Italy's upheaval set to wreck Mario Draghi’s party

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Poor Mario Draghi. For once, almost everything seemed to be going in the European Central Bank President's favour. Thanks to quantitative easing, the deflation threat had disappeared and inflation was coming back. Euro zone bank shares were soaring, growth was rising and unemployment falling. Brexit? Who cares.

And then, ever so rudely, came Italy – Mr. Draghi's home country, no less. Rather suddenly, Italy has replaced Greece as the biggest threat to the integrity of the euro zone and possibly the whole European Union. The fateful moment came at midnight, Dec. 4, when Italian prime minister Matteo Renzi, Secretary of the centre-left Democratic Party, resigned. His self-immolation came shortly after the referendum on constitutional change went overwhelmingly against him.

The referendum's outcome, in itself, was not the problem. The problem was the No vote's main beneficiary was the Five Star Movement (M5S), the anti-establishment party that had urged Italians to vote No and had its wishes fulfilled. Mr. Renzi was M5S's biggest kill, confirmation of its rising popularity at the expense of the centrist parties.

A few years ago, M5S founder, the comedian Beppe Grillo, and his band of misfits and dreamers were considered unelectable. Today, M5S is the main opposition party in the Italian parliament, the Chamber of Deputies, is leading the polls and is calling for a quick election in the belief the great populist moment in the Italian sun has arrived. It has vowed to hold a referendum on the euro if it gets elected, a scenario that has no doubt terrified Mr. Draghi, his counterpart at the Bank of Italy and the Italian Finance Minister Pier Carlo Padoan, who is trying to spare Monte dei Paschi di Siena (MPS), the country's third-largest bank, from destruction.

A Euroskeptic government in the third-largest euro zone economy would be grim news for the euro zone and exceedingly grim news for the Italian economy and its banks. An election could be called as early as spring 2017, after Italy overhauls its election law.

Would you leave your euros with an Italian bank if you thought there was even a small chance they would be converted into liras, and immediately devalued, under an M5S government? To play it safe, you might send your euros to, say Germany, and that appears to be happening already. At least that is what the ECB's so-called Target2 system is saying.

Target2 is the real-time settlement system operated by the ECB and the national central banks, collectively known as the Eurosystem. Its role, a mystery to mere mortals, is to balance out payment surpluses and shortfalls by shifting funds between national banks. Suppose you live in Italy and need to put a €5,000 ($6,970) deposit on a Mercedes that you bought in Germany. The Bank of Italy will record that transfer as a Eurosystem liability and the German central bank will record it as a credit.

A surge in any central bank's Eurosystem liabilities suggests capital is leaving that country. The Bank of Italy's soaring liabilities suggest something close to financial distress, perhaps full-blown distress, is gripping the Italian economy and financial system (interpretations vary, but there is no positive interpretation).

According to the ECB's Target2 balances, Italy's Eurosystem liabilities at the end of October (the latest date available) were €355.5-billion, a record high and equivalent to almost 20 per cent of Italian gross domestic product. The trend is even more worrisome. In May, Italy's liabilities were €276.2-billion. They have climbed 22 per cent since then. Italy's loss appears to be Germany's gain. Germany's credits to the Eurosystem were €708-billion in October, up from €655.5-billion in May.

Why are Italy's Eurosystem liabilities shooting up so much? It could be that investors and bank depositors think Italy's banking system, a reflection of the country's economic condition, is in rough shape. Italian banks are, in fact, laden with the highest level of impaired loans in the EU, at €360-billion, compared with only €225-billion of equity on the their books. MPS is the undercapitalized basket case and may have to be bailed out or nationalized by the state any day.

Since the previous Target2 data were assembled, Italy has gone through a referendum and a change of prime minister. While the political panic is over for the moment – a caretaker government under former foreign minister Paolo Gentiloni is in place – M5S is spoiling for an election. So is the other big, Euroskeptic (and blatantly xenophobic) opposition party, the Northern League. The most recent poll, published by Ipsos, put M5S at 31.5 per cent against 29.8 per cent for Mr. Gentiloni's Democratic Party.

Italy, in other words, could soon be home to the EU's first populist, Euroskepic party. If the polls keep going in M5S's favour, more money will leave Italy. There could be a bank run ahead of the elections and the only way to stop a bank run is through capital controls. Greece slapped them on its banks in the summer of 2015, after the government lost its battle with the country's bailout lenders and the economy ground to a halt within hours.

With M5S poised to win the next election, a capital flight and bank controls are no longer unthinkable. Italy is on knife's edge and could, in 2017, wreck Mr. Draghi's party – the euro zone, too.