An Italian debt default would trigger a European banking crisis with global economic and financial market ramifications, writes Desmond Lachman.
[...]Italy has all the preconditions for another round of the sovereign debt crisis, which Europe has dealt with for almost a decade. It is not simply that with a public debt to GDP ratio of more than 130% it is, after Greece, the euro area's second most highly indebted member. The country suffers from a sclerotic and uncompetitive economy. Its shaky banking sector will probably soon need a government bail-out.
One indication of Italian banks' weakness is a non-performing loan ratio that remains well more than 10% of their balance sheets. Another is that these banks hold more than €400bn in Italian government bonds. This creates a dangerous 'doom loop' between Rome and the banks.
Italy needs faster economic growth and greater budget discipline to put its public debt on a more sustainable path. This is more urgent in the light of the prospective tightening in the global credit market cycle and as the European Central Bank's government bond-buying programme winds down.
Apparently, Italy's populist government has an alternative view of basic public finance logic. Rather than committing to a reform programme that might deliver faster growth, the government seems determined to roll back the modest labour market and pension reforms of its predecessor.
Similarly, rather than committing to reducing its budget deficit, Rome is intent on delivering on its costly election campaign promises, even though this might mean running up budget deficits. This would be in flagrant violation of euro area rules, which state there must be no increase in structural deficit. As an indication of the Italian government's disregard for these rules, it has announced lavish public spending plans that will involve an increased budget deficit of 2.4% of GDP next year.
In defending its budgetary largesse, Italy is engaging in wishful thinking that somehow the country will grow out of its debt problem. Never mind that its budget policies have already resulted in a spike in long-term Italian interest rates to 3.4%, which is bound to deal the economy a serious blow. Investor and consumer confidence are likely to be shaken by the prospect that the country is on a collision course with its European partners.
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