Italy, the nightmare of the euro zone

Since Tuesday, all eyes are on Italy. The interest rate on Italian 10-year loans exceeded 4% for the first time since 2014, reflecting a loss of market confidence in the country’s economic stability. Although it later fell below this threshold, the truth is that this surge is bad news for Italy, whose sovereign debt has reached 151% of GDP, and raises the specter of the 2011 financial crisis. moment, the Italian exceeded 7%, very far from the current one, the fear that the country finds it difficult to raise money in the markets is very real. At least enough for the European Central Bank (ECB) to react. After having announced a tightening of monetary policy in the euro zoneLast week, the institution met urgently on Wednesday. An exceptional session at the end of which he promised a new strategy to limit interest rate differentials between European countries, while remaining evasive about the contours of this device.

Why did the Italian rate suddenly skyrocket? What risks weigh on the country’s economy? How can the ECB avoid widening the gap between eurozone countries while fighting inflation? explanations.

Why did the Italian rate suddenly increase?

On Wednesday June 15, the ECB announced a monetary tightening characterized by a 25 point increase in official rates in July, followed by a further increase in September. The Governing Council of the ECB also declared that it would abandon, at the end of July, its traditional asset purchase program (APP) that allows the monetary entity to buy government bonds to lower the financing costs of the latter and thus stimulate its economy. . The objective of these measures: to fight against the runaway inflation that is raging in the euro zone.

However, if these announcements were to be expected, the prospect of a faster-than-expected acceleration in rate hikes with a second installment in September has raised concerns in the markets. A fear redoubled by the warning from the president of the ECB, Christine Lagarde, about a risk of fragmentation of the European sovereign debt market in the euro zone. She was thus referring to the possibility that this monetary tightening would accentuate the propagation – that is, the difference between the 10-year rate of a country like Italy and that of Germany. In fact, the German 10-year rate is taken as a reference to calculate this difference, with Germany being the country that borrows at the lowest rate in the euro zone. If he spread is too large, there is a risk of creating an imbalance between the European economies. And that is what was discovered to have happened last Tuesday. The spread between the German and Italian rates widened to 200 basis points. A figure still far from the 600 points reached during the euro zone crisis in 2011, but too high for the ECB, which has made the fight against the fragmentation of the European sovereign debt market a priority.

What are the consequences of a rate that is too high?

Italy is one of the main issuers of debt in the euro zone. For years it has had to face a very high level of indebtedness that has worsened even more with the health crisis and the measures adopted to support the country’s economy. However, if the rise in European reference rates does not represent a short-term risk -Italy has taken on enough debt at current low rates-, in the longer term it will have to borrow at higher rates, which will weigh on the cost of its debt and calls into question Italy’s fiscal sustainability. Nevertheless, although the markets are currently concerned about it, the issue will not arise for a horizon of two or three years », clarifies Damien Rio, responsible for mandates at the asset manager Federal Finance Gestion (FFG). However, he raises another point: Rate hikes are always a very strong drag on growth. However, in the case of Italy, the brake induced by the rise in rates controlled by the ECB is amplified by the increase in the spread profitability with German rates. Therefore, growth prospects are dimming. ». It warns in particular about the consequences for Italian companies and households that are forced to borrow from commercial banks at a level higher than that of the State.

This is indeed the risk of the new European monetary policy. By curbing consumption with high rates, the ECB is trying to fight inflation, which could also, in turn, curb growth. Therefore, the institution must find a balance to prevent certain countries such as Italy, or even the entire euro zone, from falling into recession.

What tools does the ECB have?

A At the end of its exceptional meeting on Wednesday, the ECB committed “act against the resurgence of fragmentation risks”according to the press release issued by the European Monetary Institute, so “apply some flexibility in the reinvestment of reimbursements due in the PEPP portfolio with a view to preserving the functioning of the monetary policy transmission mechanism”. The PEPP designates an emergency asset purchase program deployed in the context of the health crisis in order to facilitate the access of individuals and companies to affordable financing. Launched in March 2020, it completes the traditional PPP asset purchase program (seen above), but is only temporary and is due to end in 2023. In the meantime, the ECB is committed to targeting repayments of reinvestments under this PEPP in Italian debt and in debt of other countries that need it to avoid increasing their borrowing rates. This announcement also had the immediate effect of driving the Italian 10-year rate back below the 4% mark. However, without managing to reduce the gap with the German rate.

The ECB also confirmed its intention to collect “relevant committees” of the Eurosystem to “accelerate the completion of the design of a new ‘anti-fragmentation’ instrument for consideration by the Board of Governors”. This tool would allow, not to stabilize the Italian rate, but to reduce the gap with that of Germany. But the monetary institution remained very vague as to the contours such a device could take. The ECB’s announcement about this tool has lowered the Italian rate, which is positive, but the country’s need for financing may still weigh on the gap with Germany », emphasizes Damián Río. Nevertheless, if he spread stays at 150 to 200 points, still reasonable ».

Will Italy have to take steps to reduce its debt?

If the ECB is determined to act to prevent the Italian debt from sinking, the country should also give answers in this regard. After months of necessary spending to sustain the national economy in the face of the health crisis, Brussels could encourage it to return to the budgetary rigor of the European treaties if the situation deteriorates further. However, at the end of May, the European Commission announced that these rules, imposed on EU Member States and not applied since March 2020, will continue to be suspended in 2023 due to the economic shock caused by the war in Ukraine.

Indeed, Europe will face new challenges, Damián Rio point. This conflict will generate new budget expenditures, in particular for the energy transition in order to reduce Europe’s dependence on hydrocarbons, but also to strengthen the European military structure. And these expenses will affect all states, even those in the North such as Germany, which until now advocates budgetary rigor », he explains. According to the expert, the EU must therefore equip itself with new tools, raising the idea of ​​a pooling of rates in the euro zone in some areas. We could imagine it as an institution of the euro zone that would borrow on the markets and then redistribute this money at the same rate for each State in order to finance strategic projects for Europe. », he explains. A solution similar to the one that the European Commission has undertaken with the NextGenerationEU recovery plan, borrowing on the markets at more favorable rates than many Member States could have benefited from and then redistributing the amounts.