29 May 2018 Italy: Loss of market access would have dire consequences Jan von Gerich A loss of market access would force Italy to ask for outside help or start printing its own currency. Both would be very problematic scenarios. In any case, Euro-area break-up fears would balloon and markets would go into a crisis mode. Market pressure increasing Italian assets have been hammered in the past few days. The daily moves in bond yields have actually been larger than at any time during the euro era, including the euro crisis. The rapid loss of market confidence has raised risks that Italy could lose bond market access altogether. While such risks are not close to being realized yet, they are real and it makes sense to consider the vast consequences the loss of market access would have. Unprecedented moves taking place on Italian bond markets today e-markets.nordea.com/article/44610/italy-loss-of-market-access-would-have-dire- consequences Even if the net financing needs of the Italian government are limited, large amounts of bonds mature almost every month, so there is the need to roll over maturing debt. This can be done only as long as there is appetite in the financial markets to buy Italian debt. Italy is shielded to some extent by a strong domestic investor base, including retail investors, but there are limits to how much more debt the domestic investors can buy, especially in the short term. Italy has sizable amounts of bonds maturing in over the coming year e-markets.nordea.com/article/44610/italy-loss-of-market-access-would-have-dire-consequences ECB running to the rescue? The only actor with enough fire power to calm the situation is the ECB. It has been buying bonds under its asset purchase programme, and has some inbuilt flexibility in allocating the purchases. However, the monthly purchase volumes have already come down from the highs of EUR 80bn to EUR 30bn. The Public-Sector Purchase Programme (PSPP), the part that does the government bond buying, is conducted according to the ECB’s capital key, which means that the ECB cannot suddenly shift a big part of the purchases towards Italian government bonds. What is more, the limits on government bond ownership the ECB place binding constraints on expanding the programme further, even if these constraints could be eased to some extent in a crisis. However, there is another programme the ECB could use. This is the Outright Monetary Transactions (OMT) that was introduced – but never used – after Draghi’s famous “whatever it takes” speech in 2012. This programme would allow the ECB to buy large quantities of short-term bonds to calm markets. There is a catch. A necessary condition for the activation of the OMT is strict and eective conditionality attached to an appropriate European Stability Mechanism (ESM) programme. In other words, the Italian government would need to ask for an ESM programme that would probably come with clear terms on how Italy should conduct its economic policy. Could such a programme be approved by the current Italian Parliament, if it was brought to it by a technocratic government led by a former IMF director Carlo Cottarelli? An approval would require votes from either the anti-establishment Five Star Movement (M5S) and the anti-euro and anti-immigration Lega Nord (LN), the parties that recently tried to form a government. An approval would be very doubtful. e-markets.nordea.com/article/44610/italy-loss-of-market-access-would-have-dire-consequences Alternative would be to print new currency If Italy refused to implement an adjustment programme and was denied ECB help, it would in practice be forced to have a plan B, or starting to print its own currency. The government could simply default on its debt, but its banking system could not survive a government default without ECB support (which would not be given to a country in default without an adjustment programme). But who would design and implement such a plan B in the current political situation? Certainly not a technocratic government led by Cottarelli. At worst the situation could look very chaotic, before the alternatives were reconsidered. Markets could panic big time The Italian economy is roughly ten times as large compared to Greece. Considering the worries caused by Greece, it is not dicult to imagine the damage Italy could do. If Italy lost market access – not our baseline scenario – concerns about the break-up of the Euro area would intensify severely. The euro currency would take a beating, Euro-area equity markets would tumble, German bonds would rally strongly and severe pressure would spread from Italian to other Euro-area bond markets. The ECB would have its hands full in trying to fight contagion. The Euro area could survive an Italian exit only if both the ECB and the governments in the other Euro-area countries were determined to do whatever it takes to save the euro. Jan von Gerich Chief Strategist [email protected] +358 9 5300 5191 e-markets.nordea.com/article/44610/italy-loss-of-market-access-would-have-dire-consequences 28.9.2017 1 DISCLAIMER Nordea Markets is the commercial name for Nordea’s international capital markets operation. The information provided herein is intended for background information only and for the sole use of the intended recipient. 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