Central bank | Political Unrest in Italy is a Problem for the European Central Bank

Central bank | Political Unrest in Italy is a Problem for the European Central Bank

The European Central Bank’s efforts to raise interest rates are being complicated by Italy’s political unrest, which is also bringing back regrettable memories of the eurozone debt crisis a decade ago.

Germany’s FRANKFURT (AP) — It has brought back unpleasant memories of Europe’s debt crisis from a decade ago and complicated the job of the European Central Bank as it raises interest rates for the first time in 11 years to combat record inflation. Italian Prime Minister Mario Draghi’s offer to resign has sent unsettling ripples through financial markets

Draghi, a former head of the ECB, has promoted measures aimed at reducing Italy’s high levels of debt and fostering growth in the third-largest economy in Europe. He said on Wednesday that he was open to staying in office, but political uncertainty brought on by rising borrowing costs has caused some to worry that the 19-nation eurozone may experience another crisis.

The European Central Bank is having a difficult time trying to raise interest rates from the near-zero beginning on Thursday without causing havoc on the bond market in a nation where debt is at 150% of GDP. Although some analysts aren’t completely ruling out a half-point increase, the ECB has stated that it will raise rates by a quarter of a percentage point.

The Frankfurt-based ECB will follow the U.S. Federal Reserve, the Bank of England, and other global central banks in raising interest rates multiple times to rein in spiraling inflation. However, the ECB does not want anxious markets to cause any euro member nations’ borrowing costs to increase more than is necessary given their economic strength.

The task facing the bank is already challenging enough given the growing likelihood that there will be a recession in 2019 as a result of sky-high oil and gas prices fuelled by the conflict in Ukraine.

To control borrowing costs for governments and businesses in eurozone nations that are less financially stable than the others, ECB President Christine Lagarde is anticipated to announce a financial backstop in addition to the rate increase.

The ECB faces a particular challenge because it is responsible for 19 nations with diverse economic situations that use a single currency that has fallen to its lowest level versus the dollar in 20 years.

The interim director of the Brussels-based Bruegel think tank, Maria Demertzis, claimed that “the Fed and the Bank of England don’t have this problem.” “Because the underlying outlook varies, the borrowing costs for each country when they issue debt are varied.”

The ECB seeks to avoid a repeat of the period between 2011 and 2012, when Italy’s borrowing costs spiked to about 7% due to the so-called “death spiral” of the bond market, in which rising borrowing costs fuel concerns that a government won’t be able to repay its debt, which in turn drives borrowing costs even higher.

As ECB president, Draghi promised to “do whatever it takes” to protect the euro, which was followed by a pledge that the bank would, in an emergency, purchase the bonds of nations with high borrowing costs. It was never necessary to utilize that backstop because it controlled the market so efficiently. However, it comes with stringent requirements that might put off governments.

Conditions for the new ECB backstop will likely be less onerous. It would entail committing to purchase bonds issued by a heavily indebted nation, which lowers borrowing costs if market interest rates increase excessively.

Recent days have seen an increase in Italy’s borrowing costs as well as those of other less financially sound eurozone nations like Spain and Portugal when compared to the benchmark, Germany.

Italian 10-year bonds currently have a yield of 3.4%, which is around 2.2% more than the German benchmark. Although Italy’s borrowing costs are reasonable at that level, it is preferred to keep them that way because of the potential for unexpected changes in market opinion.

According to Demertzis, each country’s borrowing costs are affected differently as interest rates rise.

The issue is that Italy’s borrowing costs will increase whereas Germany’s borrowing costs will not increase now that we are in the phase of the interest rate cycle where rates must rise, she explained.

If Italy can’t borrow money at a reasonable price, it may turn to the bailout fund for the eurozone, but because Italy is larger than Greece, it would be far more difficult to save it than Greece was a decade ago.

The challenge for the ECB will be to reassure markets while abiding by legal prohibitions against directly supporting governments and refraining from pushing governments to engage in reckless spending.

According to Neal Shearing, chief economist at Capital Economics, “any perception that the ECB is dragging its feet, or that the ultimate product won’t be successful enough, could see fragmentation fears flood back onto the agenda, fueling the fires of an entirely more alarming collapse in the euro.”

“Christine Lagarde runs the risk of making the same mistakes Draghi did ten years ago by promising to do whatever it takes. In an analyst note, he stated, “She must avoid slipping into another crisis that might ultimately force her to make a similar commitment to her predecessor.

Following 17 months of comparatively calm politics, Italy is now experiencing a political crisis that is being played out in the Parliament after the president rejected Draghi’s offer to resign due to a rift in the coalition government. To improve long-term economic growth, Draghi unveiled an expansive pandemic recovery program, which is the actual solution to keeping Italy’s debt under control.

Italy’s debt, which was the second-highest in the eurozone after Greece, decreased by 4.5% in 2021 as a result of the nation’s robust economic recovery.

Greek debt is less of a problem since, following Greece’s three bailouts during the debt crisis, much of it is owed to public entities and isn’t subject to market selloffs, according to Demertzis.

Draghi’s administration has started approving recovery plans that include restructuring a burdensome legal system that has been criticized for years for hindering firms, as well as digitizing and enhancing government services. Additionally, it intends to speed up the switch to renewable energy, expand high-speed rail and internet access to more regions of the nation, and increase the number of daycare spaces so that more women can join the workforce.

However, if Draghi’s coalition disintegrates and is replaced by a leadership less committed to advancing the reforms, markets may start to question the country’s chances for economic expansion.

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