Recently I sat in a meeting of a renowned European university with people from all over the world and the question came up what are the most dramatic issues which we are facing:
At the end, the plenary agreed that developments in the South China sea (China being the dominant party) the trade war between China and the US and the climate change were the biggest challenges.
I looked at my fellow colleagues and wondered why no European mentioned the issue which occupied me most: the recent behaviour of the Italian administration considering the huge pile of Italian debt.
In order to understand my concerns, let us look at some numbers: Italy´s recent GDP of Eur 1.75 tr makes it the third largest country in the European Union (after the exit of Britain). Its government debt is around Eur 2.3 tr, some 134% of its GDP. If we believe that Italy´s debt has an average duration of 7 years, we can compute that for each 1 percentage points increase in yields, Italy will have to pay 7% more to its potential lenders for rolling over its debt.



As the market is losing confidence and Italian spreads (spread in this context means the gap between German bond yields and Italian ones) are rising to 3.5%, note that for an average Italian yield increase of 2%, Italy will have to pay some Euro 320 bn in excess for borrowing money. Italy´s annual tax revenues are some Eur 730 bn.
Thus, each time yields go up (as investors do not buy Italian debt, subsequently prices come down and they potentially yield more) as Italy wants to spend more on populist measures (such as Eur 20 bn on minimal salaries); note that a yield increase by 1% adds potentially Eur 150 bn to Italian debt.

However, let me stress that the Italian problem is not purely a mathematical issue. It goes much further: there is a lack among Italian leaders to consider that the actual Italian budget will limit Italy´s financial freedom considerably. Its European partners take issue that the draft budget for 2019 projects an Italian deficit that is three times higher than an EU mandated target. We seem to be on a confrontation course between Italy´s administration and the other EU members.
So far most Italian citizens are in favour of the Euro, not necessarily of  the EU; however, the European integration has not provided the expected prosperity and leads some people to look in new directions. It might only be a question of time when there will be a majority in Italy blaming Brussels and the EU for the state they are in…

What would be a worst-case scenario?

As old German Finance minister Schaeuble stated: no EU country can default on its debt. It will either stay in the EU and pay or be out and default.
A potential worst-case scenario could be that Italy will not find a way to refinance itself over the next months as yields will be melting up and that restructuring of its short-term debt becomes a necessity. Even if we believe that the short-term debt would be some Eur 500 bn to 600 bn, (probably double the amount as needed for the restructuring of Greek debt), will Germany, the IMF and the other EU countries have the appetite and willingness to spend their tax money on Italy?
How would the Italian population react while being confronted to seriously reduced government spending? In order to limit the short-term pain would Italy´s citizen vote for leaving the EU? Or would Italy be forced to leave the Union as the Italian government would not be willing to consider any fiscal adjustments? Would this cascade any defaults of the Euro 2.3 tr government debt…What would happen to the Eur 400 bn Italy owes its European partners in the European Central Bank´s Target2 clearance system, the settlement system for the Eurozone if Italy would vote for leaving the EU? And finally, what would happen to the rest of the European Union? Would any serious recession and write-offs of a partner country´s debt, limit the appetite of Europeans to have an economic union or even to have a common currency?

What would happen to the Euro?

Let us not get too excited and let us have a realistic look of the next months: Italy and Brussels agree on a budget which is hardly accepted by either side, but which will stand. Markets will eventually calm down, and yields come down or move sideways as Italy has shown that it is willing to play by the rule. Conformation of a credible Italian plan in line with EU rules seeking budget deficits of under 3 per cent of economic output could prove to be a step that encourages investors to buy Italian debt.
In this environment, economic growth of the EU and Italy is key. As UniCredit says If the macro numbers for 2019 are as constructive as we expect with a budget deficit for 2019 close to 2 per cent, the 10-year spread between Italy and Germany will likely tighten to the 200-210 basis point area.
However, if we have a harsh recession sometime over the next three years, and Italy´s tax revenues will falter, yields would spike and Italy would again get very close to restructure its debt. We feel confident that this scenario could be overcome as long as Italy´s administration does cooperate with the EU. But we could easily be finding ourselves in our worst worst-case scenario…

What ever the outcome is, it is fair that Italy has one of the highest debt ratios in the Eurozone (over 130% of GDP) which makes it particularly vulnerable to a sovereign crisis. Only in a handful of years, we will know how Italy and the EU has overcome this potential crisis. European politicians have understood that the entire financial stability of the Eurozone could be threatened by irresponsible budgets of the current administration in Italy.

And make no mistake: Italy is not Greece-its impact is much worse: if Italy loses the confidence of the markets, then the Euro will too.