EU braces for new eurozone debt crisis after right-wing coalition led by Giorgia Meloni wins

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His thinly veiled threat caused howls of outrage in Rome. But it underscored deep concern in Brussels that Italy’s new government is refusing to abide by eurozone rules.

A terrible legacy

Admittedly, the new Italian government inherited a dire economic situation, with galloping inflation and a heavy debt burden that now exceeds 150% of gross domestic product – the second highest level in the euro zone after Greece.

Moreover, the energy crisis in Europe will probably force the new government to propose new initiatives in the coming months to protect households and businesses from exorbitant electricity and natural gas prices.

However, this will blow the budget deficit beyond the previous target of 5.6% of GDP, which was rolled back in April, and means there is little room for the tax cuts that some members of the right-wing coalition wish.

Meloni has previously signaled she wants to renegotiate the terms of Italian aid (including €68.9 billion in grants and €122.6 billion in low-cost loans) that Rome is expected to receive under the plan. European recovery package of 750 billion euros (1,113 billion dollars).

But Brussels has the upper hand in these negotiations. The aid money is disbursed in tranches and is conditional on the implementation of certain structural reforms.

To date, Rome has only received 36 billion euros in grants and 10 billion euros in cheap loans, which means that it still has to meet certain conditions to receive the approximately 140 billion euros in remaining help.

And while Brussels can accept some superficial changes to these conditions, it is unlikely to agree to major changes.

More generally, some analysts predict that Meloni will be wary of triggering a sell-off in Italian bonds, which would drive up the country’s borrowing costs sharply, and will therefore take a pragmatic stance on economic policy.

After all, she tried to appease the country’s business community and softened her criticism of Brussels in the weeks before the election.

Moreover, Euro-skepticism is no longer as popular in Italy as it was a few years ago.

It is possible that Meloni will choose to cooperate with Brussels, while moving closer to the positions of countries like Hungary and Poland on issues such as abortion, gender equality and migration.

But if Meloni decides to take a different approach on economic issues, it won’t be long before intense tensions with Brussels become apparent.

Potential debt crisis

Hedge funds are already placing huge bets that Italy is headed for another debt crisis, as economic growth falters and the country is crippled by rising borrowing costs on its mountain of debt. debts.

Analysts are already predicting Italy, the euro zone’s third-largest economy, will tip into recession next year as businesses and households cut spending and investment in response to rising borrowing costs. .

Speculators also expect Italy’s new right-wing coalition to enjoy a short lifespan, given that it is essentially a marriage of convenience between three groups with competing ambitions.

Encouraged by the prospect of political instability and another explosion in Italian public debt, hedge funds raised their bets on further declines in Italian bond prices to the highest level since early 2008.

Already, those bets are paying off, with yields on Italian 10-year bonds climbing to 4.35%, a sharp rise from 1.2% at the start of the year. (Yields rise as bond prices fall.)

If Italian bond yields remain at this level, rising debt servicing costs will further weigh on the country’s already precarious fiscal situation.

At the same time, the difference – or spread – between German 10-year Bunds and Italian 10-year bonds exploded to 230 basis points from 130 basis points at the start of the year. This spread, considered a barometer of risk, peaked at 575 basis points at the height of the latest eurozone debt crisis.

Vulnerable to “fate loop”

Analysts also point out that although the Italian banking system is more robust than it was a decade ago, Italian banks still hold large amounts of Italian government bonds. (Italy’s public debt is about 10% of the country’s total bank assets.)

This leaves Italian banks vulnerable to a “catastrophic loop”, which occurs when government bond prices fall, and banks are forced to top up their capital reserves.

With their capital under pressure, banks typically reduce lending, which slows economic growth and pushes bad debts higher, further eroding banks’ capital cushion.

Of course, a major difference with the previous debt crisis is that the European Central Bank implemented a number of programs to prevent the bond yields of more profligate countries, such as Italy, from collapsing.

The ECB argues that a wide divergence in borrowing costs – what it calls “fragmentation risk” – reduces the effectiveness of its monetary policy.

At its July meeting, the ECB agreed to create a new bond-buying tool called the Transmission Protection Instrument (TPI), which aims to prevent rising interest rates from triggering another collapse in European debt. the euro zone.

The ECB can now buy unlimited amounts of bonds from any country where it deems borrowing costs have risen beyond the level warranted by economic fundamentals.

The problem is that the ECB’s new tool can only be used if Italy agrees to follow the rules of the euro zone, particularly in terms of limiting budget deficits and pursuing structural reforms.

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