With the Washington Post stepping up to put a floor under US stocks Thursday afternoon by reporting that President Trump would meet Chinese President Xi Jinping at next month’s G-20 summit (while the headline soothed the market, it doesn’t change the fact that, as with everything involving the Trump administration, this too remains subject to change), investors have apparently overlooked the latest ominous headlines out of Italy. To wit, Reuters reported that the ECB won’t come to Italy’s rescue if its government or banks run out of cash unless the Italian government first secures a bailout from the European Union. Of course, this would almost certainly require that the populist coalition end its ongoing game of fiscal chicken with Brussels and abandon its dreams of lowering the retirement age and extending a basic income to the Italian people – policies that would effectively secure a political future for M5S and the League.
In effect, the ECB’s latest trial balloon is tantamount to blackmail: Either the Italians agree to fall back in line and obey European budgetary guidelines, or the central bank will sit back and watch as bond yields surge, providing the ratings agencies even more ammunition to cut Italian debt to junk – effectively guaranteeing a Greece-style banking crisis as the liquidity taps are turned off.
And to eliminate any lingering doubts that this was a deliberate coordinated leak, Reuters cited “five senior sources familiar with the ECB’s thinking,” many of whom were “present at the economic summit in Indonesia.” Of course, the ECB sources explained that they are merely acting in the best interest of the monetary union. Because if Italy is allowed to shake off the yoke of European austerity and re-assert its sovereignty, then what would stop Spain or Portugal from doing the same?
The sources, present an economic summit in Indonesia, said Italy could still avoid a debt crisis if its government changed course but should not count on the central bank to tame investors or prop up its banks.
This is because EU rules do not allow the ECB to help a country unless this has already agreed on a rescue “program” – political jargon for a bailout in exchange for belt-tightening and painful economic reforms, an option the Italian government has firmly rejected.
Any attempt to circumvent those rules would damage the ECB’s credibility beyond repair and undermine acceptance of the monetary union in creditor countries, such as Germany, the sources said.
“It’s a test-case to show Europe and its mechanisms work,” said one of the sources on the sidelines of the International Monetary Fund’s annual meetings in the Indonesian resort town of Nusa Dua.
Now, if Italy instead embraced the path of fiscal discipline, the ECB would be more than happy to backstop the country’s debt via Outright Monetary Transactions (the never-used program adopted by the ECB in 2012 to restore confidence in the euro and euro-area debt amid a burgeoning debt crisis).
But here’s the rub: Even if the populists ignore this threat and refuse to kowtow to the European Commission, the ECB could still step in and unilaterally strong-arm the government into abandoning its plans for fiscal stimulus. Because once Italian bonds lose their investment-grade status (a scenario that’s increasingly looking like a when not an if), Italian banks will be faced with an impossible choice: Unable to use the Italian debt on their balance sheets to secure more short-term liquidity, and unable to sell them back to the ECB as part of the central bank’s QE program, Italian banks that don’t have enough non-Italian debt on their books would be forced to ask for Emergency Liquidity Assistance from the Bank of Italy. But before the Bank of Italy could go ahead and disburse these funds, these banks would need to prove that they are solvent (which they wouldn’t be) or the Italian government would need to ensure that a program of fiscal discipline is in place. If they refuse, the savings of regular Italians would be in jeopardy.
Banks that don’t have alternative collateral of good quality would then need to apply for a lifeline known as Emergency Liquidity Assistance, supplied by the Bank of Italy.
“There are some banks that are actually in pretty good shape so it wouldn’t be all of them (requesting ELA),” another source said.
But even ELA could run into constraints after a while if reliance on grew too high.
As ELA can only be granted to solvent banks, the ECB’s Governing Council could require that an economic program is in place in Italy before it gives its all-clear to large amounts of ECB cash being disbursed, much like it did in Greece.
But before credit conditions deteriorate to such an extreme degree, depositors would likely have cut their ties with the Italian banking system – as many would (correctly) assume that their money would be safer under a mattress and a brutal bank run would ensue.
S&P Global and Moody’s, two of the four ratings agencies recognized by the ECB, are expected to issue an updated opinion on Italian bonds later this month. But given the obstinance that Luigi Di Maio and Matteo Salvini (the party leaders who are effectively running the country) have demonstrated in recent months, we imagine Italian stocks, which recently entered a bear market, are headed for even lower lows.