Brexit – Risk of hard Brexit to remain
Italy – Who's afraid of Brussels?
Will EU and UK make it into overtime?
The next summit of the European Council will take place in the upcoming week. Although the media reports put their emphasis on the Brexit issue, it plays a minor role in the official agenda. The main emphasis of the summit will be on migration, internal security and external relations, which hardly includes Brexit, as the United Kingdom is still a member of the EU. Officially, the heads of state and government will only address the state of progress of the negotiations regarding Brexit at the joint dinner. In September, Donald Tusk, the president of the Council, announced the October-summit as the moment of truth. However, at the moment, this seems unlikely.
This week, the EU's chief negotiator Barnier drew attention with his statement that a completion of the negotiations could be "in reach" until the summit next week. In that case, an extraordinary summit for November, which would seal the terms of separation, would be stipulated. However, this would only be the prerequisite for further negotiations. During this transitional phase, which would more or less preserve the status quo from April 2019 to December 2020, the future coexistence would be negotiated in detail, including trade relations. If no deal were reached during the next few weeks, negotiations would not make it into this timely extension and a hard Brexit, the United Kingdom's withdrawal from the EU without a new agreement, would be inevitable. According to EU representatives, the chances for a consensual separation must be good, at least for a special summit to be called for November. We think that a special summit will be announced in any case next week because anything else would signify a breakdown of negotiations. The next regular summit of the Council is scheduled for December 13-14, which would only leave three months and half until March 29, 2019, and this would probably be too short.
The publicly demonstrated calmness by both is definitely a negotiating tactic, but this does not do justice to the importance of the subject. A hard Brexit would at least have noticeable temporary implications, which are only roughly assessable. The economy could begin to stutter both in the United Kingdom and the Eurozone, especially when the lead time until Brexit would be short. From our perspective, a hard Brexit is a quite feasible scenario at present. The most pressing question at the moment is the border between the Republic of Ireland and the British Northern Ireland. In addition, an agreement should be reached over the outline of the future relationship. However, EU negotiators cannot consent to important parts of the so-called Chequers plan of the British government. At the same time, this plan represents a minimum compromise within the ruling conservative party and a majority in the parliament is already doubtful now. Any compromises would very likely increase the internal party resistance and thus obtaining a majority would become more difficult or even impossible.
The stakes are high: A hard Brexit means customs clearance between the United Kingdom and EU. It is merely possible to build appropriate capacities for this until March 29. Next to the payment of (likely) WTO tariffs, this may well result in delays in delivery that might accumulate in the case of just-in-time-production to a substantial degree. Then there are unified product approvals. In the case of a hard Brexit, this responsibility would be shifted to the competence of the importing country. At worst, these might have to be recreated even for existing products. British financial institutions may have already prepared for a hard Brexit and applied for licenses for sites in the EU. Much more difficult is the situation with derivatives. Without an appropriate legal precaution by part of the EU, contracts of EU institutions at UK clearing houses amounting to GBP 41trn could become void past March 29 in the case of a hard Brexit (according to a current Bank of England report). Even though it is also possible to move the corresponding derivative contract to another clearing house with a lead time of three months, it is more than questionable whether any clearing house in the EU will be able to increase their capacities to this extent so fast. More importantly, the risks posed by the process of moving could lead to significant uncertainty and thus market disruption, especially if under time pressure.
We assume that a hard Brexit will remain on the table for quite some time after the upcoming summit. At first, the pressure to complete negotiations successfully will only shift to the following weeks until the probable special summit in November. Even if an agreement between the EU and United Kingdom were reached in November, the risk of a hard Brexit would still not be eliminated. The negotiated package still would have to be approved by the British parliament in December or January at the latest, with an uncertain outcome. Time would be running short until March 29. If no majority is reached, the worst effects of a hard Brexit would have to be avoided quickly by special and transitional provisions by the EU. So, the EU will probably start preparing for a hard Brexit already before the vote in the British parliament takes place. As the clock will be ticking louder and louder, markets should respond to the risk of a hard Brexit with rising risk aversion until the vote in the British parliament. This means support for the safest investment categories (US Treasuries, German Bunds, Swiss francs and US dollars). The potential for a significant market reaction is all the greater, since the markets are still relatively relaxed about Brexit so far.
Italy – Credibility of budget assumptions on test bench
Next week (October 15), Italy will, like all other EU countries, deliver its draft budget for 2019, 2020 and 2021 for evaluation by the Commission in Brussels. Substantial parameters of the budget have already become public and caused heated debate between Rome and Brussels. Financial markets were also strongly shaken by the planned increase of the budgetary deficit for 2019 from the previously planned 1.7% to 2.4% of GDP. Within the scope of the preventive arm of the Stability and Growth Pact, Italy is required to continuously reduce its structural deficit (deficit adjusted by cyclical fluctuations) as well as its overall indebtedness to GDP. Even though the current budget draft stipulates a marginal reduction of the debt ratio (to approx. 130% of GDP), the structural deficit will, conversely, increase significantly from the currently envisaged 0.9% of GDP in 2018 to 1.7% of GDP in 2019. EU guidelines require a reduction of the structural deficit along with a swifter lowering of indebtedness.
The credibility of the underlying assumptions will be the crucial issue for an assessment of the draft budget. Since the Italian government intends to interfere substantially in the existing system regarding both revenues (tax reform) and expenses (reduction of retirement age, implementation of a basic income), forecast uncertainty is especially high in our assessment. Furthermore, assumptions regarding real GDP growth (+1.5% for 2019) as well as the conversion factor (GDP deflator: +1.6% for 2019) to calculate nominal GDP growth are an issue, as the development of the fiscal deficit as well as the debt ratio are heavily dependent on nominal GDP growth. Over-optimistic assumptions regarding real growth and the deflator pose a risk that the Italian government's current budget draft underrates the expected deficit for 2019. We therefore expect that the commission might arrive at a higher result regarding indebtedness and deficit figures in the course of their evaluation of the Italian budget. The commission might consequently urge the Italian government to profoundly revise the draft budget for 2019. Due to the pugnacious attitude of the Italian government (Di Maio and Salvini), it is rather unlikely that Italy will give in. Since Italy already barely avoided an excessive deficit procedure in Spring 2018, it might be unavoidable this time in Spring 2019. In essence, an excessive deficit procedure entails increased fiscal surveillance by the commission. At worst, Italy might be obliged to deposit a sum amounting to 0.2% of GDP as security with the Commission.
Italy– Danger of "snowball" effect
In light of Italy's high indebtedness (approx. 132% of GDP), the recent significant rise in yields on Italian government bonds (triggered mainly by strongly increasing risk premiums) constitutes a major risk factor for the Italian budget. In spite of the strong slump of the yield level between 2014 and 2017, the implicit interest rate on Italy's public debt of approx. +2.9% was still 0.8% above the nominal GDP growth of +2.1% in 2017. This means that the so-called "snowball" effect (combined effect of nominal GDP growth and interest rate level on debt ratio) had an unchanged dampening effect on the Italian public debt ratio. In the event of disappointing nominal GDP growth rates and/or a continued rise in Italian yield levels, the burden on Italy's indebtedness could possibly increase in future, due to this "snowball" effect. This would reduce the Italian government's budgetary scope accordingly and require massive spending cutbacks.
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