Abstract :
- The negotiations currently underway between the European Commission and the Italian government are causing considerable concern and volatility on the financial markets.
- While some concerns appear legitimate (such as Italy’s ability to meet its public deficit targets), others are more speculative (such as the end of Italian bonds’ eligibility for the ECB’s public asset purchase program).
- The structural weaknesses of the Italian economy and its near-zero growth potential justify a fiscal stimulus policy. However, it is the means used that are divisive.
- The economic and political stakes for the European Commission and the Italian government should prompt both sides to tone down their rhetoric and engage in more conciliatory negotiations.
This article sheds light on the budgetary situation in Italy, which has become a source of tension with the European Commission. It also provides insights into the deteriorating economic outlook and emerging economic risks.
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The new coalition currently leading the Italian government, comprising the Five Star Movement and the League, has entered into a standoff with the European Commission. Elected last May on expansionary budgetary programs, which had already worried the markets, the coalition wants to keep its promises and implement them in the draft finance bill (PLF) for 2019. The 2019 budget bill proposed by the Italian government has been rejected in its entirety by the European Commission, a situation that is causing considerable concern in the markets.
How are the markets reacting?
The markets are heavily focused on the Italian risk, which is reflected in particular in the sharp underperformance of the Italian bond and equity markets (-20% for Italian banking stocks, -11.8% for the FTSE MIB[1]) since the government’s announcement on September 27. Indeed, since the Italian government announced its intention to target a deficit of 2.4% of GDP, the financial markets have reacted strongly. The 10-year BTP-Bund spread[2] has increased by 75 basis points, reaching its highest level since June 2013 at 327 basis points.
Since the Italian government’s first official announcement on the 2019 budget (September 27), the euro has also depreciated by 3% against the USD, and the EUR/USD exchange rate is strongly correlated with the evolution of the 10-year BTP-Bund spread, meaning that the market is mainly focused on Italian risk. Eurozone equity markets have also been penalized by this risk, with particularly strong underperformance. Eurozone banking stocks, and Italian banks in particular, have been hit hard.
At the height of the tensions over Italian rates, investors sought greater protection against the risk of Italy leaving the eurozone (redenomination risk) than against the risk of default. The contagion effect on other peripheral eurozone countries (Spain, Portugal) has so far been limited, as ECB President Mario Draghi pointed out at the press conference on the monetary policy decision on October 25. In other words, Spanish and Portuguese sovereign interest rates have reacted little to the rise in Italian rates compared with last May.
Why are investors concerned about the current situation surrounding the Italian budget?
Investors consider the 2019 budget proposal announced by the Italian government to be lacking in credibility at present and identify several risks:
- Italy is the third-largest economy in the eurozone and therefore represents a systemic risk to the functioning of the EMU;
- Investors anticipate that the public deficit will be higher than expected. As the public deficit is the ratio between the change in debt and the change in GDP, GDP growth forecasts seem overly optimistic, and rightly so. With Italy’s potential growth close to 0% and the country’s average growth at 0.1% since 2010, the Italian government’s growth forecasts of 1.5% (2018), 1.4% (2019), and 1.6% (2020) seem unrealistic. Overly optimistic growth forecasts, accompanied by an increase in public spending, will inevitably lead to higher interest costs, which will ultimately hamper growth.
- The markets also doubt the effectiveness of the measures announced by the government.According to an article by economist O. Blanchard, who calculates both the impact of public stimulus through the fiscal multiplier effect and the increase in the debt burden due to higher interest rates, all other things being equal, the implementation of this economic program would have a negative impact on growth of -0.1%.
- While the increase in interest costs, which will inevitably weigh on growth, is a high risk, the sustainability of Italian debt is much less so. Indeed, it is important to remember that Italian debt has an average maturity of nearly seven years and that 70% of the debt is at fixed interest rates.
- Italy’s rating downgrade is also worrying the markets about the possible ineligibility of Italian bonds for the ECB’s public asset purchase program. However, it is important to remember the rules of operation. The ECB purchases securities from countries with a rating equal to or higher thaninvestment grade. However, a country must lose its investment grade rating from four rating agencies defined by the ECB (Moody’s, Fitch, S&P, and DBRS) for the purchase of public assets to end.
How is the current situation affecting the Italian real economy and what are the prospects?
The Italian real economy is affected through the banking channel. More than 60% of Italian debt is held by banks, and an increase in sovereign rates forces banks to limit their exposure to risk. A fall in bond prices causes an increase in capital provisions, forcing banks to reduce credit distribution to the real economy due to the increased risk on assets already held in their portfolios. This slowdown will negatively affect growth by reducing household consumption and business investment. According to the October Bank Lending Survey, Italian banks have already begun to tighten their lending conditions.
Italy needs a long-term economic policy that can strengthen its long-term growth. Italy’s potential growth is estimated at 0.5% according to the Bank of Italy, which clearly shows that the outlook for the Italian economy is gloomy. The Italian economy is facing deep structural problems: high youth unemployment, high labor costs, and low productivity. Public investment accounted for 3.4% of GDP in 2009 and is now below 2%. It therefore seems essential to stimulate long-term growth through additional spending, which the government appears to want to do.
While there is broad consensus on the need for an economic recovery program in Italy, the channels used to achieve this are a source of disagreement. From a social perspective, the introduction of a universal basic income seems justified both by the risk of poverty or exclusion and by the youth unemployment rate:
- The risk of poverty or exclusion in Italy is 28.9%, which is significantly higher than that of the European Union (22.5%), France (17.1%), and Germany (19%).
- The youth unemployment rate (15-24 years old) stood at 31% in August 2018 (compared to an overall unemployment rate of 9.7%).
The introduction of a universal basic income is a policy designed to stimulate growth through consumption. However, implementing this type of policy in a country with low economic growth and in a context of European and financial mistrust poses a double risk. The first risk is that this stimulus through consumption could be directed towards additional imports, which would worsen the trade balance and reduce Italy’s current account surplus. The second risk, which is less quantifiable but just as harmful, could come from negative expectations regarding growth on the part of households, which would not consume this additional income but would prefer to save it.
Conclusion
The confrontational approach currently being taken by both sides (the government on the one hand and the European Commission on the other) is far from ideal, given that it is in the interests of both parties for the negotiations to proceed in a calm manner.
While at the European level the European Commission must protect the monetary union from moral hazard and ensure compliance with the Maastricht rules, there are nevertheless two important issues at stake: the European elections and the review of the European monetary system. If the European Commission takes too confrontational and uncompromising a stance in the negotiations, this could continue to fuel anti-European and extremist parties in all member countries, creating a significant risk in the elections next May.
For Italy, the risks are mainly economic, as we have mentioned. These negotiations are causing an increase in interest rates on sovereign bonds, which risks weakening growth in two ways: by slowing down the distribution of credit and increasing the interest burden.
The parties could agree on the need to revive the Italian economy, while redirecting spending towards more public investment and training to stimulate long-term growth. They could also agree on a reduction in employer contributions (policies pursued by former Prime Minister Renzi, which led to an increase in employment) or policies to support the banking sector in order to help banks deal with the decline in non-performing loans, with a view to supporting short-term growth.
Article co-written with Théophile Legrand
Sources:
https://www.istat.it/it/archivio/221818
http://www.camera.it/temiap/documentazione/temi/pdf/1130413.pdf?_1539224471075
https://www.imf.org/~/media/Files/Publications/CR/2017/cr17237.ashx
http://www.mef.gov.it/inevidenza/documenti/Lettera_Ministro_Tria_Alla_Commissione_22-10-2018.pdf
