Italian debt market flashes warning as Draghi government teeters

Investors are demanding a higher premium to hold Italian debt after prime minister Mario Draghi offered his resignation in response to a major rift with a key constituent in his cross-party national unity government.

Draghi’s resignation was rejected by the country’s president late on Thursday, sparking uncertainty about whether the former head of the European Central Bank will remain in office, or whether early elections are around the corner.

The prime minister is due to address parliament next Wednesday.

Against that backdrop of political turmoil, the gap in 10-year borrowing costs between Italy and Germany, seen as a key measure of risk, hit a one-month high on Friday morning. The spread widened as German Bunds, a regional haven asset, rallied strongly, pushing yields lower.

The widening Italy-Germany spread — which hit 2.19 percentage points on Friday morning — highlights investors’ growing worries over politics in Rome at a time when the country also faces rising economic risks.

The ECB is expected on Thursday to lift interest rates for the first time in a decade. The prospect of higher borrowing costs has raised concerns over so-called fragmentation risk in the eurozone — a divergence in the yields of heavily indebted southern European economies with their northern peers.

The gap still remains below the highs reached in June before the ECB announced that it is working an “anti-fragmentation” programme, but Rabobank analysts said Italian spreads have now entered “the ‘danger zone’ of 2-2.5 percentage points that has prompted verbal interventions from the ECB in the past.”

Italy’s political crisis erupted on Thursday after the populist Five Star party boycotted a parliamentary vote on a €26bn package to help families hit by rising food and energy prices.

Although the measure was adopted by parliament with a comfortable majority, Draghi had always said that he was only willing to lead a broad, cross-party national unity government to ensure support for an economic and social reform programme intended to lift Italy’s long-term growth trajectory.

Italy has committed to carrying out the reform agenda in order to access its €200bn share of the EU’s €750bn Covid-recovery fund. Lifting Italy’s long-term growth trajectory is also critical for ensuring the sustainability of its government debt, which is over 150 per cent of its GDP.

“Draghi’s departure from the political scene and snap elections would be a clear negative for Italy and the EU,” said Ludovico Sapio, economist at Barclays. He added that Italy would not benefit from the ECB’s anti-fragmentation tool “if its financial conditions deteriorate due to political developments”.

Members of Italy’s business community are also aghast at the developments, which come at a time when the country’s economic prospects have dimmed due to the fallout from the war on Ukraine.

Italy’s next elections are due in spring, but early elections, following a government collapse, would complicate the preparation of the new budget in the autumn.

“Regardless of the internal disagreements, pulling the plug on a government that was at the end of the road is simply nonsensical from a business standpoint,” said a Milan-based chief executive who spoke on condition of anonymity.