Italy is now the epicenter of COVID-19 in Europe, with 1,835 cases – 272 of which were added on March 2.

The outbreak is centered on the northern of Lombardy and some 50,000 people in 11 towns are currently under lockdown. It has led to the cancellation of major events, such as portions of the Venice carnival, Milan Fashion Week, the Bologna Marathon, and several Serie A football matches.

The closures come at a significant economic cost; in the case of the tourism industry, one that has an immediate and severe impact on small businesses. And given Italy’s weak fundamentals even before COVID-19 hit, there’s a lot more pain to come.

Analysis

Two economic vulnerabilities predate the arrival of the coronavirus: excessive sovereign debt and an economic contraction to close out 2019.

As per last week’s article on how COVID-19 may exacerbate debt risks worldwide: The Italian government presides over a public debt worth 138% of GDP. Of this debt, around 17% (400 billion euros) is held by Italian banks and 20% (450 billion euros) by foreign banks. The fiscal risks inherent to such excessive debt levels have long been obscured by robust investor appetites for Italian debt, which is a stand-out among otherwise negative-yielding euro zone alternatives. According to Reuters, nearly half of all positive-yielding euro area debt is issued by Italy, and there has been a glut of buying in the early months of 2020, which served to drive yields down by as much as 50 basis points through January. One strategist at ING described Italian debt as “Bunds on steroids” just two weeks ago.

However, the COVID-19 outbreak is acting as a wake-up call, and borrowing costs have now begun to creep upward as investors reassess the risks. Last week, yields on Italian 10-year bonds were up by 20 basis points – the biggest weekly increase since October.

The Italian authorities do not have the luxury of fiscal wiggle room to work with, and a run on Italian debt could bring lending to a grinding halt in the Italian financial system, which would have obvious run-on consequences in the wider euro zone.