Italy: worst case scenario

With populism and the extreme right on the rise, the possibility of a splintering of Europe is becoming greater. Despite the UK’s Brexit negotiation problems, some political parties would very much like to follow the country’s lead. We explored the scenario of an Italian referendum on whether to remain in Europe. If one morning in March 2019, Italian eurosceptics won the battle and a majority of Italians decided to leave the eurozone Here is our take on the immediate aftermath of such a vote.

Monday 4 March 2018 

Referendum on Euro membership : Italy votes ‘no’.

Eurosceptics won the battle as a majority of Italian voters decided to leave the Eurozone yesterday with a majority of 52.3%.

This morning, global stock markets plunged with the FTSE Mib in Milan down 18.35%, the IBEX in Madrid down 16.1%, the PSI in Portugal down 15.6% and the Eurostoxx 50 down 13.1%, its highest dip since the referendum outcome on the Brexit in June 2016. The volatility index in Europe jumped to the roof at 304.20, even higher than 2008 during the financial crisis.

Spreads on the Italian bonds are widening with the 10-year yield reaching 17.4% vs 4.2% on Friday. Credit spreads on other EU countries are also widening, especially Spain, Portugal but also those of France and Belgium. Similarly, markets are questioning the stability of many European banks due to the lack of desired clarity out of Italy and the continuing growth of non-performing loans in Italy.

Fears of a Eurozone collapse have clearly resurfaced and have reminded investors the last episode when Standard & Poor's downgraded Greek debt to junk status in 2010. The systemic risk is now a reality. Last but not least, the euro hit its lowest vs the US dollar since its creation at 0.81.

Italy’s GDP is barely higher than when the single currency was formed in 2000 and its unemployment rate is one of the highest in Europe. No doubt that capital controls will be put in place and the likely severe uncertainty shock might trigger a recession. Italy has also been one of the EU’s financial weak links for years thanks to bad loans racking up enormous debts so one of the main central concerns now is the potential for the country to default on nearly € 2.3 trillion in debt.

Italy’s unwinding of the Eurozone will have huge repercussions for economies all over the world. The world’s largest economy, the US, has investments and trade ties with the EU that will be negatively impacted by a breakup of either the Eurozone or the EU as a whole. On a basic level, many of the euro bonds will take losses when they are translated into another currency or simply defaulted on entirely. This wholesale destruction of capital and the uncertainty of currency risks and contract law will have huge repercussions on global trade.

This shrinking of global trade and financial uncertainty might cause a worse global recession than that of the 2007-08 global financial crisis. The high growth economies that sell to the EU and US will slow down along with the rest of the world. Even China, which has diversified its trading partners, could see a decline as the western economies suffer losses on a national level along with every level of investor from institutional to retail to pension funds.

At ECB level, the problem will come if capital drains from Italian banks and if there is a dramatic sell-off in Italian bonds. In that case the ECB might in theory claim a clear need to intervene to prevent damage to Eurozone banks outside Italy.

In these circumstances, a new European summit has been called on March 8 in Brussels as it may be time for radically new thinking. Discussions will start on the possibility of keeping each country with one currency and as already debated in the aftermath of the 2007-08 crisis, two groups might emerge in order to save the euro: one euro for the Northern bloc countries with the highest financial and economic stability, i.e. Germany, Austria, Netherlands, Finland, Luxembourg and one euro for the Southern bloc countries allowing them to devalue and regain competitiveness as a result, i.e. France, Belgium, Italy, Spain and Portugal.