Italy’s Multi-Headed Hydra Predicament.

By Don Quijones, Spain & Mexico, editor at WOLF STREET .

For the last three years, the political establishment in Italy and beyond have had a field day attacking, ridiculing, and vilifying Beppe Grillo’s 5-star movement. Europe’s media have tarred him with the brush of populism. In 2013 The Economist labelled him a clown on its front cover. Yet his party still leads the polls. And that lead is growing.

A new Ipsos poll in Corriere della Sera newspaper has put Beppe Grillo’s 5-Star Movement on 32.3% – its highest ever reading. It placed 5.5 points ahead of the governing PD, on 26.8%, after the PD dropped more than three percentage points in a month, as former prime minister Matteo Renzi battles to reassert his authority following a walkout by a left-wing faction.

Internal political battles are nothing new in Italy. The country enjoys a hard-earned reputation for political instability and paralysis, having seen 63 governments come and go since 1945. The problem this time around is that internal weakness and strife in Italy’s traditional center-left and center-right parties could end up gifting the next election to a party that refuses to play by the book.

If it wins the next elections, which could be brought forward to as early as June this year, 5-Star Movement has pledged to hold a referendum of its own — albeit a non-binding one — on Italy’s membership of the euro. As polls have shown, there is much broader public apathy toward the single currency than in just about any other euro zone nation. Grillo’s plan could also receive the backing of former prime minister Silvio Berlusconi who is determined to pull off a political comeback and is talking of restoring the Italian Lira.

As Reuters reports, such a scenario could spook financial markets “wary of both the 5-Star’s euroskepticism and the threat of prolonged political instability in Italy,” which boasts a public debt burden of over €2 trillion (133% of GDP). In any normal situation that would be a problem. But Italy is not in a normal situation; it is on the cusp of a potentially very large financial crisis that, if mishandled, could bring down Europe’s entire financial system.

Unlike many other Eurozone economies like Spain, Ireland Portugal, Italy did not experience a real estate or stock market bubble in the 2000s; nor were its banks heavily exposed to the financial derivatives that helped spread the fallout from the U.S. subprime crisis all around the world. As such, Italy has not had cause to bail out its financial system — until now.

While other countries, Germany and France included, lavished tens of billions of euros on their troubled banks at the height of Europe’s banking troubles, Italy’s banking problems have been allowed to fester and grow until they have reached the stage that the banks now require a massive infusion of public funds from a government that already boasts the fourth largest public debt on planet Earth. The Italian government has so far managed to club together €20 billion worth of funds to save — or at least stabilize — Monte dei Paschi and a clutch of mid-sized banks, but it still needs explicit approval from the European Commission to proceed with the operation.

That approval is still not forthcoming, for two obvious reasons:

A bailout without a bail-in of the banks’ creditors would be against new EU rules on bank resolution and if there is a bail-in, it could exacerbate fears of contagion within the financial system as creditors withdraw even more money from Italian banks; There’s little appetite for more bailouts of Southern European banking systems among Northern European countries, as was clumsily articulated by Dutch Finance Minister and President of the Eurogroup Jeroen Dijsselbloem.

As a result of EU inaction, the Italian banks that need a last-minute reprieve continue to languish in limbo. Monte dei Paschi, which has the highest proportion of problem loans among Italian banks in relation to its capital, is waiting on the results of the ECB’s latest audit of its books, which could unearth even more unpleasant surprises on its balance sheets. As MPS itself said, the possible impact on the bank’s solvency is an element of “significant uncertainty” regarding its ability to continue to operate.

Then there are the two regional banks Banca Popolare di Vicenza SpA and Veneto Banca SpA which were supposed to have been saved last year by an intervention from government-sponsored, privately funded bank bailout fund Atlante, but which are now requesting more public funds.

Some experts, including the U.S. bank hired at great cost last year to save MPS, JP Morgan Chase, have warned that Popolare di Vicenza and Veneto Banca will not be eligible for a bailout since they are not regarded as systemically important enough. This prompted investors to remove funds from the banks, further exacerbating their financial woes. According to sources in Rome, the two banks’ failure would send shock waves through the wider Italian financial industry. It would also provide fresh fodder for anti-euro forces in Italy.

Italy’s current predicament is a multi-headed hydra: a banking crisis, an economic crisis, a debt crisis, and a political crisis all rolled into one, and all coming to a head at the same time. It’s the reason why economists including Deutsche Bank AG’s Marco Stringa are calling Italy, not France or Greece, the “main risk” to euro-area stability.

From a Eurozone-stability point of view, and from a bondholder point of view, the best-case scenario would be the rescue of Italy’s banks, with taxpayers bearing most of the brunt. That should help steady investor nerves and put an end to the gathering exodus of funds out of Italian assets.

But even then, the social, political and economic price to be paid in a country already with public debt of over €2 trillion, youth unemployment of almost 40%, and an economy that is 12% smaller than it was 10 years ago, will almost certainly be way too high. If roughly half of all Italians are against the single currency today, imagine what it will be like when austerity begins really biting. By Don Quijones.

If the ECB scales back stimulus, banks face even greater risk of collapse. But now there’s a new solution. Read… Deepening EU Banking Crisis Meets Euro-TARP and Taxpayers

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