Italy's alarm over reform of euro zone bailout fund may be overblown

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© Reuters. Italy’s alarm over reform of euro zone bailout fund may be overblown

By Jan Strupczewski and Gavin Jones

BRUSSELS/ROME (Reuters) – A political storm has erupted in Italy over reform of the euro zone’s bailout fund, known as the European Stability Mechanism (ESM).

The main government and opposition parties, as well as the Bank of Italy, say the reform could hurt market confidence in Rome’s debt and potentially make a debt restructuring or even default more likely.

Here are some questions and answers on the reform:

WHAT IS THE AIM OF THE REFORM?

The role of the ESM is being expanded to include backing up the European Single Resolution Fund (SRF) for banks in case the SRF runs out of cash in a particularly large bank crisis.

Under the reform, the fund would assess a government’s ability to repay loans if it asked for a bailout and, if requested by governments, it would act as a mediator with investors in the case of a debt restructuring.

It would also, from 2022, oblige countries to issue bonds with conditions attached, known as “single-limb Collective Action Clauses,” which would make debt restructuring easier.

DOES IT MAKE DEBT RESTRUCTURING MORE LIKELY?

The introduction of single-limb CACs in all euro zone bonds will help prevent holdout investors blocking a debt restructuring to get a better deal. This would make a restructuring more orderly and predictable, but not, on the face of it, more likely.

“There is evidence – we looked at that very carefully – that the introduction of such CACs does not have any negative impact on bond markets,” the head of the ESM Klaus Regling has said.

Neither should the ESM’s role as a mediator in case of a debt restructuring make such an event more likely. The ESM can only act on the request of the government in question and on an “informal, non-binding, temporary, and confidential basis,” according to the proposed change.

Some Italian critics argue the very mention of debt restructuring for private investors — so-called private sector involvement — in the ESM treaty could trigger market panic. The ESM treaty does contain a paragraph which says:

“In exceptional cases an adequate and proportionate form of private sector involvement, in accordance with IMF practice, shall be considered in cases where stability support is provided accompanied by conditionality in the form of a macro-economic adjustment program.”

But it has been there since 2012 and has caused no panic.

WHY IS ITALY UPSET?

Part of the furor may be political opportunism to attack the government. Matteo Salvini, leader of the hard-right League party, says approving the reform “would mean ruin for millions of Italians and the end of our national sovereignty.”

The League says the reform means Italy will only be able to obtain ESM funds if it agrees to restructure its debt. The reform does not entail this automatic conditionality.

However, Italy’s central bank chief Ignazio Visco, its banking lobby, and prominent Italian economists have also expressed concerns.

Visco warned of the possible psychological effect on markets of any debt restructuring mechanism. This could “trigger a perverse spiral of expectations of default, which may prove to be self-fulfilling,” he said in a speech last week.

Giampaolo Galli, former chief economist of employer’s lobby Confindustria, warned parliament that making debt restructuring “too easy” could have “very negative contagion effects on the whole euro zone.”

The issue of debt restructuring is particularly sensitive in Italy. Its public debt, at around 135% of gross domestic product, is proportionally the highest in the euro zone after Greece’s, and its sustainability is often questioned at times of rising bond yields.

WHEN WILL THE REFORM COME INTO EFFECT?

The ESM reform was broadly agreed politically in June, and is due to be endorsed by euro zone leaders at their summit in December. The updated ESM treaty will then have to be ratified by all 19 euro zone parliaments, which is likely to take a year.

WHY THE ALARM NOW?

Italy has woken up to the fact that euro zone governments will sign off on the reform next month, meaning there is little time left to try to block or change it. In addition the League, now in opposition, can gain political capital by attacking the government over the reform. The League was in power until August, when it quit the coalition.

CAN ITALY VETO THE REFORM?

As with every treaty change, the ESM reform requires unanimity and so Rome can veto it, even if it agreed to it in June. But that would mean also rejecting the ESM’s role as a backstop for the bank resolution fund, which Italy wants.

WHAT DOES IT MEAN FOR BROADER EURO ZONE REFORM?

Because the ESM reform is part of a bigger package of steps for deeper euro zone integration, Italian reticence about changes to the ESM may be linked to the parallel discussion on making euro zone banks more stable by limiting their exposure to a single sovereign and attaching risk weights to sovereign debt.

This is anathema to Rome, because most of Italy’s sovereign debt, the biggest in Europe in absolute terms, is held domestically by financial institutions and households.

Prime Minister Giuseppe Conte has said he will only sign off on the ESM reform as part of “an overall package.”