The Italian media, not unlike that of other EU countries, focuses most of its attention on political and economic issues that often bore ordinary people. Many are more interested in the relatively minor issues that affect their daily lives. In the last few months, lo spread – the difference between Germany’s 10-year bond yields and those of Italy – has been regularly featured in news broadcasts. So why are so many Italians worrying about this technical issue that few understand?
Following the announcement of the European Central Bank to stop buying more bonds of governments with stressed public finances and to raise interest rates from later this month, financial markets’ fears have become more pronounced.
The spread on Italian bonds has doubled to about two per cent since this announcement. While this is far below the levels reached during the 2012 sovereign debt crisis, when the spread rose to five percentage points, Italy’s debt today is even higher than in the last crisis.
The Italian media understandably fears that Italy could be trapped in an unsustainable spiral of rising debt costs. Other risks are appearing on financial observers’ radars. The Italian government coalition is again looking very unstable despite the respect that financial markets still have for Prime Minister Mario Draghi.
The Italian political soap opera never ceases to frustrate many ordinary Italians who want their politicians to improve their lives rather than manoeuvre to guarantee their political existence beyond its expiry date.
Disgruntled politicians, like Matteo Renzi and Luigi Di Maio, left the major political parties they militated in to form small splinter parties. They hope to become kingmakers for forming a new government when Draghi is forced out in an early election, possibly later this year.
Another complication making the Italian debt spread issue more worrying is that the ECB again appears to be resorting to patching strategies to avoid the risk of a hard lending in financial markets. The ECB has not yet convinced the eurozone political leaders of the importance of bridging the gap between contrasting monetary and fiscal policies.
In the last few months, ‘lo spread’ – the difference between Germany’s 10-year bond yields and those of Italy – has been regularly featured in news broadcasts
The 19 countries sharing the euro still have separate fiscal policies, meaning they can experience a growing divergence in their borrowing costs, especially when the rising rates raise anxieties over high debt levels.
A surge in borrowing costs for weaker southern European countries like Italy and Greece is leading to a divergence in yields with northern member states – a phenomenon central bankers describe as “fragmentation”. ECB president Christine Lagarde promised a new financial tool to address this phenomenon to prevent another debt crisis in the eurozone.
Still, the now-familiar squabbling caused by the different attitudes of the ECB’s governing body is becoming more noticeable. Pierre Wunsch, head of Belgium’s central bank and ECB governing member, told the Financial Times, “If the fragmentation in bond markets is unwarranted, then we should be as unlimited as possible. The case is strong when faced with unwarranted fragmentation”.
The head of Germany’s Bundesbank has warned it will be “virtually impossible” to decide if a divergence in borrowing costs between eurozone countries is justified. He adds: “It would be fatal for governments to rely on the ECB support.”
Financial engineering skills are critically important to managing risks in financial markets. Still, they cannot resolve the significant challenges caused by the lack of competent political leadership, which has been endemic in the EU for too long.
By the introduction of a new instrument to avoid the risk of fragmentation, the ECB is expected to buy the bonds of countries whose borrowing costs it believes are rising because of market speculation to levels beyond those warranted by economic fundamentals.
The devil of how this scheme will be implemented will always be in the operational details. Wunch tempers his enthusiasm for the new ECB tool by arguing: “The difficulty will be about the grey zone in between what is warranted and what is not, and that is the area of moral hazard we have to navigate.”
Some Italians understandably fret about the prospect of lo spread getting bigger due to bungled political and monetary policies. They mistrust their politicians, who continue to fudge solutions to Italy’s structural economic problems. Their frustration only gets bigger when they see EU leaders regularly bickering about national issues rather than working to make the Union a credible and sustainable political reality.
The ECB stopgap measures being considered to calm financial markets may not meet investors’ expectations. Kicking the can down the road will only make future economic challenges more daunting.