Italy is frequently mentioned as the potential biggest risk factor in the euro area. Given the current market complacency about Italian risks, we discuss the potential triggers for renewed market focus on Italy.
The Italian banking system suffers from a high share of NPLs and weak capitalisation. Although the Italian government has started to address the problem, a thorough overhaul of the banking system as a whole is still needed, in our view. According to our estimates, the cost of a banking sector clean-up would not be out of proportion with what other European countries have spent. However, new European rules on state aid for banks make bank restructurings in Italy contentious.
Problems in the Italian banking system and government bailouts are a particular concern because of Italy's already-high public debt burden. Although the fundamental weakness in Italy is currently not priced in, concerns about debt sustainability could resurface and bond yields rise, once the ECB shifts toward policy normalisation and/or political risks come back into focus.
Although early elections look increasingly unlikely now, there is a risk that the euro-sceptic Five Star Movement could come to power after the next general election, due to take place by May 2018 at the latest. However, even with a Five Star government, an actual 'Italexit' seems unlikely given that the process would be long and cumbersome and public support for the euro has recently increased.
The limited scope of rescue funds available for Italy should a debt crisis actually erupt makes Italy a key risk for general market sentiment and the sentiment towards the above-mentioned risks crucial to follow.
To read the entire report Please click on the pdf File Below: