The euro area’s most vulnerable economy is heading into a storm.
16 agosto 2018, 08:00 CEST
Let it die.
Photographer: Geraldine Hope Ghelli/Bloomberg
Ashoka Mody is a visiting professor in international economic policy at Princeton University. Previously, he was a deputy director at the International Monetary Fund’s research and European departments.
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The renewed turmoil in financial markets should send Italy’s leaders an urgent message: They must speed up a costly and possibly disruptive repair of their fragile banks to prevent even greater costs and disruption later.
When Turkey’s currency plunged last week, Italian bonds and bank stocks were among the first to feel the repercussions. In fact, Italy has limited exposure to Turkish risk. The real reason for market skittishness lies elsewhere: a perfect financial and economic storm is gathering force.
Borrowing costs are rising as central banks around the world remove monetary stimulus. The European Central Bank had, through its bond purchase program, kept Italian rates extraordinarily low. The inevitable rise has begun — with a recent jump triggered by its own politicians’ missteps. In the coming months, Italian interest rates have only one way to go: ever higher.
Meanwhile, economic growth is slowing: Italy’s gross domestic product expanded at an annualized pace of 1.2 percent in the second quarter of 2018, down from 1.8 percent in the last quarter of 2017. As the Chinese economy continues to decelerate, the pace of world trade growth will fall, which for Italy implies a possible halt in GDP growth in the second half of the year.
This combination — of rising interest rates and slower growth — will put financial pressure on the government, which must refinance more than 300 billion euros in debt at higher interest rates before the end of 2019, at a time when weakening growth will eat into tax revenues and raise the demand for social spending. As a result, the debt burden will increase further.
But serious as the fiscal problems are, the storm will, as it always does, cause the maximum havoc where the structure is most fragile: the banking system.
Italian banks are heavily invested in government bonds, creating a “doom loop” in which the banks suffer losses when rising interest rates and worries about the government’s finances cause the bonds to lose value, chewing into the banks’ capital. Worse, an economic slowdown will leave the banks with even more non-performing loans, and buyers of their distressed debt will shy away. As weak banks become more of a liability for the government, the doom loop will intensify.
When approaching a financial crisis, all policy options are bad. But history’s one repeated lesson is that delaying action leads only to greater costs later. Like its predecessor, the new government is unwilling to inflict pain on delinquent borrowers and imprudent creditors of Italian banks. The decision makers continue to hope that an extended spell of low interest rates and steady growth will heal the borrowers and permit repayment of creditors. Such optimism, always misguided, is now palpably illusory.
In the second half of 2017 and early months of 2018, Italy experienced a brief sweet spot. With interest rates still low, a rare spurt of synchronized global growth lifted its economy as well. This allowed Italian banks to find buyers for some of their bad loans at 10 percent to 35 percent of face value. The government helped by providing some limited guarantees on the loans. These were steps in the right direction: Italian banks recognized losses and began a slow move towards normal functioning.
With that sweet spot now receding, the government must act rapidly. It must speed up bankruptcies of zombie borrowers, enforce losses on creditors and require banks to increase their provisions against bad loans. Naturally, such moves will elevate market tensions, but they’re necessary to prevent the stress from becoming unbearable in the coming months.
And that’s not all. Italy is heavily overbanked: Some institutions must — as Danièle Nouy, the head of the ECB’s banking supervision arm, astutely put it — “die in an orderly fashion.” Trying to merge them into stronger banks is not enough. In Italy, this applies with special force to Monte dei Paschi di Siena, the chronically sick bank repeatedly propped up and now nearly 70 percent owned by the government. There is no imaginable reason to keep it alive.
Italian authorities need to wake up. Merely fulminating against an international elite and financial speculators is not going to cut it. The country’s economy and finances are dangerously vulnerable, the consequence of decades of political factionalism and policy stupor.
With its many social and fiscal objectives, the government may be inclined to punt. After all, strengthening the roof before a storm approaches always seems an indulgence. The risk of inaction, however, is great. Building a shelter once the storm rages will prove impossible.
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To contact the author of this story:
Ashoka Mody at email@example.com