HERE we go again. Financial markets don’t much like uncertainty. Thanks to Italy’s politicians, in recent days they have had plenty. By May 30th some calm had returned: it seemed possible that a pair of populist parties, the Five Star Movement and the Northern League, would form a government after all (see article). Markets had been in turmoil for two days, unsettled by a farcical back-and-forth between the populists and the country’s president, who had rejected the parties’ choice of a Eurosceptic economist as finance minister. The politicians may have done the markets a service, by shaking them out of complacency. Investors may have returned the favour, by shaking some sense into the politicians—at least for now.
Italy is perennially slow-growing and groans under public debt of around €2.3trn ($2.7trn), or 132% of GDP. The drama reawakened dormant worries about those two problems—and the deeper fear that the euro zone’s third-biggest member might be sneaking towards the exit. So the yield on Italian two-year bonds, negative as recently as May 15th, leapt to almost 1% on May 28th. It carried on climbing the next day, touching 2.73%, the highest since 2013, before retreating. Ten-year yields also rose, if less spectacularly. Yields on German Bunds, Europe’s safest government bonds, declined.
Share prices tumbled. Banks in Italy, holders of €600bn of government bonds, were hit hardest. UniCredit, the country’s biggest, fell by 9.2% and Intesa Sanpaolo, the number two, lost 7.2% on May 28th and 29th. Other European banks’ shares were also roughed up. The worries rippled across the Atlantic. The S&P 500 index slipped by 1.2% on May 29th, with banks again leading the way down. The yield on ten-year Treasury bonds fell from 2.93% to 2.77%, the biggest drop since the day after Britons voted for Brexit in June 2016.
So far, this adds up to a nasty bout of the jitters rather than full-blown panic. Italy’s two-year bond yield is far below the 7.6% it hit in November 2011, at the depths of the euro zone’s previous crisis. The effect on the euro area’s other problem members has been limited—even though yields in Greece, Portugal and Spain, where the prime minister faces a confidence vote on June 1st, reached their highest this year on May 29th.
Foreigners are also unlikely to have suffered much direct harm from the fall in bond prices (the corollary of rising yields). Although Italy’s huge public-debt market gives it a decent weight in global bond indices, foreign investors, knowing a bad bet when they saw one, had cut back. Analysts at Deutsche Bank calculate that between the second quarter of 2015 and the third quarter of last year foreign investors other than banks cut their Italian holdings from €473bn to €250bn. Deutsche’s Torsten Slok adds that the exposure of banks outside Italy has fallen by almost half since 2009, to €133bn.
Nor has the run-up in yields yet threatened the sustainability of Italy’s debt. On May 30th Italy sold a total of €5.6bn-worth of five-, seven- and ten-year bonds at yields of 2.32%, 2% and 3% respectively. Granted, that is dearer than in the recent past, but it is well below the average coupon of 3.4% on its existing stock of debt. And the longish average maturity of its bonds, around seven years, gives it breathing space. Alberto Gallo of Algebris, an investment firm, estimates that yields would have to be at least 4-4.5% for several months before higher coupon payments would make debt unsupportable. That is not unimaginable, but is some way off.
One reason for that is the backing of the European Central Bank (ECB)—ironically, a bugbear of the Italian populists. Under its quantitative-easing programme, which has held down borrowing costs across the euro area, the ECB has bought €340bn-worth of Italian bonds; it holds around a sixth of the stock. In effect, it has been a willing buyer as foreigners have quit.
Yet none of this means that markets could not turn against Italy with greater violence—if, say, a populist government undid recent reforms, opened the fiscal taps or picked a fight with bureaucrats in Brussels or Frankfurt. Although the biggest banks are now in decent health (or getting there), they own lots of government bonds. One bank, Monte dei Paschi di Siena, is still in intensive care. The bad-loan burden, though reduced, remains heavy.
Departure from the euro area would be unthinkably costly—for both Italy and the zone. As when Argentina abandoned dollar parity at the start of 2002, the value of Italians’ bank deposits would plunge. Italy is not Greece (see article), in that it is in far better shape. But it is not Greece, too, in that it is much, much bigger. In 2012 Mario Draghi, the ECB’s president, quelled the crisis that looked likely to destroy the currency club by saying that the ECB would do “whatever it takes to preserve the euro”.
If liquidity dries up the ECB can conduct “outright monetary transactions”—buying a government’s bonds on secondary markets—although it has not used the scheme yet. But this scarcely gives Italy a free pass. It is intended for extreme circumstances. As Mr Draghi’s deputy, Vítor Constâncio, who was due to leave office on May 31st, told Der Spiegel, a German magazine, this week, such help comes with strings. A government has to request it and be in an adjustment programme agreed on with European institutions. Greece has been labouring under a similar regime. Italy’s populists are unlikely to volunteer.