What Are The Implications Of Italy Leaving The Eurozone?

The mere threat of Italy leaving the European Union and the euro currency area roiled the world's financial markets following the victory of "eurosceptic" populist political parties of the both the right and the left in parliamentary elections in early March.^[1]

While these parties have yet to form a government—and indeed may never get the chance—the possibility of an "Italexit" has concerned many people.

But how realistic is it? And what would happen if it did become reality?

Bigger Than Brexit?

If Italy did choose to leave the EU, it would be the second large country—and the second of the four largest in the EU—ƒto do so in the past two years. In June 2016, U.K. voters elected to leave the EU, with the "Brexit" process expected to take several years to complete.^[2]

The prospect of an Italexit is seen as a much bigger issue because Italy is also a member of the euro currency union, while the U.K. is not. Also, Italy is the third largest economy in the eurozone, behind only Germany and France.^[3]

Therefore, Italy's exit would have much wider and more deeply felt implications, not just in western Europe but throughout the world. That's because the euro is the second-most widely used currency in the world after the U.S. dollar, as nearly 340 million people use it every day in 19 of the 28 EU member nations.

"If [Italy] left the Union, there would be a storm in the markets," Lorenzo Codogno, former general director at the Treasury Department of the Italian Ministry of Economy and Finance, told the U.K. Express newspaper.^[4] "Italy would suffer but Europe would also be hugely affected. Italexit would be something very difficult to manage for the EU, so the bloc would do anything to make the country remain."

"If Italexit were to happen, I think it would be reasonable to imply that the EU in its current form would be under threat and would be failing to prove its essentiality," added Guy Shone, a market analyst and CEO at global research firm Explain The Market.

Referring to Brexit, Codogno said: "Leaving the eurozone poses a much greater problem than walking out of the bloc," i.e., the EU only. Italexit would be "complicated enough to threaten the survival of the single currency," Express reported.^[4]

The Euro's Biggest Crisis

Italy leaving "would present the eurozone with its biggest crisis to date," according to The Economist Intelligence Unit.^[5] "The macroeconomic impact on Germany would be modest," but the impact on France, whose banks "have considerable exposure to troubled Italian banks," would "be felt keenly across the domestic, corporate and financial sectors."

According to The New York Times' chief diplomatic correspondent in Europe, Steven Erlanger, an Italian withdrawal from the currency zone would seem "unlikely." However, he wrote that "the mere prospect is more dangerous to the future of the European Union than the bailout of Greece, whose economy is dwarfed by Italy's, [or] Britain's vote to leave the bloc."^[6]

"The consequences of leaving [the eurozone] would be big," Erlanger added. "Those would be likely to include a devalued Italian currency that would savage Italian savings accounts overnight and increase the country's already large burden of debt. Then there is the potential damage to the European Union itself."

While the "currency would almost surely survive an Italian exit and manage the economic contagion," Erlanger wrote, "the damage to the idea of Europe would be severe."

Italy's national debt is more than 30% larger than its GDP, which is more than double the eurozone's limits, and all of it is in euros. "Having to repay that debt in a devalued currency would be a major struggle and would badly harm Italian savers and investors, who hold most of it," Erlanger reported.

Are There Benefits To "Italexit?"

There might be one benefit to Italy dropping the euro and creating a "new, weaker currency," presumably the lira, according to Wall Street Journal market reporter Chelsey Dulaney. It "could help Italy become more competitive by making its exports cheaper," she wrote.

However, that would likely be more than offset by the "cost and complexity of such a move" and make it "more expensive for the country to pay back its €2.3 trillion in debt and raise the risks that it is forced to default," Dulaney added. She continued to write that "Italy's economy would also come under pressure as a devaluation would send inflation higher by raising the cost of imports."^[7]

But how likely are these scenarios to even take place?

Maartje Wijffelaars, a senior economist at Rabobank, dismissed Italy's threat to leave the eurozone as "empty." Even if the country was dead serious about leaving the zone, which is itself questionable, it would take years before it could accomplish that. "They would need to change Italy's constitution, which is a very lengthy process—we're talking about years with almost certainly a referendum at the end of the process," she said.^[8]

"I don't think the euro is at risk, Wijffelaars added.

Indeed, many observers believe that Italian politicians will eventually back off the edge of the precipice, just as Greece did several years ago when it threatened to leave the eurozone but didn't.

"I think they realise—at least the current leadership—that a confrontational approach to the EU and the markets is ultimately self-defeating," Federico Santi, Europe analyst at Eurasia Group, told CNBC.^[8]

Summary

Several populist "eurosceptic" political parties who support Italy leaving the European Union and the euro currency zone won the country's March 2018 parliamentary elections, which has unsettled financial markets. Italy is the fourth-largest economy in the EU and the third largest in the eurozone, so its exit could have a huge impact on both regions and the greater world financial markets.

However, those parties have yet to form a government, and even if they did, it's not certain they would carry out their anti-EU and anti-euro agendas, much as happened in Greece. If they did decide to carry them out, it would likely take years to accomplish.