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Italy is awakening demons of a eurozone break-up

28 May 2018 15:17|Marcin Lipka

"A few days ago, it seemed that Italy might be facing a serious fiscal crisis and the risk of further increase in debt. Today, we are already facing a much more serious threat - Italy's exit from the eurozone," writes Marcin Lipka, Conotoxia Senior Analyst.

Marcin Lipka, główny analityk Cinkciarz.pl

In just two hours, the interest rate on Italy's 2-year government bond has tripled to levels that have not been seen in four years. The difference between the yields of the 10-year debt instruments issued by Italy and Portugal has reached its highest level in 12 years. Currently, the cost of issuing Portuguese debt with a 10-year maturity is more than half a percentage point lower than for the Italian debt. It is worth remembering that Portugal has a junk rating and Italy still has an investment rating. It is likely that investors are worried not only about the Italian rating cut, but also about the serious constitutional crisis and Rome's future membership of the eurozone.

Political stalemate

The current situation in Italy is primarily the result of weekend events. President Sergio Mattarella did not accept the candidate for Minister of Finance put forward by the 5 Stars Movement and the League coalition. Paolo Savona was rejected on the grounds of his euroscepticism.

In Italy, the President has the right to appoint his own ministers, if he does not like the proposals put forward by the winning parties. This is what happened. On Monday afternoon Mattarella entrusted the formation of the government to the former director of the International Monetary Fund, Charles Cottarelli. However, he is not an ally of the populist groups that won the parliamentary elections in March. Among other things, Cottarelli estimated that the election ideas (guaranteed income of 780 euros per capita, tax cuts, pension reform withdrawal) of the League and the Movement would cost 126 billion euros annually, over 7% GDP.

Cottarelli's cabinet will therefore not get a vote of confidence from the populist and eurosceptic-dominated parliament. What does this mean? The most likely solution is the next elections, either in early autumn or at the beginning of next year. There is, of course, nothing wrong with elections, however, in this case the whole campaign could be conducted under one dictation. Will Italy stay in the European Union and eurozone or should it leave?

Is Italy in or out?

"Either the EU rules change or there is no point for Italy to stay in it," said Matteo Salvini, the leader of the Eurosceptic League, today, according to Bloomberg. On the other hand, Cottarelli, who was appointed Prime Minister of the technical government, said that staying in the eurozone was crucial.

It is likely that these two issues will now attract voters' attention. At the moment, the Italians are divided into those who want to use the single currency and those who don't. Support for this project is only at 45%, the lowest among all countries, according to the European Commission's survey from December last year.

Italians do not trust the EU institutions (52%) and believe that their vote doesn't count in the EU (64%). On the other hand, 80% of Italians believe that the country's economic situation is bad and 58% believe that the economic situation of the whole EU is unfavourable (the highest among all EU countries).

Populist and eurosceptic voices are therefore on a very vulnerable footing. In addition, the League and the 5 Stars Movement will be able to launch a campaign suggesting that a centrist environment close to Brussels has prevented the formation of a government. Salvini said on Sunday evening that "only Italians decide their own destiny and neither Germans nor French will do it for them".

The market is already valuing the disaster

On Monday around noon Italy's 2-year treasury bond yields reached 1%, which may not seem much, however, remember that very morning they were at 0.3%. They were even below zero in mid-May, as interest rates are negative in the eurozone and the ECB has been buying government bonds from the market as a part of a quantitative easing operation.

The spread between 2-year German and Italian bonds exceeds 1.6 percentage points and the highest since 2013. This situation is possible only when the market starts to value the debtor's insolvency.

On Friday, Moody's decided to review the Italian rating. At present, it is two levels above the junk limit with a negative perspective. The events from the past few hours will not be viewed positively in the context of creditworthiness.

The Italian crisis is turning into the EU crisis

If the new election campaign is conducted under the dictates of Italy staying or leaving the Union and the eurozone, then the market will start to fear the collapse of the entire common currency area and perhaps the EU as well. This is disastrous news for the euro exchange rate and for Italy itself, which would probably have to go bankrupt when it returned to the lira. It is also terrible news for the zloty, the value of which depends, to a large extent, on the EU economic and political condition.


28 May 2018 15:17|Marcin Lipka

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