July 1, 2018

Italian Economic Autonomy – What this means for the Eurozone and the Markets

Italy’s newly formed government is a coalition between two populist parties: Lega Nord (the Northern League) and Movimento 5 Stelle (the Five Star Movement). This coalition is floating the idea of issuing the “mini-BOT,” which would amount to a parallel currency to the Euro. In order to understand how this could work, let’s first look at the BOT.

The BOT: What It Is and What It Is Not

The BOT is Italy’s Treasury bill and is similar to the U.S. Treasury bill. The mini-BOT would also be a form of government debt, but it would pay no interest and never mature. The idea is the Italian government would issue the paper mini-BOTs to pay social benefits. While private businesses could accept them, they would not be compelled to do so.

Why Would Anyone Want a Mini-BOT?

In order to issue mini-BOTs, there needs to be a buyer. So why would someone buy a financial instrument that doesn’t bear interest and isn’t widely accepted as legal tender? Well, the government plans to allow both businesses and individuals to use mini-BOTs to pay taxes – and the mini-BOTs would be sold at a discount to their face value.

Thanks for Nothing

In order for the mini-BOT to function as a parallel currency, there needs to be some other mechanism for it to circulate within the broader economy. Since mini-BOT holders could pay taxes at a discount, there’s an arbitrage opportunity. Traders would appear almost immediately and set up a system where social benefit payment recipients could trade their mini-BOTs for euros at a 3 percent to 12 percent discount from the face value of the mini-BOT itself.

How the Government Benefits

The Northern League sees the mini-BOT as a method to move away from the euro and back into an independent Italian currency, while the Five Star Movement sees the opportunity to spend more without taking on debt in euros, thereby detaching Italy from the Eurozone.

The coalition is looking to add about $180 billion euros to the deficit through tax cuts, increased spending or a combination of both. Italy already has the second highest debt of any government in the region (about 132 percent GDP), so the mini-BOT serves as a financing workaround to eurozone rules, making the proposal serious. As a result of the arbitrage trade, the mini-BOT could serve as a euro alternative for numerous transactions. Since it wouldn’t be a formal currency, there is little the eurozone could do to stop it.

Leverage Italian Style

If the mini-BOT gains traction, the Italian government can increasingly finance deficit spending without breaking any rules of the eurozone, ultimately debasing the Euro. This would force Germany to leave, fracturing the eurozone and everything that goes along with it.

How far the new coalition wants to push things is still uncertain. The real crux of the matter is whether Italy is considered too big to fail given that it’s the third largest economy in the eurozone. If the eurozone and European Central Bank believe Italy is indeed too big to fail, then it’s likely exceptions will be made to allow the increased deficit spending.

Certainly, there are populist politicians in both the Northern League and the Five Star Movement who would love to exit the eurozone, while others may simply see the mini-BOT as a way to garner concessions from the European Central Bank.

Fast and Furious

The recent Italian political upheaval has already impacted the broader European markets with the yields on Greek, Spanish and Portuguese bonds rising. Investors are seeking to get compensated for the risk of loans not being repaid by these specific governments even though they aren’t the ones looking to do more deficit spending.

Greece attempted to threaten something similar back in 2015, but it failed. Italy’s populist politicians have likely learned from Greece’s attempts. If Italy decides to move forward, it would probably do so without warning since implementing the plan could set off capital flight. Basically, we could all wake up one day to learn that a new Italian currency is being established; Germany is no longer part of the eurozone; and the markets are tanking.

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