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

2. 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 ( )
Common banking supervision
ESM backstop for banking resolution
European Stability Mechanism
Outright Monetary Transactions

3. 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)

4. 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”

5. 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

10. Source: Flossbach von Storch Research Institute

11. 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.

12. The second stumbling block
Debt Restructuring

13. Italy’s fragilities
Productivity
Banks
Debt

14. Italy
Productivity
Banks
Debt -

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

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

18. Italy
Productivity
Banks
Debt -

19. NPLs ratio (weighted average by country)

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

21. Italy
Productivity
Banks
Debt

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

24. The Italian spread: default vs redenomination risk
Source: Banca d’Italia, Bollettino Economico,

26. 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 ,4
Germany 3,1

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

29. Households real and financial assets (percent of disposable income)