A serious showdown is brewing in the Eurozone as Italy’s anti-establishment coalition government takes on the EU establishment in a struggle that could have major ramifications for Europe’s monetary union. The cause of the discord is the Italian government’s plan to expand Italy’s budget for 2019, in contravention of previous budget agreements with Brussels.
The government has set a public deficit target for next year of 2.4% of GDP, three times higher than the previous government’s pledge. It’s a big ask for a country that already boasts a debt-to-GDP ratio of 131%, the second highest in Europe behind Greece. To justify its ambitious “anti-poverty” spending plans, proposed tax cuts, and pension reforms, the government claims that Italy’s economic growth will outperform EU forecasts.
Brussels is having none of it. EU Commission President Jean Claude Juncker urged Italy’s Economy Minister Giovanni Tria to desist. “After having really been able to cope with the Greek crisis, we’ll end up in the same crisis in Italy,” he said. “One such crisis has been enough… If Italy wants further special treatment, that would mean the end of the euro. So you have to be very strict.”
On Wednesday ECB President Mario Draghi held a private meeting with Italian President Sergio Mattarella in Rome, at which he reportedly raised concerns about Italy’s public finances, the upcoming budget bill, and related stock-exchange and bond-market turbulence.
The meeting evoked memories of the backroom machinations that Draghi, together with his predecessor, Jean Claude Trichet, undertook to engineer the downfall of Italian premier Silvio Berlusconi in 2011 and his replacement with technocrat Mario Monte, after Berlusconi had posited pulling Italy out of the euro during Europe’s sovereign debt crisis.
But such a drastic ploy is unlikely to work this time, since it would mean having to replace an entire democratically elected government. And Italian voters, already disenchanted with the EU, are unlikely to accept having a new technocratic government thrust upon them. But that doesn’t mean the EU doesn’t have aces up its sleeves.
Brussels knows that Italy’s banking sector, despite receiving hundreds of billions of euros of monetary support and virtually free loans from Draghi’s ECB, is extremely fragile. The longer the feud with Rome goes on, the more fragile it will grow. The Achilles’ heel for Italy’s populists is the chronically weak banking sector, whose massive holdings of Italian sovereign bonds make them particularly vulnerable to an economic downturn.
As tensions between Rome and Brussels escalate, and uncertainty grows about Italy’s economic future, investors are dumping Italian debt, causing bond values to fall and yields to rise. That, in turn, is hitting banks’ funding costs and their capital cushions. On average, banks are estimated to already have lost 40 basis points of their core capital in the second quarter and another 8 bps in the third.
The biggest fear is a return of the credit crunch that throttled Italy’s recovery after the euro debt crisis seven years ago, says Nicola Nobile, a Milan-based economist. Before that happens, Brussels hopes that Rome will do the decent thing and back down. The Italian government did offer a compromise of sorts on Wednesday by promising slightly smaller deficits in the medium term. But both coalition partners — the anti-establishment Five Star Movement and the nativist League — have dug in their heels on the 2019 budget.
Sooner or later, one side is going to have to blink, for the longer this uncertainty lasts, the greater the risk that Italy’s systemically vital banking system slips over the edge, taking Italy’s economy with it and potentially doing serious damage to the Eurozone economy. By Don Quijones.
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