Why Italy will never leave the euro

The two parties that will form the new government in Italy, the Five Star Movement and Lega Nord, have never been a fan of the euro. They see that currency as the source of all economic misery in Italy. Both sides still want to leave the euro; the only difference with the past is that they don't think the moment for it is opportune now.

However, my impression is that this is mainly bluff poker. As far as I know, Italy is the last country to say 'ciao' to the European currency. Italy has always had significant budget deficits. Between 1960 and 1990, deficits were between 8% and 14% per year. Even in the period of reconstruction, when economic growth was very high, every government succeeded in Roma writing big red numbers.

Even after the arrival of the euro in 1999, Italy continued this tradition: every year there was a deficit. With over 130% of gross domestic product, the national debt is the second highest in Europe, only Greece scores worse in that regard.

Payback capacity
At the moment it is still the case that a high government debt does not necessarily have to be a problem. If the payback capacity is large enough, and for countries that is economic growth, then there is little to worry about. In the golden economic years (between 2000 and 2008), the Italian economy grew on average by less than 1% per year. In other words: the payback capacity was, and is, very low.

A country with such a lousy track record would have long been punished by the market (in the form of high interest rates). Who lends money to Italy (for example for a period of 10 years), know that the only way to get that back depends on whether Italy will manage to take out a loan in 2028 to pay off those old loans. For that risk, a rational investor asks for an extra fee in the form of high interest.

Interest was much lower
However, the Italian 10-year yield was considerably lower a few days ago (about 1,75%) than that of, for example Australia (government debt of just over 40%) or New Zealand (government debt of just under 30%). Those 2 countries pay about 2,75% interest per year to borrow money for 10 years. That is a lot more than Italy, despite the fact that their payback capacity is considerably higher.

The interest that Italy paid a few days ago to borrow money was equal to that of Norway. This while it has no government debt for a long time and also has a savings pot of more than €1.000 billion (roughly €200.000 per inhabitant). Economic growth there has averaged 1990% since 3, far above the Italian average growth rate.

The reason that the investors asked for an equal interest rate from Italy is because it is a euro country. At the moment, this means that the ECB is buying government bonds from Italy, thereby pushing interest rates down. Looking to the future, it also means that investors can rest assured that, should the need arise, the ECB will come to the rescue when the need arises: 'whatever it takes'. It also means that investors get their money back in a hard currency, not "monopoly money."

Interest rates will skyrocket
Suppose the new Italian coalition implements the said plans. With the financial situation described above and Italy's track record, the Italian interest rate will skyrocket in the event of an Itexit. Capital would not know how quickly it has to leave the country. In addition, no one is waiting to get their outstanding loans back in a new lira.

And then it doesn't stop at foreign capital. The Italians themselves will also trip over each other to transfer their savings to another country. The supply of capital would dry up, and even with a slight fall in demand (let alone rising demand to replace runaway capital) the price of money, interest, would explode. To what level?

The plans of the new government alone, in which the exit from the euro is not even mentioned, has the 10-year-old Italian interest rates pushed up to 2,2% in recent days. That's child's play with what the interest would do if the government announced exit. The usual position of the Italian 10-year yield, before the announcement of the euro, was between 12% and 14%. Keep that percentage in mind.

Rising interest charges
On average, the government now pays less than 2% interest on the total Italian public debt. That is less than half the average interest paid by Italy in 2007 (4,4%). If that average interest rate were to rise to 2007 levels because the new government toyed with the idea of ​​leaving the currency union, the annual interest expense would rise from €35 billion to €100 billion. Every year, therefore, about €70 billion higher interest costs.

And I'm only talking about an interest rate hike to 2007 levels. If Italy were to actually leave the euro, it is likely that long-term interest rates will bounce back to levels that normal were before the euro (the aforementioned range of 12% to 14%). The annual interest charges would then amount to several hundred billion euros. It goes without saying that this would lead to the bankruptcy of the country.

Printing the new lira
The only way this can be averted is the printing of the new lira by the Banca d'Italia. The result: a very weak currency, sky-high inflation and higher interest rates. So the execution is postponed. Add to that the fact that an Italian ciao against the euro will give an extra blow to the already poorly performing economy.

According to the rules, out of the euro also means from the EU, with the associated economic damage. No, even the anti-euro parties in Italy know that very well. What they want to achieve with their threat is more money from the ECB and from other euro countries. That's the goal.

Edin Mujagic

Edin Mujagić is an economist and manager at Beleggingsfonds Hoofbosch. He focuses on global central banks, and in his blogs he writes mainly about developments in interest rates and inflation. He has also written several books.

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