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If Italy Slides Toward Default

 Italy’s debt has long been the Achilles’ heel of the euro area. 

Extensive asset purchases by the European Central Bank helped keep borrowing costs down for the government in Rome. Now the monetary authority’s fight against inflation has put the nation’s debt onto an unsustainable trajectory. 

Stabilizing the debt-to-GDP ratio would require swinging the primary balance to a surplus of 3% of GDP from a deficit of 1.8% in 2022. 

That would require some harsh austerity measures, and voters are unlikely to back that.

For the Governing Council, that will make it hard to agree that Italy’s debt is sustainable—a prerequisite to activate its new crisis-fighting tool, called the Transmission Protection Instrument. 

It will probably be deployed eventually, but only once Italy has negotiated with European partners. Expect drama.

If a crisis erupts, a solution could involve some form of fiscal consolidation, debt mutualization, or a writedown—and perhaps even a mix of the three.

The cost of servicing Italy’s debts will climb sharply as old bonds mature and new ones are issued. 

Bloomberg 16 November 2022


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