Italy's opposition to reforming the European Union's permanent bailout fund appears to be largely based on political calculations rather than economic concerns, which means that Rome may approve the EU proposal later this year. Failure to ratify the plan would keep the eurozone structurally more vulnerable than need be to destabilizing financial shocks. On June 28, the Italian parliament voted to delay ratifying reforms to the eurozone's permanent bailout fund, which is known as the European Stability Mechanism (ESM). The proposed reform would expand the ESM's involvement in the rescue of failing banks. But parties within Italian Prime Minister Giorgia Meloni's ruling coalition have long opposed the changes, arguing that they'd increase the risk of public debt restructurings. However, upon taking a closer look at how the plan would actually impact the Italian economy, the pros seem to far outweigh the cons, which suggests Rome is more concerned about the potential political implications than the economic implications. 

• The ESM was established in 2012 as an intergovernmental organization. With a lending capacity of around 500 billion euros, the fund's principal purpose is to provide euro area member states with financial support in case of distress. Since 2014, the ESM has been authorized to provide funds directly to banks rather than just governments, subject to extensive conditionality. 
• The ESM treaty reform was agreed to in 2020-21 and is principally aimed at strengthening the euro area's ability to deal with the destabilizing consequences of banking sector crises. The legislatures of the 19 EU member states that use the euro must all approve the reform in order for it to be ratified. 

The proposed reform would enhance the euro area's ability to deal with banking crises. One of the key aspects of the proposal is the establishment of an ESM-funded financial backstop to the Single Resolution Fund (SRF), the eurozone's emergency fund for banking crises. The change would allow the ESM to lend up to 68 billion euros to strengthen the SRF's capacity to intervene in the event of a major banking crisis, in an effort to prevent it from devolving into a sovereign debt crisis. In doing so, the backstop is also aimed at severing the so-called sovereign-bank nexus, whereby a country's government is forced to step in to rescue its banking sector and incur unsustainably large debt in the process. This part of the reform package is the least controversial among Italian lawmakers, as it contributes to strengthening euro area governance and particularly benefits countries like Italy that have weaker finances and are at higher risk of banking sector distress.

• The SRF offers financial support in the event of systemically important banks getting into trouble. The emergency fund is financed by contributions from banks, not governments, and currently sits on 80 billion euros. It was established in 2015 after major banking crises in Ireland, Spain and Cyprus highlighted how vulnerable the euro area was to financial instability in the event of a systemic banking crisis. 
• The proposed ESM-funded backstop is designed to only be used as a last resort, namely in a situation where the SRF runs out of money and the Single Resolution Board (SRB), which controls the SRF, is unable to raise sufficient contributions or raise additional financing. The reform will allow the ESM to act as a common backstop to the SRF in a way similar to how, in the United States, the Federal Deposit Insurance Corporation (FDIC) has access to a credit line from the U.S. Treasury.

Stabilizing the Euro Area

If approved, the ESM reform would represent a further step toward addressing the inherent fragility of Europe's Economic and Monetary Union (EMU), including euro area architecture. The eurozone's plan to implement a banking union has made little progress in the past few years due to disagreements between creditor and debtor countries, or countries that benefit from a strong financial position and countries whose financial position is potentially weak, with respect to deposit insurance. Creating a backstop to the SRF will further help strengthen the euro area's ability to intervene more decisively during systemic banking sector crises by providing additional funds to recapitalize or resolve banks without burdening the finances of the respective sovereign. But as long as banking union (common deposit insurance) or fiscal union (debt guarantees remain incomplete, monetary union) remain incomplete, the EMU will remain structurally vulnerable to destabilizing financial shocks, whether they emanate in the government or the banking sector. Then again, the euro area has come a long way in terms of strengthening its crisis-fighting ability since the beginning of the Greek debt crisis 15 years ago, including the establishment of the ESM, the SRF and ECB supervision of large euro area banks.

On the surface, Italy's skepticism about the reform stems from concerns about the ESM demanding Rome restructure its sovereign debt in exchange for assistance. The original ESM treaty calls for adequate and proportionate so-called private sector involvement (or restructuring privately held government debt) in case government debt is unsustainable, meaning that a government may be obliged to restructure its debt before being able to access ESM financing. But restructuring is only meant to take place only in exceptional circumstances. The reform proposal does not contain any changes regarding debt restructuring, nor does it make debt restructuring automatic in the sense of making it a precondition for accessing ESM funds. It is true that the ESM may have a prominent role in affecting the design of conditionality and macroeconomic adjustment due to it being in charge of analyzing debt sustainability. This is critical because it affects whether a borrower may be required to restructure their debt before accessing funds. This appears to have some Italian lawmakers deeply concerned that if the reform is ratified, the ESM may demand Italy restructure its debt in exchange for receiving financial assistance. In reality, however, the proposed changes do not present a meaningful change of ESM governance and policies or power, as one way or the other, the ESM (or rather its government shareholders) has to sign off on financing and conditionality, including demands for a debt restructuring.

Italian lawmakers have also argued that proposed changes to the rules and conditions for the ESM's various programs would make it more difficult for Rome to access financial assistance. But the changes only impact the fund's precautionary loans, which Italy may not qualify for due to its weak economic fundamentals. The proposed reforms would slightly tighten access to precautionary lines of credit from the ESM. But they do not make any changes to the fund's non-precautionary programs, which are more relevant (and should thus be of far greater concern) to financially vulnerable countries such as Italy. Italian lawmakers appear to be concerned that these new rules may make it more difficult for their country to access ESM financial support. But the changes only tighten access to precautionary programs very marginally, and again it would not make a difference to a country experiencing significant financial distress, as such a country would still have to request loans that come with macroeconomic adjustment requirements. Indeed, Italy would not qualify for precautionary financial assistance because it is not in compliance with the Stability and Growth Pact, which lays out various debt metrics euro area members are meant to observe. The Italians would surely have liked to see an easing of the conditions governing access to the precautionary credit lines and holding up ESM reform may be a way to express its dissatisfaction. But the ESM reform does not foresee any changes in terms of accessing non-precautionary programs, which more directly impacts Italy. 

• Factors that disqualify a country from accessing a precautionary ESM loan include (among other things) having a debt-to-GDP ratio above 60%, having a government deficit that exceeded 3% of GDP at any point over the past two years, and having a government budget balance below the country-specific minimum benchmark. 
• Loans from both the ESM's precautionary and non-precautionary programs come with demands for macroeconomic adjustment. But since they're only reserved for countries with sound economic fundamentals, precautionary loans typically come with far less stringent conditions attached. 

Italian critics have said they're concerned about proposed changes to so-called collective action clauses (CACs) in new sovereign bond issues as well, which in their view will increase the risk of a future Italian debt restructuring. CACs are clauses in bond contracts that allow a qualified majority of investors to modify the terms of the contract, including those related to payments. CACs allow for a more market-friendly and swifter restructuring, as having a specified majority of bondholders agree to a debt restructuring typically makes it harder (if not impossible) for bondholders to pursue their claims in the courts. The ESM reform proposes introducing so-called single-limb CACs in euro area government securities, meaning that a qualified majority of debt holders suffices to restructure all debt, instead of requiring the government to win an overall majority as well as majorities at the level of each individual issue. Italian lawmakers have argued that these less onerous CACs could lead investors to demand higher yields, and may also increase the risk of financial distress by affording investors fewer legal protections. However, it is far from obvious that the introduction of single-limb CACs would cause investors to expect higher default risk, which is largely a function of macroeconomic conditions, not legal safeguards. Indeed, when CACs were first introduced in 2013 under the ESM Treaty, they did not significantly impact Italian credit spreads. Moreover, if the Italian government wanted to, it could simply impose a restructuring unilaterally, given that 99% of Italy's debt consists of instruments issued under domestic law. In other words, investors in Italian debt already benefit (or suffer) from limited legal safeguards, in case the Italian government decides to restructure its debt by changing domestic law. If anything, the single-limb CACs proposed in the ESM reform would reduce uncertainty by limiting hold-out investors' ability to delay or could even completely obstruct a restructuring in case a country is forced to restructure for economic-financial reasons.

• The CACs that were introduced in 2013 require majorities of creditors of all outstanding debt, as well as of each individual issue, to approve a sovereign debt restructuring. This allows a small group of creditors that have built a majority stake in a single series to block the entire debt restructuring (and extract more favorable terms).

But despite Rome's criticisms, the ESM reform would have an overall limited real impact on the Italian economy. The reforms would not require an automatic debt restructuring for Italy, nor would they significantly tighten Rome's access to financing and only do so in the case of precautionary programs. The proposed introduction of single-limb CACs is also unlikely to increase Italy's default risk. The greater involvement of the ESM with respect to debt sustainability analysis may make it appear as if it has a greater say over lending and debt restructuring decisions as well as the design of macroeconomic adjustment. In reality, however, the reforms do not entrust the ESM with macroeconomic surveillance tasks exclusively, which it will share with the European Commission. In addition, the proposal doesn't change the ESM's influence, as the fund would continue to be controlled by its shareholders (euro area members), which would still ultimately sign off on financing, conditionality or debt restructuring requests.

This means Italy's opposition to the plan is likely rooted in political calculations. The ESM is deeply unpopular in Italy and it has been a political football for a long time. The Italian treasury has endorsed the plan due to its potential to improve Italy's creditworthiness — a sentiment that the country's central bank has also echoed. But the members of Italy's ruling coalition have nonetheless continued to push back against the reform, which suggests they may be more beholden to their supporters' concerns than they are to the technocratic, technical arguments in support of the proposal. Italy is not unique in this aspect, as the central banks and the treasuries typically welcome reforms that could guarantee economic and financial stability, while governments with an eye on winning the next elections often abhor any unpopular economic reforms, such as might be demanded by the ESM, that could cost them votes at the ballot box. Because the negative effects of the reform are limited, it is possible that Italy will approve the reforms before the year-end deadline after having signaled opposition to their domestic audience, mindful not to forego the benefits highlighted by the Italian treasury. Italy may also be using its resistance to the ESM reform as leverage in negotiations with the euro area over other issues, some of which may not even be directly connected to the ESM reform.