How fragile remains the euro area? Are the chances of an Italian default overblown? Casa das Garças May 21, 2019 Francesco Giavazzi Bocconi University

partial progress, but some progress, though the area reamains fragile Euro Area Reform partial progress, but some progress, though the area reamains fragile Reforms since the euro crisis (2011-12) Common banking supervision ESM backstop for banking resolution European Stability Mechanism Outright Monetary Transactions

Fragilites The area lacks a fiscal stabilization instrument that could step in when the ECB has reached its limits (as it has today), e.g. some elements of a common unemployment insurance EDIS (European Deposit Insurance) remains taboo The area lacks an instrument to stop the emergence of “bad equilibria” (OMT is subject to double conditionality) - for such an instrument to be credible its resources should be in principle unbounded (in “normal” jurisdictions this is the job of the central bank)

A single stumbling block underlies the difficulty in adressing the causes of fragility Northern countries require Risk Reduction and the possibility of Debt Restructuring before accepting Risk Sharing Thus: No EDIS, no serious macro stabilization function, no instrument to eliminate bad equilibria Risk reduction has a name: “Doom Loop”

Risk Reduction and Risk Sharing: The Northern View “Worries about Italy have led some to reject any further risk-sharing in the Eurozone Without cutting the cord between sovereigns and banks, the so-called sovereign-bank doom loop, completion of the banking union is impossible A fiscal backstop for the single resolution fund, the EU’s rescue fund for failing lenders, and rules covering non-performing loans are not sufficient To protect financial stability, the Eurozone should offer more risk-sharing through common deposit insurance. But it should also inject more market discipline through the regulation of sovereign exposures” Isabel Schnabel, member of the German Council of Economic Experts

Source: Flossbach von Storch Research Institute

Doom Loop: solutions that work and solutions that do not work - Sovereign concentration charges - ESBies (European Senior Bonds): a euro area safe asset without mutual guarantees (Brunnermeier at al) Safety achieved by some combination of diversification and seniority. Banks would purchase a standardized diversified portfolio of sovereign bonds and use it as collateral for a security issued in several tranches. The subordination level (the size of the junior and mezzanine tranches) would be calibrated so that the five-year expected loss of the most senior is about the same as that of a AAA-rated sovereign bond.

The second stumbling block Debt Restructuring

Italy’s fragilities Productivity Banks Debt

Italy Productivity Banks Debt -

Italy’s low productivity: it’s a composition problem !

Italy’s low productivity: it’s a composition problem ! Size Distribution of Firms Source, Prometeia on OECD data

Italy Productivity Banks Debt -

NPLs ratio (weighted average by country)

Italy: Net NPLs (EUR bn and as % of total net loans) Source: DBRS

Italy Productivity Banks Debt

Bottom line: Underlying Euro area continuing fragility lies the Italian debt

The Italian spread: default vs redenomination risk Source: Banca d’Italia, Bollettino Economico, 2-2019

Who holds the Italian debt ? by type of holder Foreigners 33 Bank of Italy 19 Italian banks 20 Italian insurance cs 23 Italian households 5 Country exposures to Italy (%GDP) France 14,1 Spain 6,4 Germany 3,1

Households assets and liabilities by type of asset (percent of disposable income)

Households real and financial assets (percent of disposable income)