Italy – Agreement at the last second?

Italy – Agreement at the last second? Risk premiums of Italian government bonds increased

Five Star Movement and Lega eventually negotiate government formation

Surprisingly - and literally at the last minute - Lega and the Five Star Movement started serious negotiations about the formation of a new government for Italy on Wednesday. Apparently, Silvio Berlusconi finally gave the green light to Lega to open talks, though a government coalition comprising the Five Star Movement and Lega will not be able to count on Berlusconi’s Forza Italia for parliamentary support. However, in terms of majorities, this is not necessary. Five Star and Lega asked President Mattarella for a reprieve until Sunday to negotiate an actual agreement. According to media reports, the issues of security and immigration will be the common focus of both parties. Furthermore, a basic income as well as the introduction of a flat-rate tax might become further important pillars of the government program. Interestingly enough, the Five Star Movement dismissed the idea of a flat-rate tax as a superfluous gift to wealthy people even during the election campaign. The elevation of the retirement age resolved in 2011 is to be rescinded as well. However, what obviously arises regarding all of these topics is the question of affordability. A further compromise might be that neither Salvini nor Di Maio will be appointed as new prime minister. Instead, Giulia Bongiorno and Giancarlo Gioregtti are under consideration.

Basically, it is encouraging that efforts to form a government came into motion in Italy. However, this shift in sentiment occurred very suddenly, since the Five Star Movement and Lega held heated debates until just a few days ago. Even if the negotiations should result in a positive outcome, it remains questionable how long the harmony between both parties will persist. A government consisting of Five Star and Lega would well adopt a confrontational attitude towards Brussels, as both parties operate according to the motto ‘Italy first’. Fierce conflicts with Brussels may arise, especially regarding the regulations on the public budget and compliance with the Fiscal Pact. This is mainly due to the fact that all key points of the government program will carry costs – and this is money that the Italian state does not have at hand. On the contrary, Italy would have to reduce its current expenditure to comply with the Fiscal Pact. From an economic point of view, we expect at least a slight fiscal stimulus for the Italian economy if an actual coalition will be formed with Lega and the Five Star Movement. This might lead to an acceleration of GDP growth in the short term. In the long term, we continue to assess Italy’s growth prospects as negative, as the new government probably will not focus on structural reforms and topics such as education and research will continue to be neglected.

Markets react to political development in Italy

Markets responded to the political developments during the last week with a widening of risk premiums; the spread for the ten-year government bond recently rose to 135 basis points over the equivalent German bond. Thus, the movement was extended that had already started in the last week of April. However, overall Italian yield premiums are still low. In June 2017, for example, the ten-year spread amounted to 200 basis points. Reasons for the notable narrowing of the yield premiums since that time were the ECB’s purchase program as well as an improvement of economic data.

However, the climate is expected to deteriorate and thus in our view the risks for a widening of risk premiums predominate, based on present levels. It remains to be seen how the outcome of the government negotiations will finally look. The risk of a more expansive fiscal policy and confrontations with EU regulations is considerable, though. An increase of the budget deficit and thus of the public debt per se would be hard to bear for the markets. With 130% of GDP exceeding the Maastricht criterion more than twice over, Italy has the second highest public debt burden within the Euro Area. Together with a foreseeable end of the ECB’s purchase program, which we await for autumn, risks are accumulating for Italy, which points to an increase in risk premiums on Italian government bonds ahead, in our view.

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