After weeks of uncertainty and rumours of fresh elections, a last-minute coalition deal between 5 Star Movement (M5S) and the League has been approved by centrist President Mattarella. Mattarella had not approved the initial partnership between the two populist parties because of the coalition’s choice of Paolo Savona, a noted Europhobe, as Economy Minister.
The new deal that Mattarella has approved involves moving Savona moved to European Union minister, while a more moderate Economic Minister has been chosen in the form of Giovanni Tria. The two parties’ outright Europhobia has moderated in recent months - but this is by no means a pro-Eurozone government.
A new fiscal policy agenda
The populist government’s policies will see it rub up against European Union (EU) government spending rules, creating uncertainty around relations in the short term. The two coalition partners each have their own pet economic policies: M5S wants universal basic income (UBI) while the League would like to cut taxes towards a flat tax system.
In a reflection of the differences in their views, and rather than seeking some sort of compromise, the coalition has vowed both to increase spending via UBI and cut taxes. If enacted, this kind of fiscal expansion would probably result in the Italian government coming to blows with EU leadership. This is because the EU Stability and Growth Pact (SGP) says member deficits should not exceed 3% of GDP. This is likely to come to a head in September because the Italian budget is due in October.
The government also wants to unwind important economic reforms and tighten up immigration controls. Both parties support repealing the 2011 Fornero pension reforms, which moved people onto defined contribution schemes and increased the retirement age to 67. This reform was an important step towards sustainability for the Italian economy against the demographic and fiscal headwinds the country faces. Reversing course would hit government balance sheets – estimates suggest it would cost the government €20bn per year – and undermine Italy’s long-term fiscal credibility. Labour market reforms to improve flexibility in the post-crisis era are also under threat from this coalition.
A government in a hurry
The longevity of this government is highly uncertain; both parties know this, which will increase their desire to pursue populist policies ahead of fresh elections. Although there is some policy overlap between the two parties – namely on immigration and a desire to loosen the fiscal straitjacket imposed by Brussels – there are also significant differences, while their voter support bases and internal party cultures are also very different. The M5S has a history of defections and the coalition only has a six-seat majority in the Senate. If they lose that, the parliament will be highly constrained by the Senate and unable to enact policy change. Accordingly, we do not believe that this coalition will last a full term; elections by 2019 are highly likely.
We do not believe that this coalition will last a full term.
How will the EU respond to a rogue Italy? The EU has an important choice to make: it can facilitate the populists to avoid stoking tensions, or it can lay down the EU law to validate the integrity of the Union. Technically the European Council can impose sanctions for continued non-compliance with the SGP. Such a sanction would take the form of a non-interest-bearing deposit of up to 0.5% of GDP that could turn into a fine if excessive deficits persist. Sanctions could also theoretically be extended to cuts in structural funds; Italy’s impoverished Southern region is a beneficiary of these funds. In fact, however, actual sanctions have never been imposed on member states. The EU’s response to fiscal slippage and immigration policy change will be crucial as it runs the risk of sparking more Europhobic tendencies within the coalition.
How large is Italy’s debt burden?
Total (government plus household plus non-financial corporate) Italian debt stands at 245% of GDP. In itself, this figure is not unusual - but government debt specifically is very high, at 132% of GDP.
Italian government debt has stabilised as a share of gross domestic product (GDP) over the past three years, as a modest primary surplus has offset net interest payments that exceed nominal GDP growth. However, if enacted fully, the government’s fiscal plans could cause the budget deficit to balloon, from 2.3% of GDP now to as high as 8% of GDP. Even if the new government’s proposals are significantly watered down, the budget deficit would widen. In the context of very low potential growth, that is likely to send Italian government debt decisively higher.
Target 2 imbalances must be taken into consideration. Target 2 is the settlement system for euro payment flows between the national central banks of the eurozone. When the banking system in one member country has more payment outflows than inflows, its central bank accrues a Target 2 liability with the European Central Bank (ECB). Such imbalances (large liabilities of periphery central banks, and assets of core central banks) were a key manifestation of the economic and financial disparities during the euro-zone crisis of 2011/12.
In the event of Italy leaving the Eurozone, these liabilities… would represent a loss for other member states’ central banks.
Italy continues to have the largest liabilities to the Target 2 system, at €442bn. Any outflows out of Italy would increase this imbalance further. That is not necessarily a problem in and of itself: balances do no need to be settled. But in the event of Italy leaving the Eurozone, these liabilities, which amount to a further 26% of Italian GDP, would represent a loss for other member states’ central banks. And, while Italy’s Target 2 liabilities are backed by collateral, much of that is in the form of Italian government bonds, on which the government might default in the event of exit.
How significant is redenomination risk?
Concerns about redenomination risk – the risk that Italy exits the euro, and tries to take its debt with it - briefly entered the market last week. While we think there is a small possibility of this, it nonetheless represents a tail risk.
There are five broad routes to redenomination – the first is an accidental and unwilling drop out of the Eurozone, while the other four are variants on an active political choice to leave.
- An accidental and unwilling fall out of the Eurozone. Rapid escalation in Italian government bond yields, resulting in sovereign default, inflicting a great deal of damage on domestic banks and cutting off Italy from primary market access. To recapitalise banking sector and fund government, Italy has to leave euro and issue its own currency. The ECB’s OMT (Outright Monetary Transactions) tool is designed to prevent exactly this scenario playing out – by fulfilling a “lender of last resort” function to prevent Italy from losing market access completely. With this tool, it is nigh-on impossible for a member state to unwillingly ‘fall out’ of the Eurozone.
- Rejecting OMT conditionality. OMTs come with ‘conditionality’ - member states must enter a European Stability Mechanism programme, which requires fiscal policy setting and structural reforms that put the public finances on a sustainable path. A populist Italian government may reject this conditionality, and redenominate in the teeth of a crisis.
- A rapid redenomination over a weekend. This route, which is laid out in a set of slides co-authored by Italy’s new European Affairs Minister Paola Savona, would impose strict capital and banking controls with the announcement of the intention to leave the euro area, timed for a weekend, with the change in currency following almost immediately. Savona envisages that the exchange rate of the new currency with the euro would initially be 1:1, but it would then depreciate – in the process inflicting large losses on the holders of Italian sovereign debt, two-thirds of whom are Italian domestic investors.
- A domestic political process to leave the Eurozone. This would involve a lengthy domestic political process. The government would have to decide to pursue a policy to abandon euro; parliament would have to vote to initiate a process of constitutional change; voters would have to approve constitutional change in a referendum; and finally voters would have to approve euro exit in a second referendum. There would be significant hurdles along the way, including losing these referenda or suffering unbearable capital flight in the meantime.
- A ‘creeping redenomination’, starting with the issue of a parallel currency. The League’s proposal of ‘mini-BOTs’ – which it describes as “small-denomination government securities that, if issued in sufficient quantities, could become a system alternative payment compared to the one with current banknotes” - may represent a staging post on the road to redenomination. But issuing a parallel currency within the Eurozone is illegal, and likely to invite severe censure. In addition, the parallel currency is likely to suffer from considerable volatility, impeding its ability to serve as a medium of exchange.
Implications for the Italian and the broader Eurozone economy
Political uncertainty in Italy may weigh on consumption and investment decisions at the margin. A persistent risk premium on Italian assets would push up bank lending rates to Italian business and households, creating a headwind for domestic demand.
Political uncertainty may weigh on consumption and investment decisions.
On the other hand, if enacted fully, the new government’s fiscal proposals would represent a significant boost to growth, even with potentially quite low fiscal multipliers. The combined fiscal proposals of M5S and the League add up to around €100bn, or 6% of Italian GDP and 1% of aggregate Eurozone GDP. Even with fiscal multipliers of just 0.5, that would represent a 3% / 0.5% boost to Italian and Eurozone GDP respectively.
Overall, we have recently lowered our Eurozone GDP growth forecast for 2018, from 2.3% to 2.1%, and expect growth to slow further in 2019 and 2020. The downward revision to 2018 largely reflects a combination of factors: the weakness of first and second quarter data; higher oil prices; a more challenging external environment; and, at the margin, political uncertainty in Italy. For now, we are not incorporating a big fiscal expansion in Italy into our baseline.
The ECB next meets on Thursday 14 June, when it will publish updated staff macroeconomic forecasts. We do not except any direct action relating to Italy, but there may be an effort to sound more dovish at the margin, possibly by highlighting recent weakness in incoming activity data. We expect the ECB to taper its asset purchase programme down to zero by the end of this year, and hike interest rates gradually from September 2019. This view is predicated on above trend, albeit slowing, Eurozone growth, and a gradual build in core inflation pressures.
In a scenario of a significant escalation of uncertainty in Italy, the ECB has a number of options: the provision of liquidity directly to troubled banks; an extension of the asset purchase programme; strengthened forward guidance that implicitly delays rate hikes; and, in extremis, Outright Monetary Transactions to fulfil the ECB’s lender of last resort function.