Italy’s political crisis has hit the financial markets with full force. Spikes in Italian government bond yields have reached levels last seen during the peak of the state finance crisis. The solvency of the Italian state is less jeopardised by overshooting yields, however. Given a duration of almost seven years, rising borrowing costs do not exert a notable impact until the long term.
It would be far more problematic were Italy’s liquidity position to worsen rapidly. This would especially be the case were forthcoming Italian government bond auctions to fail to achieve their desired success, and were buyers to go on strike despite the high yields on offer. The entire refinancing volume of Italian government bonds maturing until the end of 2018 amounts to EUR 136.2 billion. Without access to the market, we believe Italy would be barely able to raise such funding by its own efforts.
Were this scenario to occur, Rome could rapidly reach the point where it would need to ask the E(M)U for financial help. The ESM in combination with the ECB could potentially counter an intensifying crisis, although the costs and risks for the entire currency union would be immense, and would presuppose the unconditional will on the part of both Rome and Brussels to bring such a crisis under control. Given the political differences, it would be questionable whether Italy would ask for financial assistance given its new majority relationships, and whether individual states would also grant it – ESM aid requires the approval of Germany’s Bundestag too.
Without access to financial markets or financial aid, bankruptcy could threaten Italy within the foreseeable future. This would also entail the insolvency of various Italian banks. In such circumstances and without external help, we believe Italy would be forced to also leave the EU, or at least the Eurozone.
The consequences for Italy and the rest of the Eurozone would be very difficult to gauge. Italy would face an abrupt halt to the functioning of its financial system as well as a devastating recession, which would also impact the rest of the Eurozone. Along with the economic consequences, international bondholders would have to fear losses surpassing EUR 700 billion on a state default. We believe Eurozone banks would be hit particularly hard. Their overall exposure to Italy, including all Italian debtors‘ bonds and loans, amounts to EUR 513 billion, with French banks (EUR 310.8 billion) and German banks (EUR 90.5 billion) accounting for the lion’s share.
EMU state budgets would also suffer massively from an Italexit. The maximum loss risks for the Deutsche Bundesbank – which would ultimately affect German taxpayers – total around EUR 144 billion. To these would be added economically related tax defaults, higher spending by social security providers, and potential additional payments to the ESM, which – prospectively – would be called upon to defend against collapse several of the banks in the rest of the EMU with significant exposures to Italy. Debt ratios in some countries would be at risk of hitting new record levels. The continued existence of the entire Eurozone could depend on both the political decisiveness of the remaining member states and committed intervention by the ECB.
At least when viewed in rational terms, both Italy and the rest of the Eurozone should make every effort to prevent such a development given the risks of an extremely bleak scenario of a bankruptcy of Italy as well as the subsequent consequences for the entire EMU. Although Italy will be far from being able to fully implement its demands at European level, we believe France and Germany should signal a willingness to compromise. By contrast to the case with Greece, Italy has a much stronger negotiating position given what is at stake for all parties. For this reason, we expect EMU states to signal their willingness to enter into a financial compromise. Examples could include not only lower contribution payments by Italy to the EU but also a larger volume of subsidised investments as well as joint deposit insurance for banks. This would smooth the path to a transfer union. Although this would at least paper over the cracks in the currency union for the time being, such a step would likely encounter political resistance in core Europe. We believe this would give added impetus to the popular right, and even further augment the long-term risks of a split in the community.