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Should Malta be worried about events in Italy?

Italy is experiencing its first taste of a eurosceptic government. Some may call it populist, but given the negative undertone of the word populist, let us stick to the eurosceptic label. In fact this is what the two parties making up the governing coalition in Italy have in common – a dislike of the European Union and the European Commission in particular.

The coalition has now come to its first real test – the preparation of next year’s public sector Budget and the supporting economic policy document. The Italian government is projecting a deficit of 2.4 per cent of the gross domestic product. Independent institutions, both in Italy and abroad, have said that it will end up being much higher as the measures being proposed will not lead to the growth that the government is prospecting.

A lot of mud-slinging has taken place among Italian parties and between leading exponents of the Italian government and the EC. However these should not concern us. On the other hand, should we be worried about the economic policy of the current Italian government?  Will this policy – which seems to put aside any concern about a sustainable fiscal deficit – eventually create problems in the eurozone? We need to keep in mind that Italy’s economy is much larger than that of Greece and as such, any default on its sovereign debt will have much more severe consequences.

The financial markets are certainly worried and this has led to a widening of the spread of the interest rate earned on Italian government bonds, when compared to German government bonds. Moreover the euro has lost value against both the US dollar and the pound sterling.

The worst thing that can happen to us is being caught unprepared for the worst of eventualities

So let us go back to the question I posed: should we be worried about events in Italy? I believe the answer is in the affirmative and there are objective reasons why we should be.

First, Italy’s public sector has been spending more than it has been earning for the last two decades. Moreover data shows that this excess of expenditure over income is growing, and therefore certainly not making it any more sustainable. Previous governments had sought to introduce measures to rein in public expenditure and to a certain extent were successful. For example, some years ago a pension reform was introduced, tying the age when one applies for a State pension to life expectancy.

The current government is planning to dismantle this reform, with the result that just under half a million employees could start to receive a State pension but will not be replaced by just as many in the labour market. This would lead to a decrease in the number of persons working and would reduce economic growth, while increasing the strain on public finances.

Second, interest rates on Italian government debt are on the rise. This implies that financial markets are seeing an increased risk in the country. Countries like Japan and the US also have massive public sector debt. However, interest rates are still very low because investors believe there is no risk in these countries. On the other hand they do see risks in Italy. Moreover increased interest rates would worsen the fiscal deficit.

Third, the weakening of the euro demonstrates the extent to which events in Italy are indeed a cause for concern. The euro is built on three pillars – Germany, France and Italy. As such, events in Italy are bound to have a negative impact in the value of the euro. There are also politicians in the Italian government who openly advocate an exit from the eurozone. If this were to happen, the negative consequences on the rest of the eurozone would be massive.

Fourth, there are a number of non-Italian financial institutions that are exposed to Italian debt. A default on government debt would impact the balance sheet of such institutions, which could undermine the stability of these institutions. The Italian banking sector is still too weak, in spite of the measures taken to improve their respective balance sheet, and therefore may not be able to withstand a prolonged crisis caused by an excessive public sector deficit in the country, or worse a default on public sector debt.

Therefore I believe that we have strong grounds to be worried about the situation in Italy. I have no doubt the Maltese government, the Central Bank of Malta and the Malta Financial Services Authority are following events and evaluating options as to what can be done to mitigate the risks that events in Italy are creating. The worst thing that can happen to us is being caught unprepared for the worst of eventualities.

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