• Deficit. The US is clearly living beyond its means. The current account deficit continues to balloon with no signs of a trend reversal soon. But so far, foreigners have been only too willing to fund Americans’ excess spending.
  • Structure. The financing patterns are, however, shifting. Oil exporting countries are now the most important financiers, rather than Asian institutions. At the same time, central banks are becoming increasingly return-conscious when managing their currency reserves. This weighs on the US Treasury market . Moreover, there are also signs of stronger geographical diversification of reserves. EUR and JPY are the alternatives.
  • Impact. Diversification is weighing on the USD, without yet displacing secular support. The setback potential for US Treasuries is considerable. Ultimately, foreign demand has lowered yields by up to 75 basis points in recent years according to our calculations.
  • Danger? Despite growing risks, there are, however, no signs of instability worth mentioning or even sporadic financial turbulences. The mutual dependencies appear too pronounced. Funding patterns are changing only gradually.

Further topics:

  • Weekly Comment: Italy – it's the politics, stupid.
  • France: A nice rebound in GDP growth last year, BUT ... .
  • Tightening cycle in Scandinavia: Norges Bank accelerates, Riksbank shifts down a gear.
  • Data outlook: European purchasing managers to remain confident; clear skepticism, in contrast, in the US.
  • Market outlook: Breather for bonds, EUR holding its own.

IT'S THE POLITICS, STUPID!

Italian Prime Minister Romano Prodi resigned on Wednesday (February 21) after losing a parliamentary vote on Italy’s foreign policy strategy, including crucially its participation in the peace-keeping mission in Afghanistan. The defeat was by the narrowest of margins: at the Senate the government only enjoyed a very small majority, and had been operating on a knife’s edge since gaining power last April.

The vote proved to be the culmination of tensions between the moderate and the radical left-wing elements in the nine-party coalition, tensions that had made the government’s policy efforts difficult from the very beginning. In this specific instance, PM Prodi and the more moderate members of the coalition intended to confirm Italy’s ongoing participation in the NATO peace mission in Afghanistan, a goal strongly opposed by the more radical elements in the coalition. Technically, since the government had not asked for a vote of confidence on the bill, Mr. Prodi was under no legal obligation to resign. However, Foreign Minister D’Alema had emphasized prior to the vote that it would be considered a key test for the government. In the end, Mr. Prodi considered that the parliamentary defeat had cast doubts on the government’s ability to pursue its foreign policy goals and to maintain its international commitments, and tendered his resignation to President Napolitano.

Prodi’s resignation comes as a cold shower at a time when economic data had begun to paint a substantially brighter picture. We had been quite critical of the government’s 2007 budget for its failure to include structural cuts in public expenditures - which had risen substantially under the previous government - and fully realized that the current economic upswing owes more to the favorable international environment than to actions taken by the government during its short tenure. We were also under no illusion as to how difficult it would be for such a fragmented coalition to make significant progress in reforming the pension system and the labor market, which we regard as essential for Italy’s mediumterm outlook. At the same time, however, the Prodi government had already taken important steps in scaling back privileges and rigidities of professional categories ranging from pharmacists to notary public to hairdressers. These changes were extremely important not just in themselves but also as a signal that it was indeed possible to gradually break down the many rigidities that limit the efficiency and growth potential of the Italian economy. There is, of course, no doubt that those were the changes that were politically easier for the centre-left coalition, compared for example to tackling the inefficiency in the oversized public sector. But they were nonetheless politically difficult, and of great impact as a concrete sign of the need to move towards greater flexibility overall. The government had also finally offered its stake in Alitalia up for sale, even though there was still uncertainty on what limitations would be imposed on its restructuring.

We believe the short-term fallout from the political crisis will be limited, as the stronger growth outlook and the recent improvement in public finances offer a valuable cushion. The market's reaction as measured by the BTP-Bund spread has been extremely limited so far, and we believe it will remain contained— the underlying picture for Italy's government bonds is still positive, with expectations on 2007 issuance supportive, and the spread has narrowed significantly since last May. We would expect bond markets to remain in a wait-and-see mode as the crisis is resolved.

Looking further ahead, however, the main risk is that Italy might fail to capitalize on the current cyclical upswing to further strengthen public finances and make a more decisive push on structural reforms. The recent improvement in growth performance should not divert attention from the serious structural weaknesses which have translated into a loss of external competitiveness and keep Italy's growth performance consistently below the eurozone's average. Deep structural reforms remain in our view essential to the country's ability to sustain an improvement in both living standards and debt ratios, and the reform momentum needs to be accelerated sooner rather than later. Failure to push ahead with structural reforms would bolster the concerns of the rating agencies, which have already stressed their focus on medium term structural issues. Moreover, should political instability also translate into higher public spending and a renewed relaxation of public finances, the markets would likely reassess Italy's creditworthiness and the spread would widen again.

Much depends on what will happen next. This is very difficult to predict at this stage, and it will take at least a few days for the picture to become clearer. President Napolitano has begun consultations with political leaders, and will then have two main choices: either to entrust someone (possibly Mr. Prodi again) with the task of forming a new govern ment, or calling for new elections. We can imagine three scenarios, with different degrees of probability.

  1. A new version of the outgoing coalition, possibly with some marginal change in its composition, led again by Mr. Prodi. This, however, would be perceived to be as shaky as the predecessor, and would probably be equally short-lived.
  2. A “grand coalition” bringing together the moderate parties of the centre-left and the centre-right, leaving out the extremes at both ends. This has been proposed in the past as a way to provide broader support to reforms and moderate policies, limiting the blackmailing power enjoyed by smaller parties on both sides of the political spectrum. The idea has encountered some resistance because it could be seen as a step back towards the old days when the political scene was dominated by the Christian Democrats and a handful of other centre parties, and therefore negating the progress made towards a bi-polar system. This scenario can, nonetheless, certainly not be ruled out: the main centre-right party, UDC, has already indicated that it would be open to the possibility, on the condition that the radical left be excluded from a new coalition.
  3. New elections. We see this as unlikely. Prodi's side has lost popularity during its tenure in power, and most parties in the outgoing coalition would probably prefer to avoid the risk of getting downsized by new polls. The centre-right is leading by about 10% in recent polls, but is in the midst of an internal jostling for power, and agreeing on a PM candidate this time would not be easy.

Bottom line: It is extremely difficult to hazard a prediction. At this stage, we see early elections as unlikely, and a centre-left/centre-right coalition might well be the outcome. Reforms are inevitably put on hold. If the crisis is resolved quickly, this would not be a major issue, but it would then be crucial for the new government to give a strong early signal of its commitment to liberalization and fiscal prudence. Investors are likely to remain on the sidelines in the short term, but should uncertainty be protracted we see a risk of a moderate widening on government bond spreads.