Before Brexit, there was Grexit. In 2009 Greece admitted that its budget deficit was more than four times the limit imposed by the EU, and its lenders began to fear that the country, unable to service its debt, would have to exit the euro and reinstate the drachma.
Credit ratings agencies swooned, lenders panicked and the country’s bond yields – and therefore the cost for it to borrow money – climbed precipitously. By the time the crisis was over in the mid-2010s, the fears had spread to the so-called PIIGS countries: Portugal, Italy, Ireland, Greece and Spain (and Cyprus). All had taken bailouts to keep up their debt repayments except Italy, which only narrowly avoided having to do so.
This week the spectre of that crisis returned, with yields on Italian ten-year debt climbing above 4 per cent for the first time since 2013. The country’s lenders have become increasingly nervous that central banks’ decisions to begin raising interest rates, to combat inflation, will hinder Italy’s ability to repay its debt. They are right to be worried – like those of other countries, Italy’s debt levels climbed sharply during the pandemic as it borrowed to shore up its economy during successive lockdowns, with debt hitting 150 per cent of GDP in 2021. Unlike in other countries, however, Italy’s debt-to-GDP ratio was already high before the pandemic; in 2019 borrowing was at 134 per cent of GDP, against the UK’s 82.7 per cent and Germany’s downright prudent 58.9 per cent.
That divide has caused rifts among the European Central Bank’s rate-setters. In 2019 minutes of ECB meetings began to show a geographical split, with rate-setters in northern Europe supporting “tighter” monetary policy, while others wanted a more wary approach. It is very difficult to create monetary policy that suits Europe’s quite different economies. In Italy, for example, higher prices make GDP appear higher, which helps to bring down the country’s debt-to-GDP ratio. In Germany, however, a range of factors – from a high rate of personal savings to the cultural memory of hyperinflation in the 1920s – make inflation politically toxic.
This week the ECB made a move that, in the cautious world of central banking, counts as dramatic: it called its first emergency meeting since the beginning of the pandemic, to discuss the Italian debt situation. The outcome of the meeting was an uncharacteristically pithy two-paragraph statement pledging “to act against resurgent fragmentation risks” – that is, the risk that sovereign debt yields for some eurozone economies go up while others go down – and promising to design a new “anti-fragmentation instrument” that will essentially act as an extension of its bond-buying programme.
If its decision to convene a meeting was dramatic, the language of the ECB release was reassuringly dull. But, says Janet Mui, the head of market analysis at Brewin Dolphin, a wealth management company, “language matters”. In 2012, as the debt crisis rumbled on, Mario Draghi, then the president of the ECB, gave a speech in which he promised the central bank was ready to do “whatever it takes” to preserve the euro. Those three words are credited with ending the crisis: markets’ confidence was boosted, yields began to fall and, just to demonstrate how reliable it was, within a week the ECB had announced the Outright Monetary Transactions (OMT) mechanism, a system that would allow it to buy up bonds of distressed countries, thus injecting money directly into their economies, if they really needed it. Those two moves – words followed by action – were enough to quell lenders’ fears, to such an extent that the OMT has never been used: just knowing it existed was enough for markets.
This time around, the hope is probably that the anti-fragmentation instrument, about which we have little information, will play the same role, restoring markets’ confidence without it actually ever having to be used. But the ECB will have to tread carefully to get the agreement it needs from all the eurozone countries – last time around, Germany took the ECB to court over the OMT. Germans saw it as unfair that Germany, with its careful fiscal restraint, should have to pick up the bill for big spenders such as Greece.
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The general consensus is that, for the moment, we are unlikely to see a repeat of the eurozone debt crisis of the 2010s – although Antoine Bouvet, a senior rates strategist at Ing, the Dutch bank, says it’s not necessarily “for the right reasons”. “The ECB is now so heavily invested in that market [in the form of its bond-buying programme], it has come to the realisation that markets cannot function without it,” he says. However, Bouvet also believes that for this reason, “the chance of a repeat of what we saw ten years ago is very slim”.
Financial markets may also take some confidence from the fact that a similar cast of characters is involved this time around, albeit in different roles. Draghi is now the prime minister of Italy, while the ECB is overseen by Christine Lagarde, who last time around was managing director of the International Monetary Fund, part of the “troika” that bailed out Greece to the tune of €110bn in 2010. Both are well versed in the risks of losing control of sovereign debt. “It’s a very strong team,” says Mui.
At the same time, it remains to be seen what will happen when the ECB finally chooses to raise interest rates. It is widely expected to begin a cautious cycle of rises in July, which would be its first in over a decade. This puts it well behind the likes of the US Federal Reserve, which announced a mammoth 0.75 percentage point rise this week, its second consecutive hike, and the Bank of England, which has raised rates five times since December, this week by 0.25 percentage points.
Market confidence is a fragile thing. “Investors can legitimately have doubts about the sustainability of [Italy’s] debt,” says Bouvet. “The ECB will have to continue investing, or at least monitoring the market, making sure that borrowing costs don’t spiral out of control.”