The latest potential existential threat to the eurozone is not from reckless banks this time. A highly contagious virus is something regulators had never planned for, writes Justin Pugsley.
What is happening?
Covid-19, or the coronavirus, has taken a firm grip on the global economy, sending it lurching towards recession and knocking global equity markets into a tailspin.
In the absence of immunisation, minimising social contact is being pursued as the best way to stop its spread. Unfortunately, that means a simultaneous demand and supply shock as consumers and workers reduce their activity, following many governments' lockdown measures to combat the spread.
If prolonged, the virus’s impact on the economy and banks will be debilitating.
It comes at a very unfortunate time for the EU and the eurozone. The bloc was still trying to fully recover from the last global financial crisis and is in the middle of a messy – and expensive – divorce with the UK.
Indeed, Brexit has faded from being the EU’s chief concern, with growing worries over the fate of Italy, which was already in an anaemic state before the virus struck.
Why is it happening?
If the coronavirus does trigger a deep recession, Italy, with its large debt-to-gross domestic product ratio of 138%, weak banking system and incomplete economic reforms will likely be at the epicentre of a eurozone crisis should it erupt.
Quite simply, Italy is too big to fail and too big to bail. A new eurozone crisis would happen in the midst of an increasingly toxic political environment, with the north of Europe pitted against the south over economic policy.
Yet as Italian government bond spreads widen over German bunds, what is needed right now is solidarity with Italy, not lectures on fiscal prudence.
There is a fear in some circles that an acrimonious EU environment could propel nationalist politicians back into power in Italy at some point. This might have unintended consequences in capital markets, necessitating drastic action by the authorities.
The euro needs some form of debt mutualisation and the completion of the banking union to survive in the long term. But such is the strength of opposition among the northern states that this is simply not on the cards.
This potentially leaves Italy looking vulnerable as economic, market and health conditions rapidly deteriorate.
True, EU-eurozone integration tends to be crisis-driven, but another emerging now might be one too many.
What do the bankers say?
According to one source, behind closed doors Italian bankers are deeply concerned about the state of their country and its ability to stay in the euro if conditions significantly worsen.
Apart from more loans going sour, they fret over the value of their holdings of Italian government bonds, which are used as regulatory capital.
Though European solidarity is looking frayed, it is worth noting that the eurozone’s banking system is much more robust than it was a decade ago. Banks hold more and better quality capital, and are more risk averse. The number of bad loans has been substantially reduced.
The eurozone has a fully functioning central bank and support mechanisms for struggling member states, but supporting a country as big as Italy might stretch them to breaking point.
Will it provide the incentives?
Governments and central banks are stepping up economic stimulus measures. Commercial banks are being urged to do their bit to keep vulnerable businesses ticking over with leniency on loans. No doubt regulators will show forbearance towards banks in the face of an emergency that is not of their creation.
If the coronavirus impact is short lived, these measures should jolt economies back to life quite quickly and banks should emerge unscathed.
A threat to the eurozone is still very much a worst-case scenario, and will not materialise if the virus soon disappears. But it may drag on longer, and in anticipation of that, eurozone authorities and member states should plan on how to support Italy and its banking system sooner rather than later to keep the bond vigilantes at bay. This is in all their mutual interest.
However, it cannot be stressed enough that tackling the coronavirus is not the job of central and commercial banks. The markets know this. This is one for the healthcare sector and governments.
If the virus does not fizzle out soon, then it is going to come down to ever more stringent social restrictions until a vaccine emerges, and that could be 12 to 18 months away. Waiting that long would be a big ask for the global economy, capital markets and the eurozone.
