Does Mario Draghi still have ‘whatever it takes’?

 

Does Mario Draghi still have ‘whatever it takes’?

 

For many investors, the Italian prime minister is the last man standing between the eurozone and the abyss. What happens when he goes?

 

BY MATTHEW KARNITSCHNIG AND PAOLA TAMMA

June 30, 2022 6:00 am

https://www.politico.eu/article/mario-draghi-economy-eurozone-italy-whatever-it-takes/

 

No one is indispensable. And then there’s Mario Draghi.

 

Just when the Italian prime minister and former European Central Bank president thought he’d escaped the tyranny of bond spreads and the “doom loop,” the gathering global economic storm vaulted him back into the international spotlight. As the leader of Europe’s shakiest too-big-to-fail economy, Draghi is seen by many investors as the last man standing between the eurozone and the abyss.

 

“He’s been extremely important because he’s created stability,” said Erik Fossing Nielsen, chief economics adviser at UniCredit, Italy’s second-largest bank. “But you could also say that any country that depends on one person is in trouble.”

 

A growing concern in Rome, Brussels and Frankfurt is that the abyss may not be that far away, that persistent doom and gloom about Italy’s finances could become a self-fulfilling prophecy.

 

With jittery investors obsessing over the country’s mountain of government debt and murky economic outlook, the presence of Draghi — whom many credit with saving the euro from oblivion a decade ago by declaring the central bank would do "whatever it takes" to preserve the single currency — has acted as a salve in financial markets. For now.

 

Draghi's ability to stave off disaster once again was called into question last month after Italian spreads (the difference in borrowing costs between German and Italian benchmark debt) widened to their highest levels since the spring of 2020, when worries about the economic impact of the pandemic raised similar doubts over Italy’s financial stability.

 

It took the promise of a massive bond-buying program by the ECB to bring Italy’s borrowing costs back down the last time around. And the latest tremors have forced the central bank to prepare a similar intervention, which it has dubbed an “anti-fragmentation instrument.” Though the ECB has yet to announce full details, the purpose of this new tool will be to keep spreads from widening beyond what the central bank mandarins consider sustainable.

 

“Is Italy’s debt sustainable? That question only has one answer: If the ECB says Italy’s debt is sustainable, then it is sustainable,” said Sony Kapoor, an economist who leads the Nordic Institute for Finance, Technology & Sustainability in Oslo. “If the ECB refuses to say that, then the question will keep getting asked.”

 

The options available to Draghi's successor, ECB President Christine Lagarde, are made complicated by the political realities in the north of the eurozone, where the central bank’s bond buying and other emergency policies remain controversial. Even so, some kind of action looks increasingly unavoidable.

 

The question then becomes whether it'll be enough. The measures European policymakers took in response to the euro crisis, which began in 2010, helped prevent Greece’s eviction from the currency area, but it took a worsening crisis before Germany's then-Chancellor Angela Merkel and leaders bit the bullet. Many investors question whether Europe's bailout arsenal has enough firepower to rescue Italy, the EU’s third-largest economy.

 

The Armageddon scenario, the so-called doom loop, is that an unchecked widening of spreads depresses the value of the huge stock of Italian sovereign bonds held by the country’s banks to such an extent that they're no longer able to lend, triggering a wider crisis of panic and bankruptcy across the financial sector and broader eurozone economy that could hasten the euro’s collapse.

 

Fortunately, that kind of sudden implosion looks unlikely. With the yield on its benchmark 10-year bonds at about 3.6 percent (roughly half the rate it faced during the euro crisis) Italy can refinance its outstanding debt — which totals about €3 trillion, or 1.5 times its annual economic output — at well below inflation. What’s more, higher inflation makes its debt pile more sustainable by reducing the cost of paying it off.

 

“The numbers aren’t that bad,” said Unicredit's Nielsen, insisting that “the drama is exaggerated.”

 

The real risk is what happens in the long run, especially after Draghi is gone or is seen as being on his way out. Economists concur that Italy’s real problem is less its fiscal position than its chronically tepid growth, which has underperformed Europe’s leading economies for decades. That leaves it particularly exposed to the worsening economic environment.

 

In the coming weeks, the ECB is expected to begin raising interest rates to rein in inflation — a necessary move, but one that will also trigger further across-the-board increases in borrowing costs.

 

That’s particularly bad news for Italy’s corporate sector, which relies heavily on local bank financing.

 

Commercial loans in Italy are generally pegged to the country’s benchmark bonds. A further widening of spreads would put Italian businesses at a substantial disadvantage vis-à-vis their German and other northern European competitors whose borrowing costs are lower.

 

In other words, Italy risks facing a triple whammy of a global economic downturn, more expensive credit and a massive competitive disadvantage.

 

Many economists, including Draghi, have pushed politicians for years to deal with the geographic disparities Italian and other southern European countries face, which have nothing to do with the health of the underlying business, by further integrating the eurozone’s financial architecture with a unified banking system and capital markets.

 

While leaders have taken steps in that direction, resistance from Germany and other northern European countries to measures such as a region-wide bank deposit insurance have left the effort both incomplete and ineffective in terms of combating shocks like the current one.

 

That means staving off financial pressure in Italy comes down to maintaining investor confidence.

 

Enter Draghi. In his days as ECB president, Draghi, worried that leaders had become too comfortable in their reliance on the central bank’s emergency measures, was tireless in nudging governments to undertake structural reforms, such as by liberalizing labor markets and cutting red tape.

 

Now the shoe is on the other foot. Since Draghi became prime minister early last year as the head of a “national unity government,” his main task has been to deal with the fallout of the pandemic. In order to secure Italy’s €200 billion in grants and loans from the EU’s pandemic rescue fund, he has had to accelerate the pace of reforms on everything from the justice system to competition rules. 

 

The government strong-armed many measures through parliament by calling — and winning — 52 confidence votes to date, or 3.25 per month, the highest monthly tally of any Italian government, according to OpenPolis foundation.

 

The tactic illustrates “some difficulty by the government to bring these milestones and targets to fruition,” said Luca Dal Poggetto, a contributor at OpenPolis, a foundation collecting public data.

 

While it will take years for the reforms themselves to have any real economic impact, they’re crucial for Italy to convince financial markets that it’s not sliding back.

 

But Draghi won't be around forever. Italy is due for elections next year, and it's highly unlikely the 74-year-old prime minister — who was installed in office as a technocrat with the support of nearly every political party — will be around for another term, despite his popularity both at home and abroad.

 

"There is no bullish political outcome after the next Italian election that would be resoundingly sound for good policy, good governance and good economy. There is bad and less bad," Kapoor said. "The least bad outcome is they decide to reappoint Draghi, which is unlikely but it may happen.” Draghi recently said he will not serve as prime minister again.

 

Italy may be about to find out that whatever it takes is no longer an option.