The Italian debt market flashes warning while the Draghi government recedes

Investors are demanding a higher premium for holding Italian debt after Prime Minister Mario Draghi offered his resignation in response to a major breach of a key component of his cross-party national unity government.

Draghi’s resignation was rejected by the country’s president late Thursday, sparking uncertainty over whether the former head of the European Central Bank will remain in office or whether an early election is just around the corner.

The prime minister is due to speak in parliament next Wednesday.

In light of the political unrest, the gap in 10-year borrowing costs between Italy and Germany, which is seen as a key measure of risk, hit a level of one month on Friday morning. The spread widened as German Bunds, a regional haven, rose sharply, pushing interest rates down.

The rising spread between Italy and Germany – which hit 2.19 percentage points on Friday morning – highlights investors’ growing concern about politics in Rome at a time when the country is also facing rising economic risks.

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

The distance is still below the highs reached in June before the ECB announced it was working on an “anti-fragmentation” program, but Rabobank analysts said Italian spreads have now entered the “danger zone” of 2- 2.5 percentage points, which has led to oral intervention by the ECB in the past. “

Italy’s political crisis erupted on Thursday after the populist Five Star Party boycotted a parliamentary vote on a package of 26 billion. euros to help families affected by rising food and energy prices.

Although the measure was passed by parliament by a comfortable majority, Draghi had always said he was only willing to lead a broad, cross-party national unity government to secure support for an economic and social reform program to lift Italy’s long-term growth path.

Italy has committed itself to implementing the reform agenda in order to gain access to its € 200 billion share. EUR 750 billion of the EU’s EUR Covid Recovery Fund. Lifting Italy’s long-term growth path is also crucial to ensuring the sustainability of its government debt, which is over 150 percent of the country’s GDP.

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

Members of Italy’s business community are also appalled by the development, which comes at a time when the country’s economic prospects have weakened due to the fallout from the war against Ukraine.

Italy’s next election will be held in the spring, but an early election after a government collapse would complicate the preparation of the new budget for the autumn.

“Regardless of the internal disagreements, it is simply pointless to pull the plug on a government that was at the end of the road, from a business point of view,” said a top executive in Milan, who spoke on condition of anonymity.

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