31 October 2018

Financial Times: Italy is setting itself up for a monumental fiscal failure

Unless the Italian government has a clear-headed strategy for a eurozone exit, therefore, it is setting itself up for a monumental failure. The leaders of the far-right League and the Five Star Movement have strong views, but I do not believe they have a strategy.

The main instrument of coercion in the eurozone is not its fiscal rules, but the power of the European Central Bank to withdraw funding from national banks. This is not a discretionary power, but one that is automatically triggered once a country‘s sovereign debt loses investment grade status.

If the banks have large holdings of their home countries’ debt, as is the case in Italy, they are setting themselves up for failure if their governments run an unsound fiscal policy.

The trigger for the current rise in Italian bond yields was the rule-busting 2019 budget. The previous Italian government agreed to a deficit target of 0.8 per cent of gross domestic product in 2019. The current government’s budget foresees a deficit of 2.4 per cent. The European Commission also disagrees with the optimistic assumptions for future growth, and fears further slippage. Olivier Blanchard and Jeromin Zettelmeyer, of the Washington-based Peterson Institute of International Economics think-tank, have concluded that the fiscal plan would not boost growth and might even reduce it.

The commission is right on substance. Whether it was wise to take on a country that is too big to fail is another matter. Italy will need to issue some €250bn in debt next year. The spread of Italian 10-year debt over equivalent German bonds has been at around 300 basis points — or 3 percentage points — for most of this month. The Italian finance minister, Giovanni Tria, said such a spread would not be sustainable. He is right. So what will happen when the unsustainable ends?

There are a few steps the Italian government can take. However, most breach EU rules. Matteo Salvini, the deputy prime minister and leader of the League, suggested that the government could recapitalise the banks, which will need to refinance €18bn of their own bonds next year.

This is not so easy. EU legislation no longer allows governments to recapitalise banks in the way they used to. A bank that fails to meet solvency rules has to be propped up or wound down, according to an EU-wide bail-in regime of shareholders and bondholders.

Another option is a raft of policies that falls under the broad category of financial repression. Beyond tax incentives for Italian savers in favour of Italian government bonds, the government could impose outright capital controls, by forcing Italian-based investors to keep their savings inside the country. Greece and Cyprus introduced capital controls during times of crisis, but those were agreed by the EU.

A further escalation would be a parallel currency. Before this year’s elections, the League had drawn up plans for so-called mini-BoTs. These are state-issued securities that look like euros and have the same denominations. The big idea was to make mini-BoTs eligible for the payment of tax debt. Shops and individuals would therefore have reason to accept them as a means of payment — at a certain (but not very large) discount to the euro.  [...]

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