Italian political risk
Political developments in Italy seem to have taken a turn for the worse. Having made large inroads in the last general election, Italy’s populist parties – the Five Star Movement (FSM) and the League are inching closer towards forming a coalition government. An initial draft of both parties’ proposed economic policy calls for new, unrealistic spending programs that will likely go beyond what the government can afford. As a result, the spread between Italian and German government bond yields has widened, as investors start worrying about the Italian government’s ability to pay all that it owes. This week, we explore the validity of these worries.
The populist coalition’s economic programme calls for all sorts of goodies such as a universal basic income, income tax reductions, and a decrease in the mandatory retirement age. Unfortunately, the Italian government doesn't generate enough revenue to fund all this extra spending. It will be unable to pay for these spending proposals without borrowing money from investors to fund this budget shortfall. This will only fuel Italy’s already massive debt pile, which currently stands at a worrying 130% of GDP, the second largest in Europe behind Greece. To make things worse, the extra spending will significantly widen Italy’s ‘budget deficit’ – the amount by which the government spending exceeds its revenue. Under a piece of EU law known as the Growth and Stability Pact, no EU country is allowed to have its budget deficit exceed 3% of GDP, and all EU countries are required to keep their public debt levels at a maximum of 60% of GDP. The coalition’s spending plans will draw Italy further away from both these requirements, thus widening tensions between the Italian government and its EU neighbours.
Italy versus the EU
Unsurprisingly, markets now fear the prospect of Italy’s new government blowing a hole in its budget, prompting a surge in Italian bond yields and provoking a dangerous confrontation with the EU. Italy’s populists seem intent on sending a signal to the EU that they will not be thwarted in determining their own economic policies, however fanciful. If the EU objects too much, Italy’s new leaders will attempt to spook the EU and markets with veiled threats to exit the eurozone.
That being said, it’s questionable how credible Italy’s threat of leaving the EU actually is, if push comes to shove. According to its constitution, a referendum on Italy’s membership in the EU/eurozone requires a two thirds supermajority vote in both the upper and lower houses of parliament. This appears unlikely for now, given that the political majority has shown little appetite for such a move.
From an economics standpoint, Italy likely has a lot more to lose than to gain from leaving the eurozone. An exit from the currency union would see investors pulling money out from its domestic markets and banks, decimating Italy’s banking system in the process. Leaving the eurozone would also mean having to set up a new currency that would likely be of less value that the euro, instantly resulting in high inflation and sharply cut wages. There would also be huge legal ramifications on a range of complex issues, not least the validity and enforceability of outstanding re-denominated contracts and obligations with creditors. The cost of borrowing for Italy’s government would also spike, given that Italian bond yields will no longer be kept down by the European Central Bank’s quantitative easing programme, thus killing off the coalition’s proposed spending plans anyway. Given the high costs of an exit, it’s unsurprising that a succession of Greek governments in similar positions have opted in favour of bailout programmes, instead of leaving the eurozone. Rather than getting into a full blown confrontation with the EU, it’s more likely that the coalition would use whatever spending room they have to implement some of their promises.
Furthermore, getting these spending policies passed under Italy’s fragmented political system is a lot easier said than done. Parliamentary arithmetic is unlikely to be strong enough to fully support such an unrealistic programme. This is particularly the case in the upper house, where the populist coalition only commands a thin majority. It’s also noted that the coalition partners hail from opposite sides of the political spectrum, with the left-wing FSM drawing support mainly from the relatively poor south, and the far-right League’s electoral base residing in the wealthier north. We suspect that this will eventually pose a challenge for the coalition’s ability to agree on a concrete economic programme.
For us, the ultimate constraint on the coalition’s unrealistic spending plans is the bond market itself. No investor would lend to the Italian government if they deem it as being unable to pay back its debt. This would cause the cost of borrowing to soar for the Italian government, thus leaving it unable to fund its spending plans. The fact that European bond markets reacted so viscerally to the proposed programme last week, highlights how market forces serve as a helpful disciplinary tool for any would-be spendthrift governments.
The ongoing political situation in Italy is no doubt discomforting for investors, and the risk of an Italian disruption on the European bond market has certainly risen. However, there remain significant hurdles to the coalition’s proposed spending due to the reasons mentioned above. As a result, we think the repeat of a 2012-style Euro crisis remains a small possibility, at least for the time being. We remain positive on growth prospects for the eurozone economy, choosing to express this view through a preference for European ex-UK equities.
These are our current opinions but the future, as ever, is uncertain and past performance of investments is not a reliable indicator of future performance. The value of investments can fall as well as rise and you could get back less than you invest. If you’re not sure about investing, seek independent advice.