Risk experts take flight over Italy’s political shock

Mayday, mayday: Investors in Italy are likely to have checked under their seats for parachutes

The formation of a coalition government seems just days away, and it is one that will likely see the populist Five Star Movement (M5S), led by Luigi Di Maio, work with the formerly exclusively northern secessionists Lega (League), campaigning on an anti-immigrant platform, steered by Matteo Salvini.

They are the two political forces that made substantial gains at the elections in March – League by broadening out with a national strategy – blaming anaemic growth and high unemployment on bad governance and EU rules.

The new political law had made the prospect of a strongly euro-sceptic party taking power an extreme tail-risk, with a low probability.

Now that it is becoming a reality, it is the worst outcome from an investor perspective, radically altering risk perceptions.

What’s next?

The prospect of an M5S-League government caused considerable anxiety when leaked details of their initial draft agreement was made public this week by the Huffington Post Italy.

It suggested they would seek €250 billion of debt relief from the European Central Bank (ECB), renegotiate Italy’s European treaties and its contributions to the EU’s budget, while spurring radical reform of the EU’s stability and growth pact.

However, with the inevitable negative market reaction, not least concerning the plans seeking ways to leave the euro and reverse pension reform, it led to another watered-down draft emerging.

This avoids talk of a euro exit, contains an amended debt-relief proposal, and no parallel currency – something that former prime minister Silvio Berlusconi, leading the centre-right, had raised.

However, it remains clear the government would still push hard for root-and-branch reform of the EU and the ECB’s monetary policy. Moreover, there is no clear strategy for raising fiscal revenue to pay for spending pledges, including a “citizenship income” and reduced pension age, along with tax cuts.

Besides, there is a question of trust.

The governing partners haven’t simply abandoned their aspirations to take Italy out of the euro, even if it is not a stated intention in their programme.

Whether the head of government is an expert, a third-party politician, a League or an M5S politician, I think the coalition will be unstable 

 – Norbert Gaillard

In opinion polls, a majority does not appear to favour leaving, but that could easily change if the EU routinely dismisses Italian interests.

And the dangers of holding a referendum are abundantly clear from the Brexit vote held in June 2016 leading to the UK’s withdrawal from the EU in 2019.

In the meantime, the new administration – assuming it is formed – will likely clash with the EU over its fiscal plans and its opposition to Russian sanctions.

ECR survey contributor Constantin Gurdgiev, professor at the Middlebury Institute of International Studies, says: “It is likely that we are going to see some serious headwinds to euro-area integration and the ECB’s policy, should M5S and the League lead the new government.

“Italy’s political stability will most certainly be impaired. Adverse impacts on Italian bond yields are more than likely and, with this, Italy’s debt management costs will rise, blowing up the general government deficit.”

Gurdgiev notes that with the Italian government appearing to shift toward a eurosceptic, anti-austerity and deficits-hungry coalition, the ECB is now faced with a choice.

That is, either abandon any hope for monetary policy normalization to sustain French, Italian and Spanish economies, and electoral peace, or pursue monetary tightening to underwrite the credibility of the euro at the cost of sacrificing the euro-area’s second, third and fourth largest economies.

Jan von Gerich, chief strategist at Nordea, writes: “In the coming months and years, the Italian situation will be a negative for the entire euro-area. It can act as a brake for the ECB’s exit plans, the rise in core bonds and the euro.”

About-turn

The economic recovery across Europe had begun to brighten Italy’s prospects.

Its Euromoney country risk score rose by 3.4 points in the first quarter, in tandem with Greece, pushing the sovereign borrower higher, to 41st from 186 countries in Euromoney’s global risk rankings.

Italy had become an improving medium-risk option, closing in on Cyprus, Portugal and Spain incrementally higher in the rankings, benefiting from reforms and sustained GDP growth of around 1.5% in real terms – still below-par, but better than most years during the past decade.

Yet Italy is still some 26 points worse off in the survey compared with before the start of the global financial crisis a decade ago.

Its government stability indicator is marked down, and there are still questions over several important economic risk factors, including GDP growth, employment and the government finances.

The new coalition’s plans are not expected to improve these indicators. On the contrary, they will likely worsen the fiscal projections, adding to Italy’s huge debt burden still exceeding 130% of GDP on an EU gross basis, causing risk experts to downgrade their scores.

Plus, there is a question concerning government stability, as ECR expert and independent sovereign risk analyst Norbert Gaillard, explains: “Whether the head of government is an expert, a third-party politician, a League or an M5S politician, I think the coalition will be unstable.

“The two parties have major disagreements about economic issues. M5S wants to establish a universal basic income whereas the League advocates massive tax cuts. How will the universal basic income be funded? M5S talks to southerners, the League to northerners.”

Gaillard sees a struggle for control between Di Maio and Salvini, with divergence on key issues, and institutional risk developing between the government and president Sergio Mattarella – who has constitutional powers of veto – questioning the durability of the alliance.

Other experts in the survey broadly concur. The government would be less predictable, and much less likely to follow a consistent, orthodox path, many claim.