Italy’s economy is one of the biggest downside risks to the global financial system and could spell disaster for Europe

Reuters/Tony Gentile

The IMF has slashed Italy’s growth prospects down from 0.9% this year to 0.1%. Some analysts see the country as a significant risk to the eurozone’s financial stability.
Italy’s economy has been a topic of much debate since last summer with fears that the country’s beleaguered banking sector and ailing productivity could spell disaster.
Banks in Italy are still loaded up with non-performing and poor-quality loans, which underline growing concerns about whether the eurozone laggard will be able to service its debt going forward.

Italy’s ongoing economic problems don’t appear to going anywhere soon. The country’s bad debts could — in theory — topple the European banking system and slow global growth.

At a fundamental level, Italy poses a threat to an already unstable eurozone. Italian banks are saddled with billions of euros of bad loans, much of it governmental, and fears of contagion are never far away. The eurozone comprises the 19 countries that use the euro as a currency, under the auspices of the European Central Bank. The ECB is duty bound to ensure none of is countries defaults. Italy’s debts raise a question, according to analyst Jack Allen of Capital Economics: Why should the healthy economies of Northern Europe, like Germany, continue to support Italian debt that will be technically at risk of default for years or even decades?

"Over the next ten years, we think that Italy’s economy will fail to grow because productivity growth will remain weak and total employment will fall. As a consequence, the public debt ratio will probably continue rising and eventually prove unsustainable. This would be a bigger problem than the previous euro-zone crisis and could once again endanger the single currency itself," Allen told clients recently.

A similar situation happened in Greece after the 2008 financial crisis. That country was crippled by its own inability to pay its debts. The crisis was contained because Greece’s economy is relatively small. Italy, by contrast, is the 9th largest economy globally and sits at the core of the European economy.

A recent IMF report indicated that "potential losses on non-performing loans and mark-to-market declines in the value of government bonds could result in a significant hit to capital for some banks."

The country’s issues have been much publicized after the arrival of a new populist government last year and the ensuing battle it had with the European Commission to get its budget approved.

Italian banks have some €800 billion in government debt on their books and many are carrying risky loans on their balance sheets. Italian institutions hold around 8% of Europes non-performing loans, according to the European Banking Authority figures as of the end of 2018.

After Italy, French banks have the most exposure to Italian government debt with some €285 billion ($323 billion) held in major lenders like Credit Agricole and BNP Paribas. Some $481 billion of Italian government debt was held in non-Italian banks as of June 2018, according to Bloomberg.

It re-invents fears of a so-called "doom loop" which can see governments struggling to protect banks whose profits are hit by a drop in value of government bonds because of their own inherent weakness.

"A protracted period of elevated yields in Italy would put further stress on Italian banks, weigh on economic activity, and worsen debt dynamics," the IMF added. Attempts by European institutions to stimulate lending have been unsuccessful for Italy.

The country took on an estimated one-third of the €724 billion ($817 billion) of so-called "targeted longer-term refinancing operations" — a low-interest loan product designed by the ECB to promote lending — but still saw a contraction in loan demand from corporates, according to reporting by the Financial Times.

Things aren’t going to improve anytime soon either. The IMF slashed Italy’s growth prospects down from 0.9% this year to 0.1%. The country’s stagnating economy and relatively high bond yields put the country in a precarious fiscal position, Oxford Economics wrote in a recent research note.

The country’s low productivity growth could lead to Italy’s public debt ratio rising further to unsustainable levels. Jack Allen suggested that Europe’s economic laggard could find itself in a "perma-recession," which could have consequences worse than the previous eurozone crisis.

One of the few green shoots for Italy’s economy has been the fact that the country’s purchasing managers index figures for March reached their highest levels since September 2018, with new orders growing at their fastest pace in six months, according to IHS Markit data.

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Source: Business Insider – cburroughs@businessinsider.com (Callum Burroughs)