Europe Plays With Fire on Italy Contagion

(Bloomberg Opinion) -- Italy’s populist rulers may have been hoping for some market contagion fear to help them win their budget standoff with Brussels, but so far it’s been a dog that didn’t bark. The economic program of the League and Five Star spooked investors in Italian government bonds, but failed to affect any other member state of the monetary union, barring Greece.

This has weakened Italy’s hand. Had Spain, Portugal and France suffered selloffs, the European Commission might have been more amenable to compromise and the European Central Bank would have found it harder to end monetary stimulus this year.

It’s difficult to believe, though, that what happens in Rome will always stay in Rome. Imagine if Italy came close to losing market access for its bonds and chose not to ask for help from the European Stability Mechanism, the euro zone rescue fund. That’s not out of the question given that it would entail a package of austerity and structural reforms. Italy’s public debt stands at a towering 2.3 trillion euros ($2.6 trillion), the highest in the monetary union. Other fragile member states could easily come under pressure.

European leaders have been asking themselves whether they could deal with a bout of (for now theoretical) Italian blackmail. One option would be to allow easier access to the ESM’s “precautionary credit lines” for innocent countries caught up in market contagion. Unlike a full national adjustment program, these don’t demand that the applicant signs up to a long list of onerous conditions. Similar to credit lines on offer from the International Monetary Fund, they let member states shield themselves from turmoil at minimum cost.

This week, euro zone finance ministers signed off on a reform of the ESM, including making it more transparent for countries on what they need to do to access a precautionary credit line. But the conditions appear too strict. They won’t do much to curtail the blackmailing power of a large country that goes rogue.

The ESM can offer two forms of credit lines: a “precautionary conditioned credit line” and an “enhanced conditions credit line.” The first is available only to member states that comply with euro zone fiscal rules and have sustainable public debt – and promise to stick to the rules. It’s a very light form of assistance. The second is more stringent, but not overly so. It is open to countries that do not comply with some rules. While the ESM will demand that they fix these weaknesses, it won’t insist on a full adjustment program.

In its relatively short existence, the ESM has never used these credit lines. Euro zone finance ministers now say they want to make it clearer which countries can use a precautionary line. Conditions include meeting certain debt and deficit benchmarks, as well as not suffering from excessive macroeconomic imbalances.

It’s reasonable for the ESM to set rules for access to the cheap money of a credit line. But the criteria agreed on Tuesday seem unrealistic. For example, a country’s debt must be below 60 percent of gross domestic product, or it must have reduced the difference between its existing debt and this target by 5 percent in each of the two years before the request. Meanwhile, budget deficits have to be not only lower than 3 percent of GDP, but also comply with a rather obscure parameter called the “minimum benchmark.” According to the Commission, this benchmark would be 1.1 percent for Spain, Portugal and France. That’s extremely low.

The discussion is also relevant for the ECB. It can buy an unlimited amount of short-term debt from a member state provided the latter has applied for a full loan or an “enhanced” credit line from the ESM. But as this week’s ESM reform proposals don’t include enhanced credit lines, they don’t make it any easier for the ECB to step in to help a blameless country caught up in someone else’s mess.

The Italian government has taken a more conciliatory tone toward Brussels of late, so a confrontation looks less inevitable now. Even if investors turned against Italy, it’s more likely than not – as things stand – that Five Star and the League would accept help from the ESM. That would limit the contagion risk. The ECB and ESM combined would then have plenty of firepower to deal with a collaborative Italy.

But populists aren’t predictable. A showdown with an economy the size of Italy remains one of the biggest threats to the monetary union. Europe’s leaders should have prepared for it more forcefully. 

To contact the editor responsible for this story: James Boxell at jboxell@bloomberg.net

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Ferdinando Giugliano writes columns and editorials on European economics for Bloomberg Opinion. He is also an economics columnist for La Repubblica and was a member of the editorial board of the Financial Times.

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