Yves here. On the one hand, it is completely logical for Italy to threaten to leave the Eurozone, since its economy has fared particularly poorly. That in turn is the big driver of its slow-moving-but-getting-steam bank crisis. Ambrose Evans-Pritchard has been pointing out for years that with Italy having a primary surplus, it was the only Eurozone country with the economic heft and the fiscal stance for leaving the Eurozone to be a clearly attractive choice.
And that’s before you get to the fact that the Eurozone has created the worst of all possible worlds with the so-called Bank Recovery and Resolution Directive which went into effect in January 2016. It fails to provide for one of the key requirements of a sound banking regime, which is backstopping deposits (that is left to nation-states, many of which have deposit guarantee schemes which are not adequately funded. A deposit backstop should be provided by the regulatory authority, particularly since it is the Eurozone, and not Eurozone members, that controls currency issuance). While the US doesn’t have a credible regime for resolving too big to fail banks either, unlike the BBRD, it didn’t spend years creating a post-crisis set of regulations that actually increases the odds of bank runs.
Italy has been getting the run around in dealing with its ailing banks and on the budgetary front. This might be barely tolerable due to the realpolitik that German officials would be risking their political futures to be seen as being nice to Italy prior to the elections this fall. But there seems to be no realistic plan in the wings for addressing Italy’s banking mess. While the Europeans have made an art form of kicking the can down the road, they don’t seem to recognize that they are in a cul de sac.
Key sections from an instructive post last October by economist Thomas Fazi:
Italy’s latest budget bill – approved just a few days ago – confirms what many government critics have been saying all along: Matteo Renzi’s anti-austerity rhetoric is nothing more than that. Ever since his appointment as prime minister, in February 2014, Renzi has been an outspoken critic of austerity….
The post-earthquake solidarity was short-lived, though. A few weeks later, at the EU crisis summit in Bratislava, Renzi deserted the final press conference with his German and French counterparts because of disagreements over the economy and immigration. In the days leading up to the publication of the budget bill it became apparent that Renzi’s pleas for greater flexibility had fallen on deaf ears. First came Jens Weidmann, the infamous Bundesbank president, who accused Italy of ‘abusing’ the flexibility clause contained in the Stability and Growth Pact (SGP) and urged Renzi to focus on structural reforms and debt reduction. Then it was the turn of Pierre Moscovici, the European Commissioner for Economic and Financial Affairs, who stated that the SGP ‘works fine’ and ruled out granting further flexibility to Italy (even though he had just given Spain and Portugal reprieve from EU budget rules for running much higher deficits than Italy – twice as much in Spain’s case). Finally, Mario Draghi cut the dispute short by declaring that EU rules already provide for ‘a lot of flexibility’ and that ‘countries… should think more about the composition rather than the size of their budgets’ (despite his numerous calls in recent months for greater fiscal support to the ECB’s quantitative easing (QE) policies)…
In view of the two sides’ official positions – on one hand a prime minister who has repeatedly denounced the eurozone’s fiscal rules, and is in charge of a country facing the longest and deepest recession in its history, on the other a European establishment that insists on further austerity – an uninformed observer could be forgiven for expecting Renzi to defy EU rules and unilaterally hike the deficit. Everyone else in Europe appears to be breaching the rules: not only are Spain, Portugal, France and Greece well above the SGP’s 3 per cent deficit-to-GDP limit, but Germany has been aggressively violating the EU’s trade surplus rules for years.
But our imaginary observer would have been disappointed: not only does the recent budget bill not foresee an increase of Italy’s fiscal deficit in 2017; it actually foresees a reduction from 2.6 per cent now to 2.4 per cent. And not because the economy is expected to magically start growing – the estimated GDP growth rate for 2017 is a meagre (and overoptimistic) 1 per cent – but because the government has shamefully accepted to implement further austerity measures, in the form of additional budget cuts (even though Italy has reduced government expenditure more than any other member state since the start of the crisis).
To understand the disastrous implications of this decision it is important to understand the distinction between the primary budget balance and the overall budget balance. It is a common misconception that when we talk of ‘budget deficits’ we are talking uniquely of government revenues minus expenses: that is, governments spending more than they collect in taxes. However, the overall budget balance includes the interest payments on the existing debt. The primary balance, on the other hand, refers to how much a government earns, minus what it spends, not including interest payments on the existing debt – so logically this is the measure that we should look at when assessing whether a country is pursuing an expansionary or contractionary fiscal stance, and whether we are dealing with a ‘virtuous’ or ‘profligate’ nation, in the parlance of our times.
This is Italy’s case: despite its reputation as a reckless spender, it is one of the few countries in Europe (and in the world) to have run a significant primary surplus – meaning that, on average, it has consistently earned more than it has spent, excluding interest payments – since the early 1990s.
Source: Italian Ministry of Economy and Finance based on AMECO-European Commission data
However, this has never been sufficient to cover the country’s high rate of interest expenditure, averaging around 5 per cent of GDP since 2000 (a legacy of the sky-high interest rates of the 1980s), so the state has had to take on new debt each year simply to service its old debt – hence the overall deficit. The same goes for a number of other countries: according to data from the European Commission, between 1992 and 2008 the eurozone has constantly registered a primary surplus. Even if we look at the ‘profligate’ PIIGS (Portugal, Italy, Ireland, Greece and Spain) we see that before 2008, three (Italy, Ireland and Spain) had primary budget surpluses and one (Portugal) had a near-balanced primary budget. Greece was the only country with a serious primary budget deficit.
Yves again. A reader might say, “So why hasn’t Italy left the Eurozone?” The problem, as we like to say in Maine, is you can’t get there from here. It would take a bare minimum of three years, which means more like six or more, to re-introduce the lira. It took eight years of planning and three years of implementation to launch the euro, and that was when there was tons less computer code in the various elements of the payment system than now. Italy is not in control of its destiny, since it will take the cooperation of many players, such as international banks, to make the all the needed changes. Even in a negotiated exit with assistance of all the needed parties, this is a complex, time-consuming, and difficult undertaking. If Italy were to attempt to crash out, you’d see results like those in Greece when the ECB cut off its banking system: a near complete shutdown of imports (which in Greece’s case included essentials like food, fuel, and pharmaceuticals), with Greece on the verge of having food shortages after two weeks.
So while we have the seeming insurmountable force meeting an immovable object, what appears most likely to break is the Italian banking system, which would send shockwaves to the rest of Europe.
By Don Quijones, Spain & Mexico, editor at Wolf Street. Originally published at Wolf Street
Nerves are fraying in the corridors of power of the Eurozone’s third largest economy, Italy. It’s in the grip of a full-blown banking meltdown that has the potential to rip asunder the tenuous threads keeping the European project together.
In his annual speech to the financial market, Giuseppe Vegas, the president of stock-market regulator CONSOB — a consummate insider — delivered a bleak prognosis. The ECB’s quantitative easing program has “reduced the pressure on countries, such as ours, which more than others needed to recover ground on competitiveness, stability and convergence.”
But it hasn’t worked, he said. Despite trillions of euros worth of QE, Italy has continued to suffer a 30% loss in competitiveness compared to Germany during the last two decades. And now Italy must begin to prepare itself for the biggest nightmare of all: the gradual tightening of the ECB’s monetary policy.
“Inflation is gradually returning to the area of the 2% target, while in the United States a monetary tightening is taking place,” Vegas said. The German government is exerting mounting pressure on the ECB to begin tapering QE before elections in September.
So, too, is the Netherlands whose parliament today treated ECB President Mario Draghi to a rare grilling. The MPs ended the session by presenting Draghi with a departing gift of a solar-powered tulip, to remind him of the country’s infamous mid-17th century asset price bubble and financial crisis.
For the moment Draghi and his ECB cohorts refuse to yield, but with the ECB’s balance sheet just hitting 38.7% of Eurozone GDP, 15 percentage points higher than the Fed’s, they may ultimately have little choice in the matter. As Vegas points out, for Italy (and countries like it), that will mean having to face a whole new situation, “in which it will no longer be possible to count on the external support of monetary leverage.”
This is likely to be a major problem for a country that has grown so dependent on that external support. According to the Bank for International Settlements, in 2016, international banks in particular those in Germany reduced their exposure to Italy by 15%, or over $100 billion, half of it in the last quarter of the year. ECB intervention helped plug the shortfall, at least for a while. But the ECB has already reduced its monthly purchases of European sovereign debt instruments, from €80 billion to just over €60 billion.
As the appetite for Italian government debt falls, the yields on Italian bonds will rise. The only market participants seemingly still willing and able (for now) to increase their purchase of Italian debt are Italian banks.
Over a two-month period, Italian banks increased their holdings of Eurozone government debt by €20 billion, with €12.3 billion of newly conjured funds poured into Italian debt alone, according to a joint study by the ECB and Jefferies International. It’s the highest increase since 2015, bringing Italian banks’ total holdings of Italian government debt to an eye-watering €235 billion. When rates begin rising on that debt, those same banks, many of which are already verging on insolvency, will begin bleeding new losses.
This is a ticking financial time bomb. As the FT recently reported, just about every solution hurled at Italy’s financial crisis has come to naught. That seemingly includes the latest plan-B which essentially involved securitizing billions of euros of toxic debt and spreading it as far and wide as possible, with the assistance of Wall Street banks. According to the FT, that plan has already “floundered.”
In the meantime, Brussels continues to dither over how to proceed with the bailout/bail-in of Italy’s most bankrupt big bank, Monte dei Paschi di Siena, which just announced new quarterly losses of €169 million. Other major banks, most notably Banco Popolare di Vicenza (BPVI) and Veneto Banca, are in similar dire straits. Once again, Italy’s regulators are urging caution over applying the EU’s bail-in rules to the exact letter of the law.
In his address, Vegas proposed introducing a safeguard threshold of €100,000 euros for the banks’ bondholders, many of whom are ordinary Italian citizens, with combined holdings worth some €200 billion, who were told by the banks that their bonds were a secure investment. Not any more.
“The management of crises may require timely intervention that is not compatible with the mechanisms in Frankfurt and Brussels,” Vegas added.
To get his point across, he issued a barely veiled threat in Frankfurt and Brussels’ direction — that of Italy’s exit from the Eurozone, a prospect that should not be altogether discounted given the recent growth of anti-euro sentiment and rising political instability in Italy. So he threatened: “Merely the announcement of a return to a national currency would provoke an immediate outflow of capital that would seriously jeopardize Italy’s ability to refinance the world’s third biggest public debt.”
That’s the ultimate threat: monetary sovereignty — its own currency — under very messy conditions. Let others pick up the pieces of the Eurozone.
Italy’s latest plan is just splendid: Selling securities backed by defaulted loans to NIRP refugees. Read… Here’s Italy’s Latest Plan B Where Desperation Meets Insanity