Will Populists upend Italy?

Over the last 2 years, investors have been chewing “Brexit” word now & then and have become dominant word across the financial market. The worries over Brexit are still disturbing investors not only in the U.K., but all over Europe. The biggest political and economic union, i.e. European Union- not only needs to worry about the UK, as it is a self-inflicted injury, but current situation in Italy represents a much larger and alarming situation for the EU. The cornerstone for the political integration of Europe was laid just over 60 year ago in Rome. Today, though, Rome is the source of political risk that has the potential to inflict lasting damage on the European project.

divided we stand” says Italy’s background and fundamentals…

Italy is the EU’s third-largest economy, and a founding member of the European Economic Community as well as an original member of the euro zone. It is true that the EU has survived many crises before—Brexit, Greece, Ireland and Spain/Catalonia. The issues has been just patched up, but not yet solved. With government debt currently above 130% of GDP, this would quickly make Italy’s fiscal position unsustainable. It would lead without doubt to problems of refinancing, triggering a debt restructuring.

Furthermore, with second largest debt burden ($2.7 trillion) in the entire European Union, Italy is doomed with the lowest rate of economic growth. Every third Italian under the age of 25 is unemployed. Italy is burdened with non-performing loans (NPL) worth around €1 trillion (US$1.17 trillion) and has been forced to grapple with negative interest rates, which have eroded their already weak profitability. In contrast to other Euro zone countries that have experienced crisis, Italy never experienced an economic boom in the initial years of the currency union. Per-capita income has stagnated since last 20 years. And yet Italy has still managed to adhere to strict EU deficit rules in recent years. From the Italian perspective, however, the benefits of doing so have been negligible. Under given circumstances, the implosion of the country's political system can hardly come as a surprise.

Smile curved Politics in Italy’s Power…

Since the populist Five Star Movement and the right-wing League gathered a combined parliamentary majority in Italy’s March 4 election (Called a “smile curve” as majority are at extremes), Italian politics had been at crucial stand-off, with the two parties struggling to form a government. But first time in Italy’s postwar history that a coalition of parties from the political extremes had attempted to form a government without any input from centrist forces after prolonged six weeks. However, government talks broke down over the weekend after the surprise resignation of Giuseppe Conte, a little-known law professor that M5S and League had selected as the country's next prime minister. Conte officially stepped down, following President Sergio Mattarella's decision to reject the parties' controversial choice for economy minister. But in a surprise twist, the populist restored the coalition talks and Conte eventually accepted a new mandate for a premiership. And finally, 53-year-old took a sworn alongside his cabinet, which will see M5S leader Luigi Di Maio and League chief Matteo Salvini in key ministerial posts.

Will Populists upend Italy?

The government combining two very different sides of populism will pose a serious threat to the EU’s vision, because it could form the core of a new federation of populists and Euroskeptics . But if they succeed in governing, their political programs could serve as a template for populists throughout the EU. Both parties have promised for an expansionary fiscal stance, although with major differences. M5S party has promised the introduction of a minimum guaranteed income which appealed to voters in the economically suffering south. On the other side, the League party promised a flat tax which appealed to voters in the economically thriving north. Both parties advocated the repeal of a controversial pension reform introduced in 2011 by the government of former Prime Minister Mario Monti and have committed to repeal an otherwise automatic hike in the value-added tax (VAT) planned in the 2018 budget. The coalition also wants to introduce a two-tier income-tax system, with rates of 15 percent and 20 percent making Italy one of the lowest-taxed countries in the EU. But there this programme is compatible with the Euro zone’s fiscal rules. The programme suggests increasing annual spending by between €107 billion and €126 billion (£94 billion to £110 billion), including around €50 billion to introduce a “quasi-flat tax” of 15% on individuals’ income and 20% on companies; and €17 billion to introduce a “citizen’s income and pension”. On 2017 figures, this is a fiscal stimulus of around 6.3%-7.4% of GDP – well outside the parameters of the Euro zone’s fiscal rules.

“Market turmoil and soaring yield

The STOXX Europe 600 Banks Index, a leading gauge of European bank shares, plunged 8.5 per cent in the last week of May, with French and German banks – which hold significant amounts of Italian bonds are coming under strain. The debt of Italy’s own lenders, meanwhile, suffered steep declines as markets worried that the turmoil will prevent the efforts by Italy’s banks to dispose of their more than €170 billion in bad loans.

Italy has also benefited hugely from much lower interest rates since joining the euro. In 1992 Italy’s ten-year bond yields were around 7.5 percentage points above Germany’s. By monetary union in 2002 the gap was around 5.1 points. Last week, despite the political crisis, Italy’s treasury was still managing to issue ten-year bonds at 3%, around 2.00 points above German bund yields. Yes the spreads were much higher in the wake of the eurozone crisis. The local currency Euro which fell by almost 8% from high above 1.2550 made in Feb to make a low of 1.1520, jumped above 1.1800 levels on coalition news.

Italexit or fix it… are the only two options

At this point of time, Italy needs more growth to be able to pay down its mountain of debt, and also need more social equality, especially between the rich north and the struggling south. Key question regarding Italy right now are….. How to achieve and would it be better for the country to leave the Euro zone? Would it be helpful to abandon austerity, or is an even more ambitious savings program needed? Should the country restructure its debt? The least option of Italy’s departure from the Euro zone would plunge Europe into an even deeper crisis than what they are already facing. A debt haircut like the one applied to Greece would eliminate around a trillion Euros in a single blow with uncontrollable consequences for the European banking and insurance system. Currently Sentix index for Italy Exit (Italexit) stands at 11 and Greece exit (Grexit) stands at 4.84. Both are turning higher after recent development in the political base. That is also pushing an index for the entire euro area to 13 percent, the highest level in more than a year.

Amid all of these concerns and to avoid exiting option, Italy needs aggressive action to help the truly productive parts of the economy grow faster and exploit potential external demand. Rather than designing industrial policies to subsidize the losers, Italy should be providing opportunities for new market entrants, to reverse the high rate of emigration by skilled young people. They also have to attract public investment in infrastructure and education, which will require addressing corruption, inefficient judicial processes, and ineffective local institutions.

IFA Global Outlook

In nutshell, recently formed government has to come up with more pronounced reforms and measures to resolve Italy’s debt problem and generate youth employment to revive the growth. Any anti-Euro measures will create headwind for the Italy and EU both. Further, this will create doubt regarding survivorship of Euro zone and currency. Amid Italy’s concerns along with other GIIPS* countries issue, trade conflict, economic slowdown and geopolitical conflict- Euro zone stability remains vulnerable. Hence, Euro is expected to remain under pressure from medium to long term perspective.  On the higher side, it can be seen finding resistance near 1.1950-1.2000 zone and there is higher possibility that Euro can make a fresh low below 1.1500 to extend its bearish leg towards 1.1200 levels.

(* suggests GIIPS countries, Greece, Ireland, Italy, Portugal and Spain, were among the European countries most adversely affected after the outbreak of the global financial crisis in 2008.)