Europe

Italy’s Political Instability Threatens the Eurozone Economy


With key Italian banks on the verge of bankruptcy and capital flowing out of the country, Italy’s December 4th referendum results could hardly come at a worse time. Given the state of its economy, particularly the financial sector, the last thing that Italy needs is a protracted period of political-financial uncertainties.

Image courtesy of Francesco Pierantoni, © 2016

Earlier this month, the Italians declaratively rejected the Constitutional referendum, which would have introduced key political reforms and ensured the continued administration of Matteo Renzi. As of last Wednesday, Italy—under the pressure of a banking crisis—formed a new government, although populist pressure is unlikely to  let it govern for long. Opposition parties have already called for another constitutional referendum  in 2017, along with an election as early as February.

This period of political upheaval has proven harmful for the Italian economy and banks. Italy has been experiencing capital flight in anticipation of the referendum, but state officials fear intensified capital flight as investors fear heightened political risks. In the aftermath of the referendum, Moody’s has downgraded the outlook of the Italian economy from stable to negative.

If such political upheaval were to occur under less trying circumstances, its impact would have been limited. But these are no ordinary times for Italy. Its economy is hemorrhaging, and the Italians are suffering. With a current growth rate of 0.7%, its income per capita is lower today than it was twenty years ago, meaning that it has experienced nearly two decades of lost growth. Additionally, its unemployment rate of 11.6% is second only to Greece in the Eurozone.

Even worse, Italy’s banks are on the brink of disaster. Italian banks have accumulated more than €360 billion of non-performing loans, amounting to one-fourth of its gross domestic product. This means that 17% of Italy’s banking loans are sour, nearly 10 times worse than the U.S. level at the height of 2007-08 financial crisis.

Considering its severe economic and banking difficulties, a protracted period of political and financial uncertainty would be a disaster for Italian banks. If it is not able to assuage investor fears and stem capital flight, experts fear that Italy will experience a full-fledged banking crisis.

However, it is not only the Italians that should be the concerned: the Germans and the French have a lot to lose from an Italian banking crisis. Given the size of its economy and interconnections between systemically important banks, an Italian banking crisis might destabilize the entire Eurozone.

A recent Wells Fargo report estimated that 5% of German and 2% of French banking assets are exposed to Italian debt. Such exposure comes at a time when German banks themselves are struggling, with the Deutsche Bank identified by the International Monetary Fund (IMF) as the greatest threat to global financial stability.

On a political level, the referendum results do not bode well for the European project. The Italian results come after the Brexit referendum and ahead of major European elections in 2017, including the French presidential election and German Federal election. Marine Le Pen of France’s National Front—inspired by the Brexit referendum and U.S. presidential election—is hoping for a “Trump effect” in the French elections. Experts fear that the anti-establishment “No” vote in the Italian constitutional referendum will add momentum to Le Pen’s campaign in France and additional far right parties throughout Europe.

Italian and European Union (EU) leaders have been sluggish in addressing Italy’s banking difficulties. And given the risks posed by the Italian banking sector, it is in Italy and the EU’s best interests to ensure that the newly formed Italian government is stable, and that it addresses Italy’s banking difficulties swiftly. A failure to do so, combined with continued populist tensions, poses a great risk not just to Italy’s economy, but also to the Eurozone’s future.

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