Milan was unseasonably warm last week: a sweltering 35 degrees that had locals complaining bitterly. The pathetic fallacy was not lost on the posse of European central bankers in town for a youth education conference: with Italian 10-year government bond yields hitting a near-decade high of more than 4 per cent, and the spread over German Bunds reaching levels not seen since the start of the pandemic, the heat was on.
The central bankers tried their best to cool concerns, playing down inflation risks and talking up eurozone unity. Banque de France boss François Villeroy de Galhau told his teenage audience that the “European dream” was alive and well.
But in the short-term, at least, the eurozone outlook is more nightmarish than dreamy – and that is particularly true of Italy and its banking sector. Like many western economies recovering from the pandemic and now confronting the disruptions caused by the war in Ukraine, the country faces high inflation and the prospect of recession. Markets are singling it out as the worst of a bad lot among eurozone nations.
Every country that has been hooked on ultra-loose monetary policy for the past decade will find it painful to normalise interest rates, unwind quantitative easing and head off rampant inflation. But like some other parts of the southern eurozone, Italy faces three particular stresses. First, after a strong bounceback from the pandemic with gross domestic product up 6.5 per cent last year, growth was already threatening to return to habitual anaemic rates, even without the war in Ukraine and notwithstanding nearly € 200bn of EU recovery fund money.
Second, high government debt levels (151 per cent of GDP last year) have triggered investor fears about “fragmentation” of the bloc’s integrity as the ECB tightens its policies and states spend to cushion consumer energy inflation. And third, Italian banks may become part of the problem, caught up more directly than most with both the Ukraine conflict and the market’s bearishness about their government’s debt.
There are good reasons to dismiss lazy comparisons with the eurozone crisis of a decade ago. Then, investors concluded that high debt levels, low economic growth and weak banks were a poisonous cocktail for the southern eurozone. Fears of a “doom loop” of lenders and government weakening each other via banks’ large portfolios of Italian sovereign debt were a further drag.
This time round Italy’s banks have far stronger capital cushions, bad debts have been cleaned up and profitability has been bolstered. But optimism is fading fast. New inflation data show price rises were already running at 6.8 per cent in May, the highest for more than 30 years, with Russia’s recent cuts to gas deliveries set to compound the problem. Bank revenues will suffer, and costs will rise.
The “doom loop” risk remains too, thanks to banks taking advantage of an attractive “carry trade” that uses free money from the ECB to invest in sovereign debt with decent yields.
Italy’s banks should be nicely buoyed by higher interest rates, given their bias towards basic lending and deposit-taking. The higher rates should deliver better margins on that lending. But the cost of credit will also rise. Analysts at Mediobanca point out that a return of bad debts from their current low level to historic averages would wipe 20 per cent from earnings.
Italy’s big two banks were among the most vulnerable to the Russia-Ukraine crisis thanks to significant operations in the region. Earlier plans to return significant capital to shareholders – a key underpinning of the share prices of Intesa and UniCredit – no longer look credible, Mediobanca says. Both banks have lost about 37 per cent of their value since their February highs as investors latch on to the bear market thesis. That compares with around 27 per cent for the Euro Stoxx banks index.
Critics of the ECB say such pressures were unnecessarily compounded by botched communication and a wordy promise that “fragmentation will indeed be avoided” – a far cry from the punchy “whatever it takes” pledge of Mario Draghi, Christine Lagarde’s predecessor as ECB president.
Draghi, now serving as Italy’s prime minister, is both popular and credible in Italy and across the eurozone – and a welcome source of stability amid the country’s volatile political system. If, however, he leaves the job, potentially by next year, skeptical investors will have even more reason to be bearish on the prospects for the country and its banks.