While the ECB rate rises, Italy is considered the eurozone's weakest link

According to experts, Italy is the eurozone country most vulnerable to a debt crisis as the ECB rises interest rates and purchases fewer bonds in the coming months.

Italy is the eurozone country "most at risk of an uncorrelated sell-off in its government bond markets," say 9 out of 10 economists who took part in a poll.

The right-wing coalition administration of Italy, led by Prime Minister Giorgia Meloni, is making an effort to maintain fiscal rectitude. It has budgeted for the fiscal deficit of the country to decrease from 5.6% of GDP in 2022 to 4.5% in 2023 and to 3% the following year.

Italian state debt, however, is still among the highest in Europe, at just over 145% of GDP. The country is particularly vulnerable to a sell-off in bond markets, according to Marco Valli, chief economist of the Italian bank UniCredit, because of its "higher debt refinancing needs" and "potentially tricky" political scenario.

Since the European Central Bank started raising interest rates last summer, Rome's borrowing costs have increased significantly. Last Monday, the 10-year bond yield surged beyond 4.6%, nearly quadrupling from a year earlier and 2.1 percentage points higher than the comparable yield on German bonds.

Meloni has expressed shock at the ECB's willingness to keep raising rates in the face of concerns to financial stability and economic development. At a news conference last week, she stated, "It would be useful if the ECB handled its communication well . . . otherwise it risks generating not panic but fluctuations on the market that nullify the efforts that governments are making."

Veronika Roharova, head of euro area economics at Swiss bank Credit Suisse, stated that the new Italian government had "given investors few reasons to worry for now." However, she continued, "concerns could resurface as growth slows, interest rates rise further and [debt] issuance picks up again."

In the early months of this year, the ECB rate-setters have declared they will keep raising rates by half-point increments. The governor of the Dutch central bank and one of the council's hawks, Klaas Knot, told the Financial Times that the central bank has only just started the "second half" of its cycle of increasing interest rates.

Analysts contend that the ECB is underestimating the possibility of a recession while overestimating the risks to inflation. At the weekend, IMF managing director Kristalina Georgieva predicted that this year will see a recession in half of the EU. The ECB is expected to stop rising rates in the first half of 2023, according to two-thirds of the 37 economists surveyed  in December, and begin reducing rates the following year in reaction to weaker growth.

They estimated that, on average, the ECB's deposit rate would peak at just under 3%, which is lower than the figure on which investors are speculating, as shown by the cost of interest rate swaps.

Britain would see one of the worst recessions and slowest recoveries in the G7 in 2023, according to a separate poll of more than 100 prominent UK economists.

In order to combat inflation, which has soared to multi-decade highs in many countries as a result of rising energy and food prices following Russia's invasion of Ukraine and the lifting of the coronavirus pandemic lockdowns, central banks throughout the world have been drastically boosting interest rates.

The ECB started rising rates later than many western central banks, but since last summer it has tightened policy at a record-breaking rate, increasing its deposit rate from minus 0.5% to 2% in just six months.

Jesper Rangvid, a finance professor at Copenhagen Business School, stated that the ECB was "too slow [in] recognising that inflation was not temporary, but is now getting up to speed. I am still afraid, though, that ECB will not tighten enough because of troubles this would cause in Italy." 

By just partially replacing aging securities, the ECB is scheduled to begin reducing its €5 trillion bond portfolio by €15 billion per month starting in March, further driving up Italian borrowing prices. The eurozone runs the risk of experiencing another bond market collapse, according to senior economist Ludovic Subran of the German insurance company Allianz, "as fiscal capabilities are different across countries without the ECB's heavy lifting."

The ECB has come under fire from Italian cabinet ministers for its aggressive monetary tightening. While deputy prime minister Matteo Salvini said that increased rates "will burn billions in Italian savings," defense minister Guido Crosetto claimed that the ECB's policy "made no sense" on Twitter.

Italy's "high stock of debt, elevated fiscal deficit and need of additional energy support measures . . . makes markets very concerned," according to Silvia Ardagna, chief European economist at UK bank Barclays.

The transmission protection mechanism, a new bond-buying program launched by the ECB, is intended to combat an unjustified increase in a nation's borrowing costs. The FT polled economists in December, and more than two-thirds of them stated that they thought the ECB would never use it.

A deeper recession than anticipated might "put high-deficit, high-debt countries under even more pressure," according to Mujtaba Rahman, managing director for Europe at the consulting firm Eurasia Group. She also noted that this would "probably make for a softer path for monetary policy by the ECB." By fLEXI tEAM