A euro crisis, again: Italy's stand-off poses questions about EU's future

Europe appeared to be doing a lot better until very recently. Growth had returned to the euro zone, many of its most troubled economies were on the road to recovery, and the European project itself looked more secure after Brexit reminded voters across the continent of the value of the EU. Yet that hard-won stability has now been threatened by a crisis in Europe's third largest economy, also the world's eighth largest. Italy has been the weak link since the southern European nation held elections in March that once again saw forces of the centre lose ground to populists, many of whom are openly dismissive of European ideals and institutions. Months-long attempts by the country's famously fractious parties to form a government collapsed over the weekend, when President Sergio Mattarella refused to accept the proposed government's nomination of a Eurosceptic economy minister. The president is the custodian of Italy's international obligations; but his decision, while apparently closing the door on Western Europe's first openly populist government, has nevertheless opened the door to an election in which right-wing extremists could win even more power.

The president's choice of caretaker prime minister has infuriated many, since it seems like a major slap in the face for those who voted for a populist alternative — he has nominated a former IMF official who is known as “Mr Scissors” in Italy because of his commitment to unpopular austerity policies. He is unlikely to have the time or space to initiate the deep structural reforms that Italy needs. The country has an excess of red tape, high taxes, low growth of about 1.5 per cent, youth unemployment at 30 per cent and debt at 133 per cent of GDP.

Certainly, fear of what could follow a snap election has convulsed markets. Though unlike Greece, Italy is too big to fail and too big for a bail-out, but Italian government securities began to look a lot more like Greece's in just a few hectic hours. They fell the most since the euro was set up, as investors predicted that the re-energised populists would sweep back into power and seek to leave the euro zone. The question is whether, as during the last euro crisis, this will predate a global retreat to lower risk. European equity lost value, as investors moved their funds into US and British sovereign debt. Liquidity vanished from the market as major market makers retreated. All of southern Europe appeared in crisis: in Spain, Prime Minister Mariano Rajoy's date with a no-confidence motion in parliament sent yields soaring as well.

If political risk is back as a determinant of investors' attitudes to Europe — the world's largest economy — then the implications for emerging markets and for India, in particular, are clear. It is an unfortunate fact that a flight to safety might affect emerging market securities as collateral damage. Already, in the past two months, investors have sold $7 billion worth of Indian stocks and bonds. There is every reason to fear that the process might intensify. For India, meanwhile, this should serve as a reminder that troubles in Europe, the country’s largest trading partner, can easily spill over into problems for local companies and workers.