- Deutsche Bank’s annual Long-Term Asset Return Study focuses in 2017 on the potential cause of the next global financial crisis. Candidates include a Chinese slowdown, Brexit, and an excessively fast unwinding of the ultra loose central bank policy that has characterised the post-crisis years. Italy, however, also poses a threat, according to strategist Jim Reid and his team. The country faces a populist rising, a huge debt burden, a weak banking system, and a generally weak economy.
LONDON – In the months after Britain voted to leave the European Union last summer, some were concerned that a wave of anti-EU sentiment would build in other countries and cause the collapse of the block.
Nowhere was that more true than in Italy.
The country rejected a referendum on constitutional reforms that was widely seen as a vote against the establishment, and led to the resignation of Mario Renzi, one of the country’s longest serving prime ministers in recent decades.
Those fears diminished after Renzi was swiftly replaced by a new technocratic government under former foreign minister, Paolo Gentiloni, and the rise of the Five Star Movement – a populist anti-EU movement seemingly slowed.
Now, however, Italy's problems - both political and economic - are rearing their heads once again, and could be the trigger of the next major financial crisis, according to research from Deutsche Bank.
A new research report from the bank compiled by a team led by famed strategist Jim Reid examines all the possible global events that could be catalysts for a new financial crisis, if and when one arrives.
Events and issues that could trigger that crisis include an excessively fast unwinding of the ultra-loose central bank policy that has characterised the post-crisis years, a crisis in China, and the failure of Japan - the world's third largest economy - to grow with any real strength.
Italy's inclusion, however, is an interesting one, with its problems neatly summed up by Reid and his team in their analysis.
Italy is, they said: "A country nearing an election and with high populist party support, with a generationally underperforming economy, a comparatively huge debt burden, and a fragile banking system which continues to have to deal with legacy toxic debt holdings ticks a number of boxes to us for the ingredients of a potential next financial crisis."
Those three problems could, if badly managed, end up causing catastrophic harm to not only Italy, but also the wider eurozone.
"We can assume that if Italy does create a crisis it will likely risk triggering an existential crisis for the economic area as a whole," the team said, having argued that Italy is "perhaps the first line of defense" to any break up of the eurozone.
The 3 problems facing Italy
Looking at the three political and economic problems, the most obvious to consider is the threat of a populist government under the Five Star Movement and its leader Beppe Grillo - a comedian turned activist.
Italy must hold an election by 2018, and while a majority government is highly unlikely for any party given that none is currently polling more than 27%, there are a number of coalition scenarios that could have an adverse impact on the markets.
The waters are further muddied by the possibility of electoral reforms that have the potential to change the way any election turns out.
Here are Reid and his team once more (emphasis ours):
"An electoral system that would require a large coalition would be seen as positive by markets as it would likely penalise the 5SM. However this brings into question the counter-productivity of a muddle-through strategy.
"As our economists have previously noted, a heterogeneous, ineffectual government would struggle to boost the too low potential GDP growth and a continuation of Italy's deeply unsatisfactory economic performance would ultimately benefit Eurosceptic and populist parties. With that in mind, the longer Italy remains in a muddle-through, the greater the likelihood that Eurosceptic parties could gain an ample majority in the Italian parliament."
Italy's second major issue is its economy. Since the financial crisis, Italy has not been able to create sustainable strong growth, and has seen its debt pile grow to the second highest of any eurozone country, behind only Greece.
Debt to GDP stands at 133%, with only Greece, Japan, and Lebanon having higher ratios globally. Add to that a deficit of 2.4% of total, and Italy must spend a substantial amount of its money paying off interest on its debt obligations, as the chart below illustrates:
That said, all of these numbers have "stayed relatively constant in recent years" Deutsche Bank noted, with the European Central Bank's aggressive quantitative easing programme providing substantial assistance.
Now, however, the ECB is looking to slowly wind up its QE, with the central bank widely expected to taper its bond purchases from €60 billion per month to just €40 billion a month within its next couple of meetings.
"The question we find ourselves asking however is what happens when the ECB slows down the rate of purchases, bond markets start to reverse, and the cost of financing this debt load rises?" - they asked.
"Growing out of this debt burden would in theory be the most logical explanation, but evidence of Italy's post Euro adoption experience (see Figure 47) suggests this will be extremely hard."
Figure 47 can be seen below:
If the possibility of a populist, eurosceptic government and a huge debt burden that is likely to increase aren't enough to scare the markets, the issues in the country's banking system might.
"The issue with economic growth is that growth requires a healthy banking system. Italy's domestic banks have suffered greatly over the last few years having been poorly managed and riddled by stories of fraud and scandal."
"However the headlines have been mostly dominated by the huge stock of NPLs which exist on the domestic banks' balance sheets." An NPL is a non-performing loan, where the borrower is late with repayments.
The country's financial sector is plagued by so many bad loans that the government was, last April, forced into rallying bank executives, insurers and investors to put €5 billion (£4.2 billion, $5.57 billion) behind a rescue fund for its weakest banks. The Atlante fund is designed to buy so-called bad loans from lenders and invest in their shares in the hope that the re-energized banks will lend more to businesses and spur growth.
"Our banking analysts estimate that Italian banks still have €349bn of gross NPLs. Unsurprisingly 'significant' banks (those directly supervised by the ECB),hold the majority of these NPLs at around €267bn," Reid and his team note.
So far the fund has helped to rescue the world's oldest bank, Monte dei Paschi di Siena from collapse, as well as providing funds for several smaller Italian lenders, but problems in the sector persist.
Banks are also, as might be expected, highly exposed to Italian government debt. If, as previously mentioned, the bond markets start to turn, things could get nasty, as Italian banks hold around 20% of all BTPs (Italian government bonds with more than a year's duration), Deutsche's analysis suggests.
"Since QE started this has been a prudent move for banks, but what happens when the tide turns and the inevitable sell-off starts. It's another factor to consider. If there are ever any doubts about the Government's willingness or ability to pay, the banks will be seriously exposed to a financial crisis," Reid and team said.