We believe that there is a very small chance of Italy crashing out of the eurozone, but the risks of a series of unfortunate events leading to an accidental ‘Italexit’ have increased. Notwithstanding the news overnight that Italy looks like it has managed to form a government, the current political situation chimes with Greece in 2015 where the Syriza party won the election promising an end to austerity and questioning the role of the EU. This a useful guide, in our view, as to how the current Italian crisis could pan out. However, there are some big differences between the two countries.
Our key points are as follows:
1. The view that underpins everything is that Italy will not leave the euro. It would spell disaster for redenominated Italian household savings, for retail investors who own Italian government bonds (BTPs) and bank debt, for the Italian banks who own BTPs and for the entire European monetary union.
No Italian government would survive a redenomination – Syriza knew this and eventually backed down, in spite of the fact that Greek depositors had already moved money out of Greek banks. In Italy, deposit levels are much higher with few signs of outflows, yet.
2. In our view, the current situation in Italy is really about ending austerity and regaining fiscal autonomy from Brussels. This is an easy win for populists who push the ‘we want to give you more cash but unelected bureaucrats won’t let us’ message. Therefore it’s back to collision economics for a while. That said Brussels and Italian politicians know that Italy is constrained by the risk that leaving the euro represents. So it just depends on how close to the brink both sides are prepared to go.
3. It’s my belief that both sides will be far less reckless than during the Greek crisis. From the European side, Italy is a far greater systemic risk and the contagion potential is much larger. From the Italian side, the situation feels less hopeless (at least among the older generation) than it did for Greece – the Italians have more to lose and they didn’t vote to leave the euro. Therefore if the newly formed Italian government starts to increase its anti-euro rhetoric, some of the electorate may feel misled. We will need to keep an eye on support levels for the government in this scenario.
4. Italy’s economy is more resilient than Greece’s was:
a. Italy runs a primary surplus and has a current account surplus
b. Italy has termed out its debt and, after June, the net cash requirement is negative when incorporating European Central Bank (ECB) QE, redemptions and coupons. If rates continue to rise, the increase in the cost of debt should be gradual, whereas in Greece they had no cash left to pay the creditors
c. The level of foreign ownership of Italian government bonds is at a much lower level than ownership of Greek government bonds were
d. The Italian institutions are seen as stronger than the Greek equivalents back in 2015
5. Much of Europe has lost the religion of austerity that fed populism in core and peripheral economies. This means that, eventually, there is likely be more leeway on the fiscal side. Germany and France, with their recent experiences of populism, should recognise this and acknowledge the political realities – low growth, low earnings and high youth unemployment leads to political change and the EU is a political project. In our view, there is a clear argument for EU authorities accommodating looser fiscal policy. The risk of further economic and political instability rises if Europe doesn’t loosen fiscal policy.
Given the above, we believe the endgame for Italy is continued membership of the EU and the recent recovery in Italian bonds suggests the market agrees. The path is uncertain but we would expect a resolution to be found. The EU has its flaws and has made mistakes in its handling of the euro crisis, but we don’t think now is the time for a eurozone member to walk away from the project.