Italexit: 9 questions and answers to the Italian crisis and potential euro-exit

• Italy's political crisis triggered the worst sell-off of bonds since the height of the crisis and a sharp fall in the EUR/USD.
• Worries about Italexit, Italeave, or an Italian exit from the euro-zone have risen sharply.
• In a series of 9 questions and answers, we attempt to explain the crisis and what may happen next.

Goerge Soros says we may be heading into a major financial crisis as everything that could go wrong went wrong. The billionaire who broke the Bank of England in the early 1990s talked as Italian bond yields experienced their sharpest rise since the 1990s. 

The flight out of Italy is triggered by the risk of an Italian exit out of the euro-zone as the political crisis engulfs the country.

1) How did all this begin?

The elections that Italy held back on March 4th resulted in a hung parliament as no coalition of parties obtained a majority. The center-right block that consisted of Silvio Berlusconi's Forza Italia and the League's Matteo Salvini and the 5-Star Movement led b Luigi di Maio were the biggest blocks. The center-left PD that led governments in recent years lost ground. Talks between the parties and President Sergio Mattarella dragged on slowly with the PD insisting on recovering in the opposition. Speculation about a technocratic government was in the background.

Eventually, the League broke away from Berlusconi and began talks with the 5-Star Movement. The option of such a coalition was always the "nightmare scenario" before the elections. Both parties are anti-establishment, populist, and Euro-skeptic. Together they command a majority in parliament. 

2) Why were markets calm until recently?

Markets were slightly worried after the elections, but other events caught markets and their short attention span. Donald Trump's latest tweets, central bank speculation, and other topics have a broader impact.

Moreover, markets are awash with liquidity as the European Central Bank continues buying bonds at a pace of €30 billion per month. Worries about wages and low inflation have replaced concerns about employment and the debt crisis, especially after France's elections resulted in a resounding victory for the staunchly pro-European Emmanuel Macron.

ECB President Mario Draghi famously said in 2012 that "we will do whatever it takes" to save the Euro and the term "redenomination risk" was shoved off the table, even at the heights of the latest Greek crisis in 2015. 

3) How did the crisis begin?

Markets began paying attention when a draft version of the 5-Star League government plan was published. It included a suggestion that the ECB write off Italian debt worth no less than €250 billion and doubts about the euro-zone.

The final government program did not include these toxic ideas. However, the intention to cut taxes while providing a basic income to all Italians meant a jump in Italy's deficit, breaking European rules. The country already has a debt-to-GDP ratio worth 132%. 

Things slightly calmed when the parties agreed on Giuseppe Conte as Prime Minister. While he has no political experience, he made calming sounds and markets preferred Conte over 5-Star leader di Maio. However, the candidacy of Paolo Savona, an outright Euroskeptic, triggered worries.

4) How did the crisis turn from bad to worse?

Sunday, May 27th, marked a significant deterioration. President Mattarella rejected Savona as Finance Minister saying he could not support someone who would endanger the savings of Italians. In turn, Conte, the Prime Minister-designate, returned the mandate to form a government. Talks about a technocratic caretaker government returned. 

Markets initially cheered on the failure to form a populist government. Italian bonds saw the fresh demand and the Euro jumped. However, the mood soured quite quickly.

Mattarella's move was, in fact, defiance of democracy. The two parties achieved a majority, but they could not nominate a legitimate candidate. Both party leaders doubted that Italy is still a democracy and said that external forces are guiding the country. The message resonated with many, including those that oppose their policies. 

The Italian constitutional crisis will probably lead to new elections in August or September. The two populist parties will likely achieve the same success or even increase their share of the vote. 

Anger against the establishment and the European Union is higher now.

5) What could turn things from worse to terrible?

The 5-Star Movement and the League could win the elections, perhaps running together. They may enact the populist policies with more vigor after the current crisis. This means breaking the rules, enlarging the deficit, and possibly triggering a chain reaction. Countries such as Spain, which has also enacted austerity and is also suffering from a political crisis, could loosen their spending. 

Yet things may get even worse if rating agencies jump into the game. If they downgrade Italy's debt rating to a certain point, the European Central Bank would not be able to buy Italy's bonds according to its rules. While the ECB's bond buys are not substantial as they used to be, the ECB exit would mark a significant deterioration. 

Italian banks are highly indebted, even after improving their balance sheets in recent years. If fear grips Italian citizens, they could begin pulling money out of the banks, just like Greeks did in 2015. Back then, the ECB supplied ELA liquidity to banks in the early months of 2015 but then decided not to enlarge it, thus forcing a closure of the banks by the Greek government. 

A return of the Greek scenario in Italy would be devastating as the magnitude of the Italian economy, 12.5% of euro-zone, is much larger than Greece's 2%. 

6) What could turn things from terrible to existential?

There is no euro-zone without Italy. The nation is a founding member of the project in its original form, and the first treaty was signed in Rome. Italy is the third-largest economy in the euro-zone and the world's 8th largest. 

What could trigger a euro-exit? A Greek-style crisis described above could eventually make an Italian government decide to quit the euro-zone. The parties have always been skeptical of the project. In 2015, German Finance Minister Wolfgang Schäuble wanted Greece to "temporarily" leave the euro area. This is unlikely to be Germany's stance with Italy, but anything can happen.

Another scenario is that Italy's profligate policies are copied by other countries, and eventually Germany gets angry and decides to pull out. The current German coalition is a mainstream, pro-European one, but skepticism about the euro-zone and the EU is rising, and the AfD party which leads the opposition is gaining in opinion polls.

There are many other potential paths to destruction but the Roman Empire did not disappear in one day and neither will the euro-zone. Things can still turn around 

7) How can the crisis be resolved? 

There are many ways to improve the situation. An immediate solution would be the resignation of President Matterella. An undoing of his intervention to block the government may restore faith in the system. 

Another option is that both populist parties moderate. Both have gone from being vehemently Euroskeptic to lighter criticism. With the government program, they also left the more radical options behind. 5-Star Leader said that he never sought a euro-zone exit.

ECB President Mario Draghi may also have a crucial role to play if the crisis deteriorates. The Italian head of the central bank is stuck between a rock and a hard place. As a guardian of European rules, he will be asked to enforce them against his country and risk being called anti-patriotic by his compatriots. As an Italian, he may try to resolve the situation in favor of his country and could draw criticism from other European, mostly from Germany, where the ECB is based. In the past, he has shown great skill in resolving these situations, and it may help again, but this case could become more complicated.

8) How low can the euro go?

1.1000 is the next big round line. SocGen's Kit Juckes said the pair is more likely to head in that direction than back to 1.2000. The next big step is the low of 1.0340 recorded in January 2017, which was the lowest level in over a decade.

The parity line is one that was eyed during the worst days of the crisis and as the US Dollar strengthened after Trump's election. It was last seen around 15 years ago. The lowest level ever was 0.8200, but if the common currency falls all the way to such levels too fast, it will probably disappear altogether and be replaced by each country's local currency - the existential threat worst case scenario.

9) What is the most likely scenario?

The most likely scenario is not a breakup of the euro-zone. While some are talking about it and chances are higher, they are only at 11.3% according to the Sentix Italexit measure that measures the prospect of an Italeave within 12 months. This is a massive jump from 3.6% but still low. 

In addition, the political forces that brought the euro together will do whatever it takes to put out the fire before things become dangerous. 

A quick resolution has higher chances, but these are also low. Matterella's move was the straw the broke the camel's back, but the camel has been beaten. Grievances about elites, immigration, euro-zone bureaucrats and what not have been simmering for years.

The more likely scenario is that in the new round of elections, the two parties gain a majority once again, but once in government, they tame their policies. Moderation has been a recurring pattern, and that is also what happened in Greece. 

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