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If the coronavirus leads to another financial crisis, it might start in Italy

People in Rome stand Wednesday outside a pharmacy, one of the types of businesses allowed to remain open in Italy amid a wide-scale lockdown due to the coronavirus. (Geraldine Hope Ghelli/Bloomberg News)

If the coronavirus causes a new global financial crisis, it may start with an Italian bank.

Already, Italy’s economy has been brought to an abrupt halt by the nationwide quarantine officials imposed earlier this week in hopes of arresting the worst outbreak of covid-19, the disease caused by the virus, outside of China.

The Italian government on Wednesday tightened the lockdown, announcing that all stores, except for pharmacies and groceries, will be required to close. As commercial activity ceases in the world’s eighth-largest economy, the risk of a broader contagion may turn on how well Italy’s banks — long regarded as Europe’s weakest — withstand the test.

Cash-strapped businesses and households may stop repaying their bank loans. At the same time, the government bonds that make up a big chunk of bank assets may lose value as Rome’s costly anti-crisis spending spooks investors. That would erode banks’ capital reserves and crimp their lending, further slowing the economy.

On Thursday, the European Central Bank announced in Frankfurt measures designed to bolster Europe’s slow-growing economy against the debilitating effects of the virus. ECB President Christine Lagarde warned the union’s political leaders on a conference call this week that they would face a 2008-style financial crisis if they failed to launch coordinated actions.

The ECB said it would increase its bond purchases by 120 billion euros through the end of this year and approved a new lending program for banks designed to funnel cheap money to European businesses. The ECB surprised investors by opting not to further cut interest rates.

At a press conference following the meeting, Lagarde said the ECB would “use all the tools available” to combat the worsening economic outlook. And she called for countries that use the euro to launch “ambitious and collective" spending programs to boost growth, saying that governments’ fiscal efforts should be the “first and foremost” response to the crisis.

”It is clear the economies of the world and certainly the economies of the euro area are facing a major shock," she said.

The high-level ECB meeting came as worries about Italian banks are becoming evident.

Since mid-February, the interest rate or yield that Italy pays on its government bonds has risen even as countries such as the United States and Germany have seen their borrowing costs fall. Likewise, investors now must pay twice as much to insure their government securities against a potential Italian default.

As Italy’s stock market fell more than other European exchanges, Italian bank stocks were among the biggest casualties. Shares of UniCredit, the nation’s largest bank, plunged over the past month by 39 percent. Some analysts now worry about a “doom loop” where doubts about the finances of Italy’s government and banks feed on each other in a vicious circle.

“It’s a pretty significant downside risk,” said Neil Shearing, chief economist for Capital Economics in London. “It’s easy to see things unravel quickly if the shock to the economy is bigger than expected.”

Most analysts do not yet anticipate the virus leading to the sort of global financial tumult that shaved $15 trillion off Americans’ net worth in the 2008-09 crisis. Global banks are healthier, having been forced by regulators in the United States and Europe to hold more capital in reserve and to refrain from some of the riskiest practices that fueled the housing bubble.

But dangers lurk in some corners of the industry. China over the past year has witnessed a number of bank closures and depositor runs. With the country’s economy slowing sharply, an accumulation of nonperforming loans could become a bigger headache.

Long regarded as Europe’s weakest financial institutions, Italy’s banks have thinner capital cushions than the average continental bank and hold more than twice as many bad loans. The banks as a whole own about one-quarter of Italy’s $2.4 trillion outstanding government debt, linking the fate of the country’s financial institutions and its government in a way that could prove destabilizing in a sharp downturn.

Italian authorities also may be less capable of managing a sudden banking crisis than their counterparts in China, where the government and the banking system both answer to the Communist Party. That’s one reason Shearing calls Italian banks “the weakest link in the global chain.”

The Italian economy has disappointed for years. In real or inflation-adjusted terms, the average Italian earns no more today than 20 years ago. The economy stagnated last year and is expected to shrink by 2 percent this year, according to Shearing.

Covid-19 pushed Italy from slow growth to no growth. Meanwhile, the outbreak continues to escalate, with more than 2,000 new cases and more than 200 deaths reported Wednesday. That brought the total to 12,462 patients and 827 deaths, according to the Center for Systems Science and Engineering at Johns Hopkins University.

Italian Prime Minister Giuseppe Conte said this week the government would allocate 25 billion euros (more than $28 billion) to bolster the economy from the escalating toll — more than three times the sum set aside just one week ago.

Last week, the European Union approved Italy’s spending plans, which violated the union’s budgetary rules for countries that use the euro. That move came less than three months after Brussels chided Italian officials for their profligate ways.

The Italian government says it plans a mortgage payment holiday, which should help businesses and consumers, although it may require public aid to make up the loss to banks. But officials have yet to provide details.

As it hikes spending to offset the economic slowdown, Italy’s debt — at 135 percent of gross domestic product, second only to Japan among major economies — is certain to rise.

Ashoka Mody, a former International Monetary Fund official who designed the 2009 international bailout of Ireland’s banking system, said investors will push up Italy’s borrowing costs and precipitate a debt crisis over the next several months.

In its annual review of the Italian economy, the IMF warned last year that an Italian crisis would inevitably spread. “Spillovers from heightened stress in Italy would be global and significant,” the fund said, adding that “acute stress in Italy could push global markets into uncharted territory.”

If Italy were downgraded to junk status — which the fund said would be “unprecedented” for an advanced economy — losses would spread through financial markets. Banks in France, Spain, Portugal and Belgium all hold substantial amounts of Italian government debt, according to the fund.

To head that off, Italy will need a financial rescue that could cost 700 billion euros (roughly $800 billion), Mody said. And ECB, IMF and U.S. Treasury officials should act before the situation worsens.

“The international community has to come with bags of money,” said Mody, now an economics professor at Princeton University. “[The Italians] are dealing with a humanitarian crisis. But the fact of dealing with a humanitarian crisis is going to create a financial crisis.”

For now, despite the recent increase in government bond yields, Italy’s borrowing costs remain low by historic standards. And not everyone is downbeat about its prospects for navigating the coronavirus crisis.

Jacob Kirkegaard, an economist at the Peterson Institute for International Economics, said the Italian banks that are important to the global financial system — UniCredit and Intesa Sanpaolo— have adequate capital reserves to ride out a recession.

Financial weakness is concentrated in Italy’s regional banks, which lack the same links to global finance.

“Yes, there will be a hit to the banks,” Kirkegaard said. “But it’s not fair to say that Italian banks are uniformly weak.”

Investors hope the ECB on Thursday unveils aggressive measures to combat the pandemic’s economic costs. The Bank of England on Wednesday cut its lending rate by half a percentage point, following a similar move by the Federal Reserve earlier this month.

After more than a decade of crisis and weak economic performance, however, the ECB is almost out of ammunition. Its main bank lending rate is already at zero.

The action in Frankfurt is a reminder that Italy’s plight may soon be Europe’s. The number of patients in countries such as Germany and France remains modest, but is expected to multiply. German Chancellor Angela Merkel on Wednesday said up to 70 percent of Germany’s 83 million citizens could eventually be infected by the disease.

“We could have a situation over the next couple of months where more or less the entire eurozone economy is shut down, that is, just growth collapsing completely,” Claus Vistesen, an economist for Pantheon Macroeconomics, told clients Wednesday.