A weak Italian economy threatens the EU’s seeming solidarity.

  • + Conte calls for help from the ECB amidst an economic crisis.
  • + Coronabonds have been rejected by a few Northern European states.
  • + A lack of consensus threatens the EU’s solidarity.
Source: Reuters; Economic Times

Italy has been in the headlines of almost every major newspaper across the world over the past few weeks. While the outbreak of the COVID-19 was a major blow to Italy, another thing that has been lurking around, not so secretly, is the Italian economic recession. Just like many other countries battling dire economic depression, Italy has been no different. Yet, its case is unique as the way the government will choose to handle the situation will also directly impact the Eurozone. This is a predicament which many EU countries are unwilling to face, especially in the midst of the pandemic. 

Italy has been deeply affected by the spread of the pandemic as it was the first European country to initiate a national lockdown. Unfortunately for the Italian Prime Minister, Giuseppe Conte, the pandemic came at an unfortunate time (well, there never really is a fortunate time for such an outbreak). With the entire country under lockdown, the only form of consumer spending has been through food and medicines which account for a minute portion of the total consumer spending. With a halt in manufacturing and production, it has been predicted that the Italian GDP will contract by 3% of its GDP, that is, if the country is lucky. Adding to that, the financial sector has been piling up bad loans and non-performing assets which are only predicted to increase now, with businesses finding it more challenging to repay loans; this would eventually lead to more visible cracks in the credit system. 

On top of that, the Italian government has seen an increase in the purchase of government bonds by the financial sector over the past few years which has now made economists concerned about the formidable ‘doom loop’ which can effectively be a blow to the government’s economic stability if the financial sector further weakens. With the number of bad loans increasing, the banks have very limited options to raise finances and thus, they could also sell government bonds as the last resort. The value of the government bonds would reduce, thereby reducing the faith in government bonds as panic about economic uncertainty rises. These bonds will be perceived as ‘risky’ owing to the economic situation; they will now only be bought at a high interest rate due to the high cost of borrowing and this will further reduce the value of the bonds. This cycle seems never-ending, right? Well, that’s why it’s rightly termed as the doom loop. So now the banks are failing, the industries have momentarily shut down and the consumer spending is not helping Conte either. So, what other option does he have left now? 

To save the banks and the businesses, Conte announced a €400 billion package worth of liquidity and bank loans to shield the economy from further deterioration under the crisis. But the question is: How is the government financing this debt? Although the government has been running a budget surplus for the past 19 out of 20 years, Italy also has the highest level of public debt in the Eurozone which does not safeguard its economy when it takes on such a high burden (especially in an unstable economy). One way the government raises funds, apart from taxes, is through bonds. But as mentioned earlier, an unstable economic environment compels lenders to lend only at a high interest rate which then reduces the value of the bond. So, on the national front, the government is stuck between a rock and a hard place. 

The only other option that Conte and many other Southern-European policymakers have is help from the ECB. The Eurozone countries have been discussing two possibilities – one that seems manageable while the other completely declined by some Northern-European countries, including Germany and the Netherlands. 

Let’s look at the more ‘viable’ option first. Policymakers in Brussels have been eyeing credit lines from the European Stability Mechanism (ESM) along with unemployment assistance and reduced rates for corporate loans. But the sum being discussed right now is a loan program worth €200 billion for all the borrowing countries. Now that might seem like a lot of money but to give you a reference point, Germany itself has announced a €1 trillion package to save its own economy. Adding to that, the ESM essentially grants loans to these national governments. If Italy borrows from the ESM, it has been presumed that the debt levels could reach 160% of its GDP. Now this help from the ECB could leave Italy and other borrowing countries more vulnerable. Moreover, Christine Lagarde, the President of the ECB also stated that the organisation would not be pulling out all stops to support the member states. The frantic stress following the announcement led to the worst stock market crash in Italy’s history. 

So, loans might not be the best-case scenario for Italy but it’s the only proposition on the table as of now. The other, not-so-viable option has been completely declined by many Northern-European countries. The term ‘Coronabonds’ has become popular amongst the economists in the Eurozone lately. What such a bond would do is group the debt of all the member states into one bond which would then be backed by all the member nations. This will increase the stability of such a bond as well as maintain its value; now, the stress of issuing the bond doesn’t just fall in the hands of one nation. But Germany and the Netherlands, who enjoy fiscal flexibility and stability don’t want to partake in such an instrument since it not only threatens the fiscal sovereignty of the nations but also increases the debt levels of the Northern-European countries. This also implies that Italy and other economically vulnerable countries wouldn’t worsen their fiscal deficit to such a large extent. So, there really isn’t any point discussing this further as this policy is completely off the table for many in Brussels. 

While the ECB has announced that its €750 billion program will purchase corporate and public bonds all over Europe throughout 2020, the solidarity of the EU has definitely been tested. Merkel especially wants to avoid another disaster such as the Greek Sovereign Debt Crisis which had been exacerbated due to austerity measures. The ECB now feels a great deal of pressure to make the right decision to prevent such a mishap. Yet, they are unwilling to go all out. The COVID-19 has shown us that most of these countries have adopted policies which are lined in nationalism not only in terms of curbing the outbreak but also in terms of economic measures. Fiscal sovereignty still remains crucial for many Eurozone nations. The ESM which was basically created for preventing such an economic disaster has not proven very useful either. The current failure of the EU to come to a consensus has also given nationalist and populist parties in these countries the reason to argue that the nations’ membership in the EU is just a burden to their economic sovereignty. As the policymakers from the north and the south face off in Brussels, only time will tell if the right decision was made. 

Ishwari Sawant

Team Member of Research & Analysis