Italy at the crossroads - CBS

Italy at the crossroads
                                           By
                       Svend E. Hougaard Jensen and Andrea Tafuro ∗

 Concerns about the Italian economy appear to have evaporated under Draghi’s
leadership. However, despite enjoying a reasonably solid leadership at the moment,
Italy still remains the most fragile economy among developed countries, with a huge
public debt and low growth prospects. The recent Spring Forecast from the European
Commission helps us define the perimeter of this fragility - namely, public debt.
Currently at the order €2,500 billion, its share of GDP is set to increase to 159.8% this
year, falling only slightly in 2022 to 156.6%.

 Three elements can help secure the medium-term sustainability of such a large debt.
First, a quick recovery after the pandemic, which the Commission estimates to be 4.2%
and 4.4% in 2021-2022; second, the maintenance of the low cost of public debt and
third, sustained growth in the medium-to-long term that will be able to support the
economy when the ECB and other EU governments lift the current stimuli. If Italy is
successful in reforming its economy, public debt will start falling and it will then not
constitute a problem for the rest of Europe.

 Currently, however, the stability of the Italian economy – and the sustainability of its
debt – still poses a serious threat to EU and Eurozone stability. This is because it relies
on two things: the international credibility of Prime Minister, Mario Draghi – “mister
whatever it takes,” who saved the euro - and on the purchasing programmes of the
ECB - the QE–programmes (Quantitative Easing) that Draghi helped launch.
However, neither of these will last forever.

 A “Greek scenario” is therefore still possible for Italy. Or even worse: a complete
default. What would happen if a large country like Italy defaulted? An Italian default
could be transmitted to the European - and global - economy through three channels:
trade, the financial market, and the Eurosystem.

∗Svend  E. Hougaard Jensen, PhD, is Professor of Economics at CBS, Director of the Pension Research Centre
(PeRCent) at CBS, Member of the Systemic Risk Council and Non-Resident Fellow at Bruegel, Brussels. Andrea
Tafuro, PhD, is postdoc in the Department of Economics at CBS.

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The first is related to the depressive effects of a default that would reduce Italian
demand for goods and services from abroad, with possible global repercussions.

 The second relates to the impact of an Italian default on the assets of financial
institutions: banks and other financial institutions hold sovereign bonds as assets,
because they are considered a safe investment and can be used as collateral for
operations on the market or with the central bank. If a European country, like Italy,
defaults, a share of these assets will suddenly have a value close to zero and this would
impair the solvency of many financial institutions.

 Even financial institutions that do not hold Italian bonds could feel an impact because
they might hold debt or equity of banks that became insolvent. This might lead to a
generalised credit crunch, similar to the one observed in 2008, with devastating effects.
For a sense of scale, consider the collapse of Lehman Brothers, which involved assets
of just $600 billion. An Italian default would involve assets of app. €2,500 billion.

 Thanks to the QE and the overall reforms introduced by the EU after the Greek crisis,
the possibility of transmission through the banking system and the financial markets
has decreased. In the case of Italy, the share of sovereign debt held by non-residents
declined from 50% before the Great Financial Crisis (GFC) to 35% in 2019.

 However, this reduces only the direct effect that an Italian default will exert on
European financial institutions: the second-wave effect – the one due to the
interconnectedness of financial institutions – will still be present and can become
harmful if there is financial turmoil.

 In fact, a large share of the Italian debt now appears on the ECB balance sheet, as ECB
assets, because of QE. Already before the pandemic, the Eurosystem owned about
16.5% of the total government debt of the Euro Area, with mild fluctuations across
countries, except for Greece. This implies that at the end of 2019, the Eurosystem held
about 20% of Italian debt – something like €400 billion. According to the Bank of Italy,
this amount increased in 2020 by about €150 billion, almost covering in full the extra-
deficit determined by the pandemic (about €160 billion). The Eurosystem is therefore
set to hold about 25% of Italian public debt.

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As a consequence, an Italian default would cause a large loss in the ECB balance
sheets. The possible consequences of this are controversial. Well, a central bank does
not aim at producing profits, and it can always print money “to pay its bills”. The
profits from future seigniorage may be so high that central banks are allowed to
pursue their goals even with negative capital (as has been the case with Chile and the
Czech Republic in the past). Therefore, the only effect an Italian default would have is
that Member States will receive lower dividends from the Central Banks.

 However, the capital loss generated by Italy’s default might also raise concerns about
its ability to function effectively, and about its independence. This is particularly the
case if there are reasons to believe that loss will lead to present or future money
injection. Moreover, this would happen at a moment of high tension in the financial
markets and high cost of debt: we would observe something unprecedented
happening in unexplored territory. What would happen if markets convinced
themselves that the ECB cannot pursue its mandate appropriately anymore? The
consequences of such a situation can be potentially devastating.

 Despite this possibility, this scenario is still unlikely. In his efforts to steer Italy into
calmer waters, Draghi is supported not only by a large parliamentary majority but by
the EU Commission, thanks to the NextGenerationEU (NGEU). This is a large package
– about €750 billion – approved by EU countries to boost EU recovery and create a
greener, more digital, and more inclusive economy. Member States need to present a
Recovery Plan to get access to these funds, in which they must specify the investments
they want to pursue and the accompanying reforms necessary to guarantee long-term
economic growth.

 Italy will receive the largest share of the European funds, about €205 billion in the
period 2021-2026, of which €122.6 in the form of loans and €82.5 as grants. The country
just presented its plan, laying out how resources will be distributed. It is an ambitious
plan of reforms, with an additional fund from Italy’s own resources of about €30
billion. The plan shows three horizontal strategic priorities: Italy’s digital transition,
green transition, and social inclusion. Nearly 40% of total resources are earmarked for

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the green transition, 27% for digitalisation, and 40% for the development of the south
of the country.

 The final plan is comprised of 6 missions and 16 components in the form of individual
interventions including 48 reforms and 131 investment projects. Most of these projects
are based on investments already in place or which have been already, at least
partially, financed. This is because projects financed with NGEU funds need to be
completed by a specific date, which rules out financing investments that are still on
paper. The reforms are ambitious and concern the judicial system, public
administration, legislation complexity and increased competition. The plan should
guarantee a cumulated effect on GDP, over the 6 years of about 3.6%.

 All these reforms and investments go in the right direction, and they will free up the
country’s potential. However, it is difficult to say if this will be enough to get Italy
back on course. At the current stage, the plan is still a bit generic – in particular
regarding how and when the reforms will be implemented. In addition, the plan does
not present either a reform of taxation or reform of pension, which are crucial for a
country with large tax evasion, and which spends about 17% of GDP on pensions.

 The feeling is that the Draghi government is well aware of the limits of its mandate.
The coalition that sustains him, despite its size, is very heterogeneous: the inclusion
of elements that might be perceived as divisive could diminish the support of some
parties. A vast coalition was necessary though, to ensure that reforms and investments
will be implemented in a country where governments do not last very long.

 The recovery plan has a long phase-in of almost 6 years, and Draghi’s government
will probably not be at the helm for the entire period. It is therefore necessary that all
the major elements across the political spectrum are involved, so that they will not
backpedal on the reforms that they contributed to approving.

 However, this is also Draghi’s government’s main weakness: The need to retain their
broad consensus makes it difficult to implement high impact reforms – which are
generally politically costly in the short-term. If this turns out to be the case, the NGEU
will become another lost opportunity for the Italian economy, and the probability of a
“Greek scenario” will increase.

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Table 1. Forecast on Italy, 2020-2022

                                             2020                    2021                    2022

 Government balance                          -9.5%                   -11.7%                  -5.8%

 Government debt                             155.8%                  159.8%                  156.6%

 Economic growth                             -8.9%                   4.2%                    4.4%
Note: The table presents the Spring Forecast for the Italian economy made by the EU commission.
Source: European Commission, April 2021

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Archer, D. and Moser-Boehm, P., 2013. “Central bank finances”, BIS Working Paper No
71
Bruegel, 2021, “Bruegel database of sovereign bond holdings developed in Merler and Pisani-
Ferry (2012)”, Database extracted on May 2021
Buiter, W., 2008, “Can central banks go broke?”, No 6827, CEPR Discussion Papers,
C.E.P.R. Discussion Papers
Cohen-Setton, J., 2015, “Blogs review: QE and central bank solvency”, Bruegel
De Grauwe, P., and Ji Y., 2015, “Quantitative easing in the Eurozone: It's possible without
fiscal transfers”, VoxEU.org, 15 January.
European Commission, 2021, “European Economic Forecast – Spring 2021”, April
Government of Italy, 2021, “National Recovery and Resilience Plan (Piano nazionale di
Ripresa e Resilienza)”, Governo Italiano Aprile 2021
Stella, P., 1997, “Do central banks need capital?” International Monetary Fund Working
Paper No. 83, pp. 1-39.
Winkler, A., 2014, “The ECB as lender of last resort. Banks versus governments”, LSE
Financial Markets Group, Special Paper Series, February.

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