The European Union has sent the Italian budget back to Rome with inadequate grades. Italian bonds are as pummeled in the financial markets. Italy’s credit rating is dangerously close to junk status.
Bond traders and European politicians should be concerned about such matters. But do they really play the role of ordinary Italians and the rest of the world?
Sorry, yes. It can be scary consequences when interest rates and investors lose confidence in a country’s ability to pay off its debts.
That’s what happens. On Friday, Moody’s Investors Service downgraded its rating of Italian debt to a level above the level at which it would no longer be considered investment class ̵
1; in common language, “junk”.
Given the tension between Italy’s populist government and the European Commission, there is a good chance that Standard & Poors will follow Moody’s leadership on Friday, putting pressure on the other two rating agencies – Fitch and DBRS – to do the same.
Italy probably has several months to avoid slipping over the cliff to the junk. It may show a willingness to compromise with Brussels, or perhaps the government’s spending plans will defy predictions and, as promised, revive the economy. But if Italy suffered from another downgrade, chain reactions could be difficult for governments and central banks to control.
Here is a look at what might happen in the worst case scenario.
Italian banks begin to wave
] Italy’s major lenders have taken a blow over the last 10 years and are already in a weakened state. Everyone has large stocks of Italian government bonds. If that debt loses value, the banks will suffer from losses that will make the capital worse.
Banks can then lose confidence in financial markets, as investors worry about their solvency. All banks are dependent on a constant flow of borrowed money that they lend to customers or use to roll over debt. If the cash spigot runs dry – a so-called liquidity crisis – banks can quickly get into trouble. There were loads of banks in Europe and the United States during the 2008 financial crisis.
Italian banks have thicker pillows than they did during the financial crisis, says a report from Deutsche Bank Tuesday, but “liquidity still poses a risk.”
When Banks in the euro area are ashamed of the market, they can turn to the European Central Bank. But it raises another problem.
The European Central Bank reduces aid
The euro area banks can borrow as much as they want from the central bank without interest, but there is a catch. They must deposit collateral. One of the most common forms of collateral is, you would not know it, government bonds.
If these bonds are classified as junk by all four credit rating agencies, the European Central Bank will no longer accept them. This happened to banks in Greece when Greek government bonds fell to junk status, which contributed to serious financial difficulties.
Banks can record other collateral, such as bonds from more solvent countries or corporate debts. But experience shows that troubled banks usually lack other assets. They can still borrow money from the central bank, but at significantly higher interest rates, giving them a competitive disadvantage.
The European Central Bank has a separate program that would allow for the purchase of Italian bonds in the open market, which helps to reduce the country’s borrowing costs. But Italy would only be eligible if conditions agreed that would certainly include spending limits, something that the populist government is unlikely to accept.
Italy suffers a credit crunch and collapses
Bankruptcy is a problem every day as businesses and consumers can no longer get credit. They spend less and growth decline. In Italy, the exaggerated government would not be able to pay for bank redundancies. (One of the reasons that Italy is so much debt is that it has already spent large sums saving its banks.)
When people spend and earn less, they pay less tax. Government revenue is falling, Rome’s ability to make debt payments suffers and a vicious circle begins which is difficult to stop at the country’s borders.
Italy’s wrath spread around the world
Economists are discussing whether Italy can provoke another major financial crisis. Some experts argue that the financial system has grown stronger since 2010, when Greece’s debt problem almost destroyed the euro area.
“The core of the financial system is much more resilient than before the global financial crisis, with strengthened bank capital and liquidity,” Financial Stability Board, a group of central banks, regulatory authorities and government officials trying to keep up with threatening crises, said in a statement Monday.
However, there are many ways that local melting can go globally. Banks or investment funds outside of Italy can own Italian government bonds and suffer losses. Investors begin to save other time bombs to cross. They fly all stocks or bonds that seem risky, which causes the markets to fall. Stock markets worldwide, which have been hopeful in recent weeks, slid lower on Tuesday.
The biggest risk may be something that most people have not considered yet. Bankers are always inventing new ways to make money, spawn new financial risks. The members of the Financial Stability Board also warn on Monday about the dangers of shadow banking: financial transactions of hedge funds, private limited companies that have acquired great financial power but are easily regulated at all.
“New forms of interconnection have occurred,” said the board, “which in some scenarios can serve as channels for domestic and cross-border risk enhancement.”
It is a polite way of saying “panic”. The world is not there but the conflict between Brussels and Rome has increased the chance.