created by the Italian populist government, which has engaged in a “budget saga” with the European Commission for months. Brussels said that Italy’s budget plans were in “particularly serious non-compliance” with the rules, raising doubts about the solidity of Italy’s public finances due to its massive public debt pile. This has led some commentators to make a comparison with a Greece-like crisis. However, the circumstances that put Rome under the European Commission radar are very different from those that brought Athens under the Trioka’s supervision. Italy’s problem is so not much of a financial nature, but in its absence of political will in observing the rules of the European Monetary Union (EMU).

The row between Brussels and Rome has had a direct impact on Italian banks, which are the main buyers of Italian sovereign bonds, while investors’ demand for Italian debt has slowed down considerably and the sale of bonds dropped. A bigger selloff in two-year debt prompted deep concerns about the nation’s near-term financial solidity, mixed with the European Central Bank’s decision to tweak capital key and adjust the capital shares of national central banks in 2019, cutting Italy’s share in bond-buying. Moreover, it’s still unclear how the ECB will deal with its holdings of Italian securities as it rolls back gradually its loose monetary policy.

Niall Walsh,

Niall Walsh,

Niall Walsh, an analyst at Oxford Analytica, says “market optimism is unlikely to last for long” if the Italian government doesn’t respond adequately to EU’s demands the equity market could fall again and the spread could widen above 300 basis points. If interest rates on debt repayment were to grow to levels over 4%, the write downs of Italian banks on their government bond holdings would be so high that they would have problems with their capital ratios. Walsh noted “if the spread widens to 400 basis points, they will likely require fresh capital injections”.

Mario La Torre

Mario La Torre

Mario La Torre, a finance professor at the Sapienza University in Rome, also agrees that higher spread will impact first on the value of banks’ government bond portfolios, which lastly will put pressure on their free capital. However, he points out “Italy does not face any risk of a new banking crisis as the Italian banking system has put in place a significant effort in cleaning their balance sheets from non-performing loans”, while its largest banks have performed well at the last European Banking Authority (EBA) stress test.

Overall the Italian banking system doesn’t show any particular deviations that could trigger fears of a new crisis. According to figures from the Italian Banking Association (ABI) in October 2018 the spread between the average lending rate and the average rate on household and non-financial corporations funding remained at 188 basis points, showing a sharp decrease from more than 300 basis points prior to the onset of the previous crisis.

Iain BeggThe Italian financial system, unlike the Greek one, can count on current account surplus and its debt has a longer debt maturity profile. Moreover, private savings and deposits offer a significant cash buffer, which makes it very unlikely that Italy would run out of money or miss its debt obligation, as instead was the case for Greece. The Italian national debt is about eight times larger the size of Greece’s debt, but over 70% is held by domestic creditors, and contrary to Greece, has yet no difficulty in refinancing its debt. Domestic savings can easily be used to cover for even a bigger fiscal deficit. Iain Begg, a Professorial Research Fellow at the European Institute of the London School of Economics (LSE), argues “we are still quite a way from a scenario equivalent to Greece because Italy is not insolvent, and unlike Greece, much of Italian debt is owned domestically by Italians”.

The nature of the Italian populist government, led by Eurosceptics forces, suggests that tension between Rome and Brussels is likely to continue in the upcoming months in the run-up to the European elections in May. However, the worst-case scenario of a possible “Italexit” is far from materialising anytime soon as that would have unquantifiable political and economic negative ramifications on Europe and the rest of the world.