Rabobank considers the theoretical scenario and implications of Italy(or any other country) deciding to leave the Euro and issues a severe warning over the implications. Any decision should not be taken lighly.
“Countries that may be considering an exit from the Eurozone would be well advised to do what they failed to do when the euro was introduced: carry out a proper cost-benefit analysis beforehand.”
Rabobank stresses that it does not believe that Italy under the current or a future administration will actually deliberately leave the Eurozone, but the country is used as an example for illustrating the complexity of the issue.
Populists promote Italian Euro exit
In this scenario, a populist and anti-Europe is elected to power under the false premise that economic problems are due to EU membership. The analysis also assumes that the complicated steps can be managed and the country leaves the Euro.
Under this plan, Italy would replace the Euro with the new Italian Lira (NIL).
Rabobank points out that there is no mechanism to leave the Euro under EU treaties “Adoption of the euro is irreversible. In practical terms, this means that a country can only leave the Eurozone by scrapping the European treaty entirely.”
Costs would mount quickly, banking sector would face collapse
The difficulties leaving the Euro area have already been illustrated by the protracted UK struggle in leaving the EU. The UK, however, runs its own currency and the difficulties involved in introducing a new currency make this task massively more difficult.
Direct costs would emerge very quickly as the behaviour of consumers, businesses and institutions would change extremely quickly and certainly before any actual exit takes place.
“As soon as people realize that an exit from the Eurozone is on the cards, they will want to put their money somewhere safe.”
There would be an immediate run on the banks as cash demands increase sharply. There would be a high probability that restrictions on cash withdrawals and overseas transfers would have to be implemented.
The liquidity problems for the Italian banking system would be even more severe, because foreign creditors would try to call in their cash and other claims in Italy.
Italians with assets abroad would certainly not want to repatriate them.
“Bank balance sheets would come under further pressure due to the likely price declines in Italian government paper. The Italian banks own more than a quarter of the total Italian government debt while 11 percent of their assets are held in Italian government bonds.”
ECB unlikely to offer support
The ECB of course has the power to help the Italian economy through this difficult phase, and provide liquidity to the banks in its role as the lender of last resort. It could also buy Italian bonds to stop interest rates rising. The question is whether the ECB would be prepared to do this.
Rabobank points out that the ECB priority is to protect the Euro area and not Italy.
The experience of ECB actions in the Euro-zone debt crisis in general and Greece in particular does not suggest that the central bank would lend support.
Italy also looked to take a defiant stance in 2018 which was quickly brought to halt as EU institutions effectively forced Italy to capitulate as bond yields moved sharply higher.
Indeed, the reverse is more likely as the central bank has effectively been able to block populist government policies by threatening to remove emergency liquidity assistance.
Default risk would increase
Foreign creditors would demand payments of debts in Euros while the Italians would want to repay debts with the NIL.
Rabobank expects that there would be prolonged and bitter legal disputes to determine payment terms.
Whichever way it goes, it seems likely Italy would ultimately have to deal with a debt restructuring. If the debt is repaid in NIL, at least part of the creditors will be able to officially declare the country to be in default. If Italy wishes to meet its obligations in euros, debt ratios will explode after a depreciation of the NIL and the country will almost certainly remain in default with respect to its debt obligations.
Limited beneficial impact on exports, devaluation cycle back in focus
There would be a boost to competitiveness from a weaker currency.
There would, however, be potential barriers to trade under a new trade regime. There would be an important risk that countries exporting to Italy would demand hard currencies in payment and Italy would have difficulties in securing essential imports.
The cost of imports would increase and overall inflation rates would be likely to increase.
Prior to the Euro’s introduction, Italy had frequent episodes of lira devaluation. Inflation ran at higher levels that countries such as Germany and higher inflation eventually undermined competitiveness which forced the currency to devalue.
According to Rabobank, there would be a high risk that this cycle would return.
EU area suffers, geo-political risks likely to increase
If Italy left the size of the Euro area would be reduced by 15%. According to the bank, there would also be geo-political risks as Italy could look to secure financial support from China or Russia which would be likely to increase political tensions between the EU and Italy.
“The most important lesson is that an exit from the euro is not something to take lightly. The fact that countries would have been better off not joining the euro at the beginning does not mean that exiting 20 years later can proceed without serious problems. “