Italian Debt: The Beginning of a New Crisis?

By Finn Watson

With Europe facing a storm of political, economic and financial challenges, does Rome have what it takes to help debt-laden Italy and mitigate the potential for crisis?

It has been over a decade since the start of the disastrous Euro Crisis which shook the eurozone to its core and once again worries about European sovereign debt are surfacing. In many ways, the Euro Crisis was never fully resolved. Instead, through complicated and painful remedies administered by the ECB, European Commission, and IMF, as well as then ECB President Mario Draghi’s famous commitment to do “Whatever it takes” – the crisis came to pass. This time the focus of markets and eurozone leaders is not on Greece, but Italy.

In the past few months, fissures have grown wider in the market for Italian bonds. The spread between Italian and German 10 year bonds has been steadily widening from 135 basis points at the start of the year to 230 bp at the end of September. This divergence in interest rates highlights rising uncertainty and an increase in the perceived risk of holding Italian bonds. As the spread widens, speculative activity by hedge funds and other groups has increased markedly. The futures market – the choice for actors looking to bet against Italian debt – has seen both a surge in volume of activity and a steady decline in the price. Such activity is indicative of investor’s fears about Italian debt sustainability and should be taken seriously especially because similar hedging derivatives (CDSs) were widely used to protect against default of Greek debt during the runup to the previous debt crisis.

Italy finds itself with a particularly large debt. The country has a debt to GDP ratio over 150%, the market for which is around 3 trillion euros. In addition, Italy’s budget deficit was over 9% of GDP in 2020 and 5.5% in 2022 which is beyond the limit set by the Maastricht Treaty. This lumbering pile of debt is the result of years of spending and most recently measures taken to fight the coronavirus and the subsequent economic fallout have added considerably to Rome’s debt position. Fiscal support in response to the pandemic in 2020 and 2021 as shown by the change in primary balance was recorded by the European Commision at 14.1% of GDP. Although this number does include some funds provided by the EU, the scale of Italian fiscal support was the largest seen in its history and demonstrates the budgetary weight added because of a crisis out of Rome’s control.

Why is the sustainability of Italian debt just now getting pressured by the market and worrying European officials? The shifting political landscape of Italy, changing monetary stance of the ECB, and European economic woes – specifically the recent general election, rise in interest rates and the end of COVID-era quantitative easing – are to blame. Inflation, caused by multiple factors but most importantly collapse in energy supplies as a consequence of the Russo-Ukrainian War, has erupted in Europe. In lockstep with its European peers, Italian CPI inflation year to date has surged to over 9% largely due to the increase in natural gas prices as a result of Putin’s war in Ukraine. In fact, Italy is particularly vulnerable to fluctuations in Russian natural gas imports since natural gas is used in 50% of electricity production compared to the European average of 25%.  As a result of surging inflation, the ECB has shifted its monetary policy stance from pandemic-era stimulative rate cuts and QE to anti-inflationary rate hikes and ending QE. Unfortunately for Rome, these rate hikes have placed even greater fiscal pressure on the country through higher debt service which has added to concerns about the ability to sustain its massive debt.  Furthermore, the ECB’s commitment to end the vast OMO and asset-purchasing activities has impaired the market for debt by decreasing liquidity meaning that the fund managers and other market participants wishing to leave the bond market because of value deterioration, and decreased confidence have enlarged bid-offer spreads further adding to volatility.

The list of problems that Italy faces is not just limited to the purely economic sphere as the election of Giorgia Meloni and her right-wing coalition which replaces Mario Draghi heralds significant political shifts and increased uncertainty. The new Italian government is led by Giorgia Meloni and her ‘Brothers of Italy’ (Fdl), a party with roots in the Italian Social Movement that embodies a post-war neo-fascist philosophy, whose ‘tricolor flame’ emblem is toted as their logo. Core policy goals of the Fdl include a strict anti-immigration policy,  support for traditional values, and soft-euroscepticism.

Fratelli d’Italia is joined in a coalition with Matteo Salvini’s league and Silvio Berlusconi’s Forza Italia party. Both Salvini and Berlusconi have been criticized for their close relationship to Putin and comments relating to Russia’s war. As part of his ‘patriotic economics,’ Salvini has questioned the need for sanctions as he claims that they have not been effective in harming Russia and has unduly effected the wellbeing of Italians. Furthermore, Berlusconi defends Russia’s war by supporting the narrative that Putin was ‘pushed into’ the conflict by Western policy and that he just invaded to fix the Ukrainian government and promptly leave. These comments play into broader skepticism by members of the European right such as Victor Orban about the validity and effectiveness of  the sanctions as diminished gas flows increase pressure on the continent. This massive shift in political posturing by Rome represents a significant divergence with Brussels in many ways, further adding to the market uncertainty about Italy’s future political position vis-a-vis the European Union and Russia.

Nowhere else is this divergence better symbolized than the exit of Mario Draghi from the role of Prime minister. Mario Draghi is best known for his role as ECB president from 2011 to 2019 in which he turned the euro crisis around by pledging to do ‘whatever it takes.’ It was from his 8 year term as ECB president where his reputation as a skilled and stabilizing technocrat was cemented. When the COVID-19 crisis made its way to Italy causing the second Conte government to collapse, Draghi stepped into the void as Prime minister with the support of liberal and centrist parties. He oversaw the pandemic management, economic recovery, and domestic reforms during his brief tenure as Prime minister and was largely viewed as a stabilizing and responsible figurehead whose past experience as ECB president and subsequent close relationship with EU leaders brought lots of political capital.

In contrast, the new right wing coalition has a history with euroscepticism which might prove a challenging obstacle in its relationship with Brussels.  In the past, Meloni has openly called for Italy to exit the Eurozone. While she has moved away from such radical euroscepticism, she is likely to align with a softer euroscepticism similar to that of Poland and Hungary embodied in her support for broader use of veto powers and promising to fight for national sovereignty. In this way, the Meloni government represents a significant departure from Draghi-era cooperation and integration with the EU. Factionalism and national animosity was a significant problem in effective crisis management over a decade ago. Germany’s fiscally conservative lobby within the eurozone, headed by figures such as German finance minister Wolfgang Shauble, took hardline stances on Greece leaving many feeling negatively towards Germany (Greek approval of Germany fell to 29%.) In this way, national divisions within the eurozone accentuated by Meloni’s soft euroscepticism reinforces worries by market actors about Brussel’s ability to manage potential crises.

If the political economy of Europe continues to deteriorate to the point of Italian debt collapse, what would it look like for the global economy? It would potentially be a crisis much worse than the crisis initiated in Greece over a decade ago. Italy’s economy is notably larger and more integrated with European markets. Italy’s GDP is around 10 times larger than Greece’s at 2 trillion and 216 billion respectively. Furthermore, the market for Italian debt is currently over 3 trillion dollars compared to peak market capitalization for Greek debt in 2011 of half a billion. Moreover, in 2019 the exposure of Italian banks and investment funds with non-Italian beneficiaries (foreign creditors) was 400 billion and 450 billion euros respectively. In this way, the size of the Italian debt and economy means that a meltdown similar to that experienced by Greece would be exponentially more damaging to the European and by extention global economy. 

Thankfully, the ECB and Eurozone are better prepared to deal with such a crisis. Irish finance minister and head of the ‘eurogroup’ (informal meetings of eurozone finance ministers,) Paschal Donohoe stated that Europe had “deeper foundations of our common currency” as well as “stronger architecture.” For example, instruments such as common debt as well as NextGenerationEU’s Recovery and Resilience Facility (RFF) which provides over 700 billion euros in funding and grants strengthens the ability to fight crises by providing large funds while pooling the risks. Furthermore, the ECB’s new ‘Transmission Protection Mechanism’ which has received mixed reviews and remains untested has promised to increase the effectiveness of ECB monetary policy. Whether Italy will have continued issues with debt and whether the Eurozone has adequately improved its debt crisis infrastructure has yet to be seen. In conclusion, there are stormy seas ahead for Italy and Europe. Whether the Eurozone will sink or remain afloat depends on chance and prudential maneuvering by Rome and Brussels.

The views expressed in this article are the author’s own, and may not reflect the opinions of The St. Andrews Economist.

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