By Francesco Canepa

FRANKFURT, (Reuters) – Italy faces new questions regarding the viability its debts as the European Central Bank cuts back on emergency support which helped eurozone’s largest indebted countries survive the coronavirus epidemic.

The cost of fighting the health and economic crisis is high. Governments have gone to great lengths to assist households and businesses. Italy’s total public debt rose from 134.8% GDP in 2019 and a targeted 153.5% for this year.

The ECB purchased Italian debt worth 250 billion euros under its Pandemic Emergency Purchase Programme, (PEPP), in March 2020. This has helped to keep borrowing costs down. However, Italy’s 10 year bond yield, at 0.9%, is now lower than prior to the pandemic.

The possibility of PEPP’s end in March raises concerns about Italy. This third-largest country in the euro area has a history of slow growth, and can destabilise all 19 member currencies.

Jesper Rangevid, a Copenhagen Business School Professor of Finance, stated that it was likely that Italian yields could rise significantly if the ECB stopped buying Italian bonds.

“The euro area would again be in trouble.”

Although the euro area’s central bank has a smaller, older bond-buying program in place, it could be discontinued within twelve months if inflation stabilizes at 2% after large swings during pandemic.

Many have even invoked the eurozone debt crisis of a decade back, when bond yields in Spain, Italy, Portugal, and Portugal spiked as investors bet against the collapse of the single currency.

This was ended by Mario Draghi, then President of the ECB, who pledged to “whatever it took” to save euro – the code that allows for the purchase of bonds from troubled countries.

John Cochrane at Stanford was a senior fellow at the Hoover Institution. He wrote that if the ECB stopped buying or removed the promise to ‘whatever is necessary’ purchases, then debt service costs would rise once again, triggering the doom loop.

THE DRAGHI EFFECT

Draghi may be able to find a solution again, as he is now Italy’s Prime minister and oversees a wide coalition.

It will be crucial that Italy is able to make use of the 200 billion euro in EU Recovery Fund loans and grants. This fund is available until 2026, provided Italy meets all conditions.

Some protection is expected to be offered by the credibility of the ex-ECB chief with Brussels markets.

However, the economy of Italy still has its old weaknesses, such as a low unemployment rate, stagnant productivity and lack of investment in education, technology and bureaucracy. There is also a widening north-south divide.

Draghi, widely believed to be the next head of state after the elections in 2023, will be removed from his direct executive position in the last year.

Lorenzo Codogno (an ex-official at Italy’s Treasury) said that “my fear is that…political parties will kick off the can and many reforms wouldn’t be approved.” He also runs consultancy LC Macro Advisors.

BUFFER

Italy’s years of low interest rates helped to build up a buffer against the market storm.

Rome paid 4.5% GDP to service its 2007 debt, when the debt-to-GDP ratio in Rome was 104%. According to OECD data. Even though the debt ratio had risen to 156%, borrowing costs were only 3.3% by 2020.

Italian Treasury also took advantage the generosity of ECB in order to prolong the average maturity its debt. It was able to protect itself against sudden rises in yields.

Italy now has less to worry about in order to maintain its stable debt: its nominal growth rate is higher than its interest rate.

To have a steady debt trajectory, you don’t necessarily need to see a macroeconomic miracle. However, you do need growth and inflation,” Dirk Schumacher of French investment bank Natixis said.

Whatever it takes

It is not easy to see how Italy can be so unstable and grow slowly.

Rising yields worldwide could lead to a reverse inflation, leaving vulnerable borrowers, such as Italy.

Investors will be interested to see if Christine Lagarde, chief of the ECB, is willing to honor her predecessor’s promise if that occurs.

Frederik ducrozet, a Pictet Wealth Management strategist said that “I feel fairly confident the ECB could do whatever it takes in the event financial fragmentation.”

Lagarde (an ex-French finance minister, and chief of the IMF) stated that Italy was under pressure from the markets early in the pandemic.

She later regretted those remarks but doubts about her dedication linger.

Carsten Brzeski (an economist at Dutch bank ING) stated that “it” still echoes on the markets and weakens the credibility of ECB. It was an expensive slip of tongue.