Italy experienced this crisis in a more dangerous situation than most. Here the European Senior Economist and Strategy Azad Zangana explains the reason.
This will be the deepest recession for the eurozone economy in modern times.
Just as Italy has been one of the hardest hit countries in the Covid-19 crisis, there are fears that its economy and public finances could also be one of the most vulnerable – and even that it could leave the euro zone.
Here Azad Zangana, Senior European Economist and Strategist at Schroders, explains why.
What’s special about Italy?
It is the third largest EU member country and one of the most indebted. So it goes into the coronavirus crisis in a vulnerable position.
“Debt as a share of GDP stands at 134 percent, and is now expected to increase to more than 150 percent of GDP by the end of 2020,” Azad said.
What problems does Italy face?
Along with Spain and Greece, it already feels more expensive to borrow. “That, of course, reflects the higher level of credit risk inherent in this bond going forward,” Azad said.
Because this country is deeply indebted, it highlights two main problems.
“Number one: how they will pay off future debt. And number two: how will they refinance that debt on an ongoing basis? “
Azad said that while this year the Italian budget deficit might rise to more than 10% of GDP, there would be support offered.
What support will Italy offer?
“The European Union has provided a three-pronged approach to helping member states get out and with that about 2-3 percent of the value of GDP funding can be provided for Italy from the start.
“At the same time the European Central Bank has expanded and expanded many of its asset purchase programs.”
This is what is commonly called quantitative easing. It aims to provide liquidity for the government bond market and keep the financial system running.
What is the Italian fare in the long run?
The first risk is withdrawal of support, once the Covid-19 crisis ends. How will Italy cope with an even higher debt burden?
“When and if the ECB decides to reduce their quantitative easing program, that support will be removed.
“Also, some loans offered from the European Union are really only for this year and should be targeted at unskilled workers [and] health care costs, “he added.
The second big risk is that Italy hasn’t grown much.
“This hasn’t really been done since the Global Financial Crisis, an average of around 1 percent in nominal terms since then. In fact it grew less than half of the average growth rate for the eurozone as a whole for that period.
“So as a result he has difficulty controlling his public finances and controlling debt.”
Azad added that if things didn’t improve then Italy’s growth problems would only get worse because the working population was aging and shrinking. “So the long-term dynamics of paying off debt, serving only debt, will be very difficult,” Azad concluded.
But I think it is Greece with all the problems?
When the sovereign debt crisis took place, Greece, Ireland and Portugal sought bailouts from the European Union and the International Monetary Fund. But these countries are small and relatively easy to redeem.
“Italy today is almost three times bigger than what these countries put together, so it makes no sense to spend enough capital to guarantee Italy’s exit for a long period of time if they are removed from the bond market.”
Also, Italian politics are poisoned, Azad said: “We have a populist party that really controls the government and the opposition.
“Italy believes that coronavirus is not their fault. They should not be stigmatized because of taking assistance from the European Union. But at the same time, creditor countries still need to look at several ways that this is not just a cash grant without future behavior changes. “
Sounds difficult, what will happen?
There are various options for EU monetary support – namely the Monetary Outright Transaction and the bail out of the European Stability Mechanism – but there are a number of inherent conditions including partial debt defaults. And Azad said that Italy apparently did not want to go this way because it would be unpopular with domestic savers.
“Even if that happens, there is no guarantee that it will change the long-term dynamics of its public finances. In the end, the situation of growth will continue to deteriorate and therefore the bailout they receive may not be of help for a long time.”
What is the opinion of other EU member countries?
“The problem is trust,” Azad said. “There are only shortcomings at the moment. Can you really trust this government or future governments in Italy to comply with regulations, to do the right thing, to reform their public finances and their economy to ensure that their finances are controlled?
“That is a very big question and difficult for many member countries to answer. Germany is clearly reluctant to offer grants at this stage. He wants to ensure that he has power over money by offering loans.
“But in the end, what we have seen in the past is loans which eventually become long-term loans. They were finally fixed at near-zero interest rates and in that case they might also be called grants at the time. “
Are there any dangers of Italy leaving the euro?
Many investors think Italy can solve some of its problems by leaving the euro zone.
Then it can, “…[D]Evaluating its currency, defaulting on euro-denominated debt that is there, converting what domestic debt has into new lira and moving forward from there, “Azad said.
This will be an entirely political decision.
Azad said that, “it should be noted that in the past when the two political parties had discussed this openly, they had backed away from the idea of exiting the euro very quickly after suffering in elections”.
“So of course not because Italy will leave the eurozone, but we think there is a very high chance that they are experiencing a debt crisis in the next two to three years, and that the fear of leaving the eurozone will be in the minds of many investors out there. “
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