“[T]he mini-BOTs… are either money and then they are illegal, or they are debt and then that stock goes up…. I don't think there is a third possibility.” ECB President Mario Draghi, press conference, 6 June 2019.

In the March 2018 general election, two Italian political parties (the League and the Five Star Movement) that eventually formed the current government campaigned against many of the structures that are the foundation of the European Union. One part of their agreed policy program, a proposal that resurfaced in the past week, concerns the possibility of issuing mini-BOTs (which stands for Buoni del Tesoro). These would be small denomination “bonds”—non-interest-bearing, tradeable securities—issued by the Italian government to pay debts and usable to pay taxes or purchase goods and services provided by the state. Printed in the size and shape of currency notes, recipients could view them as a new means of exchange (see the sample image below).

Sample image of a €5 mini-BOT

In this post, we discuss the possibility of Italy leaving the European Monetary Union, and why there is an increased incentive for the government to plan for an abrupt and unanticipated exit. The strategic analogy is to the appearance of a first-strike capacity that undermines nuclear peace. In our view, however, that appearance is misleading: any attempt to exit would not only be a disaster for Italy, as we explained in our post from a year ago, it would be what Barry Eichengreen aptly called the “the mother of all financial crises.”

It is easy to understand Italians’ dissatisfaction with their current economic condition. The following chart shows cumulative real growth for 10 countries, as well as the euro area, over the past 20 years (we leave out a set of small euro-area countries with growth in excess of 50%). Italy’s average annual growth is less than one-half of one percent, a full percentage point below the euro-area average. (Over this same period, labor productivity has barely changed, total factor productivity has fallen by more than 10 percent, and unit labor costs are up by more than 40 percent!) We attribute this poor performance to the lack of labor and product market reforms. However, populist politicians have gained support by laying blame on the euro and the constraints imposed by the EU.

Cumulative real growth in selected euro area countries since 1999

This brings us to the risk that Italy may try to leave the monetary union. As we see it, the problem is that the Italian government is currently in a position where they will be tempted to think that some of the usual costs of creating a parallel currency and exiting the euro have declined. Unlike an emerging market economy facing the possibility of a sudden stop, Italy is running both a current account surplus and a primary (non-interest) budget surplus (see the chart below). In addition, its net foreign liability position has plunged to less than 4 percent of GDP, down from nearly 25 percent in 2014. Consequently, were Italy cut off from the rest of the world, it would not require a sudden contraction of either domestic investment (saving exceeds investment) or government expenditure (interest expenses can be financed by mini-BOTs). We also note that Italian banking system net claims on the rest of the world exceed $450 billion, which is more than 25% of Italian GDP.

Italian current account surplus and primary budget surplus (Percent of GDP), 1999-2018

Absent an immediate balance of payments or government financing crisis, observers might reasonably fear that Italian authorities will make secret plans to leave. We are surely not the only ones to realize this. The following chart shows the spread over (currently negative) German long-term interest rates of Italian and Spanish rates. The Italian spread widened sharply in the aftermath of the 2018 general election and the May 2018 formation of the current government, and has remained between 250 and 300 basis points since then (recent readings are around 260 bps). Perhaps the surprise is that the ongoing mix of a weak Italian economy (which failed to grow over the past year) and rising populism has not led to a further widening of the spread.

Harmonized long-term interest rate spread over Germany for Italy and Spain (Basis points), 1999-June 2019

Source: ECB through April 2019 and updates using 10-year sovereign yields from Bloomberg.

Given its high sovereign debt, is Italian government finance sustainable? Maybe. But, absent an unexpected pickup in growth or a decline in the risk premium, sustainability will require some further austerity. The greater risk is that a rise of the modest risk premium will put sustainability out of reach. As we describe in our primer, fiscal sustainability requires that the government’s primary surplus (that is the excess of revenue over expenditure, excluding interest payments on existing debt) exceed a market risk premium (measured as the nominal interest rate less nominal GDP growth) times the current ratio of debt to GDP. With its net government debt in excess of 120% of GDP, the interest rate on its 10-year bonds at 2.4%, and nominal GDP forecast to grow about 1 percent this year, Italy needs to run a primary surplus (that’s the budget surplus less interest payments) of about 1.7 percent of GDP to prevent a further rise of the debt-to-GDP ratio. Yet, the IMF projects Italy’s primary surplus at less than 0.5 percent of GDP over the next five years.

Perhaps unsurprisingly, Italy looks to be in violation of EU budget rules – which require an overall fiscal deficit of less than 3 percent of GDP. This brings us back to the mini-BOTs: an attempt to pay the government’s bills without exceeding the agreed-upon deficit limits. The problem is that mini-BOTs are much more than just a mechanism for evading the rules. The printing and use as a means of exchange of such paper bank notes from €5 to €500 euros (see here) would be the first step in leaving the euro.

However much domestic politicians may wish otherwise, should an Italian exit become a real possibility, we would expect to see an immediate run out of Italian banks and Italian assets. As we described a year ago, anyone who could would move their holdings of euro-denominated assets into those parts of the euro area perceived to be safe (in the past, this meant Germany, Luxembourg, the Netherlands and Finland). In this sense, the attack on Italy would resemble what happens in emerging markets: currency depreciation (albeit of the parallel mini-BOTs), capital flight, and a collapse of the domestic financial system. In the presence of a parallel currency, people would also come to doubt the continued willingness of the others in the Eurosystem to support Italian banks’ need to replace the funds that flee.

Should Italy actually leave, things would turn from bad to worse inside the country. We expect that Italian firms would not be able to obtain credit, so trade would require cash payment. Related to this, international authorities likely would disconnect Italian banks from parts of the cross-border payments system. While they might maintain access to SWIFT, they would surely not be able to continue to send payments through the Target2 system.

Despite the public debate in some countries (notably Germany), we do not view a sudden Italian exit at this stage as a severe threat to the Target2 system. (For the mechanics of this system, see here.) While the buildup of Target2 balances in 2012 signaled the fragmentation of the euro area financial system, the more recent gradual increase since 2015 is a direct result of the asset purchase program associated with the ECB’s monetary policy operations. As a result, the Bank of Italy has securities that it could use to pay the bulk of its Target2 liabilities. Furthermore, as President Draghi wrote several years ago in a letter to the European Parliament: “If a country were to leave the Eurosystem, its national central bank’s claims on or liabilities to the ECB would need to be settled in full.” But, even if they are not, we would expect that any remaining losses would be to the Eurosystem as a whole, so they would be shared.

Our bottom line is simple: while a shortsighted Italian government may believe it is possible to escape EU budget rules through the issuance of a parallel currency—a view that ought to concern investors—the reality is quite different. Any increase in the threat to print mini-BOTs for the payment of the existing Italian government obligations would almost surely lead to a wider risk premium in form of higher Italian sovereign bond yields. Eventually, this would prompt an unsustainable increase in debt. Should investors perceive the threat to leave as credible, the result would be a run on the Italian financial system. And, should Italy actually leave the euro, not only would the country pay a very high price, but so would everyone else.

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