Italy’s Debt to ECB Reaches $565b and Growing Rapidly

A widely watched measure of eurozone capital flows suggests that Italy’s debts to the European Central Bank are set to hit €500 billion this summer, reflecting the eurozone’s persistent financial imbalances.

The country’s Target 2 balance—the difference between incoming and outgoing cross-border payments—is €480 billion ($565 billion) in the red and growing rapidly, according to ECB data. Meanwhile, Germany’s Target 2 surplus is on track to reach €1 trillion, news outlets reported.

Target 2 was set up by the ECB and eurozone national central banks to allow banks to make large payments to one another quickly. More than 1,700 banks use it to transact with one another.

The issue of eurozone cohesion will come to the fore once more this autumn when Italy’s new populist Eurosceptic coalition government sets out its spending plans. The coalition’s ascent to power in May triggered a sharp market sell-off as investors recalibrated their expectations of political risk in the bloc.

Eurozone central bankers view the rise in the imbalances as a natural consequence of the €2.4 trillion quantitative easing program, under which the central banks in the region buy mostly government bonds from investors.

Marchel Alexandrovich, senior European economist at Jefferies, said the growing divergence in Target 2 balances had been driven by QE. The situation may have been exacerbated in recent months by overseas investors shedding their Italian holdings, he added, but it was “hard to know how much is due to worries about Italian politics”.

“As long as the eurozone stays together, all of this is an accounting issue,” he said. “But these imbalances are the most obvious way in which eurozone countries’ taxpayers are exposed to break-up risk.”

  Political Turmoil

The recent political turmoil in Italy has again become a spotlight on the challenges facing the country. Despite signs of improvement in its economic situation, helped by a stronger global economy and firming domestic demand, several factors weigh heavily on the outlook for Italy–the eurozone uncertainty and the drop-off in cyclical growth momentum globally. Navigating these issues will be top of the agenda for the country’s next government, EJInsight reported.

The political upheaval in Italy has raised a number of fears, not least is that Europe’s fourth-largest economy may want to withdraw from the European Union, if not subvert the euro with a parallel currency.

Both events are unlikely, but the mere prospect of them occurring–amid continuing political uncertainty–caused cascading market reactions: yields on Italian debt soared as prices plummeted; a selloff in Italian equity markets spilled over to the United States; and the euro fell to its lowest level against the US dollar this year.

At the climax of the recent crisis, markets were pricing in a high probability of default on Italian debt, with no possibility of outright monetary transactions by the ECB. The subsequent re-steepening of the yield curve is a welcome sign of normalization.

  Fast Changing Environment

The political environment in Italy is fast-changing. Since parliamentary elections in March, which resulted in a hung parliament with no party or coalition winning a majority of seats, Italy hasn’t had a government.

On May 27, President Sergio Mattarella rejected the nomination of an economics minister whom he considered anti-EU and anti-euro. This triggered the latest surge of market volatility globally and raised the specter of his impeachment.

Italy’s political situation boils down to two possibilities, both of which are likely to create a degree of certainty that may buoy financial markets in the short term:

- The formation of a caretaker government, led by interim Prime Minister Carlo Cottarelli, followed by a new round of elections that would effectively be a referendum on Italy’s role in the EU.

- The formation of a new political government, possibly with the Five Star Movement and the League party; or a center-right government led by the League.

If new elections are held, a populist outcome could be more hostile to the EU’s leadership. Then again, recent events could trigger an earnest dialogue with the EU, which would not want Italy to leave the union.

  Headwinds Persist

Even before recent events in Italy, the global markets were facing a few headwinds:

- Leading economic indicators may be rolling over as the global economy moves into a late-cycle stage of growth.

- A general sense of political uncertainty. This is an issue that may persist on a global scale for some time, considering that the underlying reasons for populism’s rise are not going away: growing inequality, threats from automation and an anti-globalization mood–as already exemplified by Brexit.

The euro is less popular in Italy than it was a few years ago, and this has unnerved politicians throughout the EU.

  Investment Implications

Investors are already cautious on Italian government debt, and recent events have not changed the stance. The ECB is set to begin withdrawing quantitative easing. The ensuing rise in interest rates would be a key issue for the affordability of Italian debt, and it could have global implications given that Italy is the third-largest borrower in the world.

Italian equities were generally doing well before recent events as the country’s economic cycle improved and earnings growth looked positive.

But Europe seems to be a center of uncertainty for global investors, as recent troubles in Spain have added to those in Italy. The selloff of eurozone banks seen in recent days has been driven by systemic fears, the banks’ holdings of Italian sovereign debt and a lack of interest-rate rises as the ECB ends QE later this year.