Italy: A marriage made in...?

Will the seemingly imminent and inevitable political crisis be restricted to Italy; or will it roil Europe as a whole?

It’s almost all over for the election…

“The men who…[are] on the verge of taking power in Italy cannot be trusted to run it.”

The Economist, 19 May 2018

The headlines notwithstanding, the post-election process is not quite all over in Italy yet. It has taken over ten weeks for a majority coalition to be proposed following the 4 March general election (which is not so long by the recent standards of Germany, Spain and the Netherlands, let alone Belgium!). But my base case is that a government will be formed shortly comprising the anti-establishment and ‘left-wing’ in conventional terms Movimento 5 Stelle (M5S) and the nationalist ‘right-wing’ Lega Nord (LN, which now prefers to refer to itself simply as Lega). Nevertheless, despite the two parties agreeing on an agenda, there are still hurdles to be overcome before this can happen.

First, and probably foremost, the two party leaders, respectively Luigi Di Maio and Matteo Salvini, have to win the approval of their party members at the ballot box. [Note: Subscribers to the Financial Times may wish to check out a pen picture of Mr Salvini in the 19 May edition of the newspaper.] There will almost certainly be dissenters given the historic gulf, not to say animosity, between the two. But I am confident that a combination of the heady prospect of national government and the comprises which have been struck on substance (more of which below) will ensure that sufficient support will be forthcoming on both sides of the aisle. Indeed, in an online vote held on 18 May 94% of M5S members reportedly voted in favour. LN members are due to vote on the 20th.

Second, the two have to agree on who will be prime minister. The M5S has almost certainly been arguing that the premiership is its by rights since it actually ‘won’ the election. However, this is clearly not as straightforward as it sounds otherwise agreement would likely have been reached by now. Nevertheless, I find it hard to believe that this will prove an insurmountable obstacle — and the ‘smart money’ now is that the prime minister will be drawn from academia (and probably be an economist), with Mr Di Maio taking the foreign ministry and Mr Salvini the interior portfolio.

Third, the coalition would then require the approval of President Sergio Mattarella to its agenda, its choice of premier and the cabinet line-up. But I find it even harder to believe that this would be anything other than a formality if everything else has fallen into place. This may happen as early as 21 May.

Finally, what should be another formality, ie securing a vote of confidence in the new government in parliament.

In short, whatever ‘Brussels’ and investors may be hoping, it looks as if we are going to be confronted with what I have long argued would be potentially the worst likely outcome of an Italian election, ie an M5S/LN coalition. This would be not only Italy’s first all populist government but western Europe’s.

… and is it also ‘all over’ for Italy?

“Dangerous in isolation, their policies could be worse in combination. If Mr Salvini and Mr Di Maio reach an accord that includes both of their budgetary priorities, it would be fiscally irresponsible. Implementing the flat tax, the universal basic income and the pension roll-back would cost tens of billions of euros a year, probably increasing the deficit from 2.3% of GDP to more than 3% and breaching European rules.”

The Economist, 19 May 2018

A quick glance at the agreed agenda of the two parties is sufficient to understand why both Brussels and investors are concerned. Key points (in brief) include the following:

  • A two-tiered, ie 15% and 20%, ‘flat’ income tax rate for individuals and a flat corporate tax rate (both of which may only be introduced gradually);
  • A EUR780 per month basic income for poor families — supposedly only available to job seekers and the most needy;
  • The repeal of pension reforms passed in 2011 which would, inter alia, have gradually raised the retirement age;
  • Major challenges to the way in which the EU’s single market runs (even though references to leaving the euro and demanding EUR250bn debt forgiveness from the ECB, which appeared in earlier drafts of the coalition agreement, have been dropped…for now at least);
  • The probable cancellation of the sale of bankrupt Alitalia;
  • The dropping of all Ukraine-related sanctions against Russia; and,
  • The early deportation of an estimated 500,000 migrants/refugees currently in Italy. [Note: In this context it is worth recalling that just over three years ago then Prime Minister Matteo Renzi warned that if Europe did not show solidarity with Italy over the refugee crisis, it should not expect Italians to show solidarity with Europe. As far as substantive help is concerned, the EU has largely ignored this warning despite promises to the contrary. With refugees remaining one of the, if not the, most politically difficult issues in the EU, there is little possibility of this changing.]

On top of this, the two parties seem to be more or less oblivious to the urgent need for long-overdue structural reforms. As the 19 May edition of The Economist puts it:

“The pity is that neither the League nor M5S offers solutions to Italy’s real problems. Italian productivity has scarcely risen since 2001. (In Germany it is up by 16%; in Romania, by 134%.) To put this right will require loosening labour laws, reforming the courts, investing in education and infrastructure, and attacking corruption. Although the League and M5S pay some attention to these issues, their chief plan seems to be a huge burst of stimulus from tax cuts and handouts, financed by wishful thinking.”

Taking the first five points above together with the absence of any meaningful commitment to structural reforms, it is hardly surprising that Italian stocks are coming under pressure and that the yield on the benchmark 10-year government bond has gone up 52 points over the past two weeks. BUT let’s keep this in proportion: the yield on the 10-year, currently around 2.23%, is still light-years away from the 6-plus we saw at the height of the eurozone crisis; and the spread relative to the benchmark German 10-year bund, although it has recently jumped out to around 1,5 percentage points, remains well below its long-term average of 2.01pp. So, although investor concern is clearly evident, this is hardly markets going into panic mode!

Nevertheless, if the new government follows through on these pledges they are more or less sure to put Italy significantly in breach of the Maastricht-defined 3% of GDP government deficit rule (which only Malta and Spain breached last year) and push out still further Italy’s total sovereign debt of 132% of GDP (the second highest in the eurozone after Greece).

Thus, similar to the market calm which followed the actual election and last week’s moves notwithstanding, we may still be looking at a triumph of hope over expectation in the investor community (as well as the nascent coalition), as implied recently by Sky News as follows:

“Investors in Italian assets are hoping that, once the government is formed, Five Star and the League will rapidly become aware of the limits of what they can do in power and that the financial markets will keep them in check.”

If this assessment is correct (and I think it is, we can reasonably assume that we shall be seeing further sell-off of Italian assets and, probably given that we are talking about the third largest economy in the eurozone, some downward pressure on the euro too. The big question from the perspective of investors in particular is how far is this likely to go.

“Barbarians” at the Berlaymont

“If Italians do not sort [productivity] out, the markets will render a harsh verdict.”

The Economist, 19 May 2018

Last week, the FT reportedly (eg according to The Guardian newspaper) upset the pugnacious Mr Salvini by publishing an op-ed (subscriber access only) about the emerging coalition agreement under the headline ‘Rome opens its gates to the modern barbarians’ — a reference to the sacking of Rome in 410 by the King Alaric of the Visigoths (pictured above). However, the article did include the following acknowledgement:

“Yet Rome in 2018 is not Rome in 410, and neither Five Star’s Luigi Di Maio nor the League’s Matteo Salvini is King Alaric of the Visigoths. The two parties enjoy unquestionable democratic legitimacy, having won the elections. It is right that they should have an opportunity to govern Italy.”

Furthermore, “barbarians” or not, it is, in my view, more pertinent to be thinking of the seemingly inevitable clash between the Italian government and the European Commission (headquartered in the Berlaymont building in Brussels).

On some issues, notably Russia sanctions (where, remember, consensus is required for renewal) and migration, Rome is likely to garner significant sympathy and support among MS. But on economic issues it is likely to run into a wall, especially with the north Europeans, led by Germany, and even with the French, historically sympathetic towards Italy but with President Emmanuel Macron needing the full support of Berlin if he is to be able to roll out even in part his ambitious EU reform agenda.

Optimists like to point out that populist governments in both Greece and Portugal quickly toned down their rhetoric and largely fell into line. And it is certainly the case that the responsibilities and realities which go with power can be sobering. However, I cannot see either Mr Di Maio or Mr Salvini rolling over easily. Between them, they have a popular mandate for ‘change’ (incoherent though that may be in many respects), on which their supporters expect them to deliver. To all intents and purposes, the LN is to Italy what the Front National in government would be in France (and remember how much concern that possibility raised just last year!); and the M5S is wedded to direct online democracy which has attracted a wide range of activists from both left and right to its banner. Perceived surrender — no matter how unrealistic and, indeed, mutually incompatible in some cases their policies may be — would be potentially suicidal at the ballot box. The Economist again:

“Small wonder that signs of disquiet are emerging in Brussels. The vice-president of the European Commission, Jyrki Katainen, warned that Italy will get no exemptions from the euro zone’s fiscal rules. His colleague, Dimitris Avramopoulos, hoped that the government would not change Italy’s stance on migration. Mr Di Maio and Mr Salvini reacted indignantly.”

“And then there’s Italy”

“With a national debt of over 130% of GDP, the eurozone’s third-largest economy is too big to bail out — even if the single currency is at stake.”

The Economist, 19 May 2018

So, battle there almost certainly will be. With the distinct possibility, in my view, that if they are initially thwarted in their aspirations by ‘Brussels’, as I expect they will be, Messrs di Maio and Salvini will up the ante by putting back on the table some of their currently shelved demands/threats, up to and including attempting to hold a referendum on euro area membership (constitutionally difficult though this would be to do). This would almost certainly trigger a major market reaction, potentially tipping the eurozone back into crisis.

The potentially 'good news' is that such a cloud could bring with it what some would see as the proverbial silver lining. Mr Di Maio may be correct in claiming that the coalition negotiations have taken time because they are “historic”; but they have also taken time because the two parties have had to paper over or put to one side some major differences (eg the M5S’s strong environmentalist agenda versus the LN’s commitment to major infrastructure investment, eg high-speed rail). It is very likely that, after an initial ‘honeymoon period’, internal tensions in the coalition will mount. Coupled with pushback from Brussels and escalating financial market pressure, we may well see the coalition collapse well before the current parliament has served anything like its full term.

Nevertheless, attractive though this may seem for the short-term, it is extremely unlikely that in the interim any of Italy’s deep-rooted political and economic challenges will have been satisfactorily addressed. And history suggests that the next government, whatever its make-up and political hue, may be little more successful in addressing these challenges than past ones have been for nigh on three decades now.

The bottom line? As I have recalled on many occasions over the past three years or so, at the start of the euro crisis investors frequently used to say to me: “There’s Greece, Portugal and Ireland; but the real problem is Spain. And then there’s Italy”. The comment about Spain may no longer apply. But the concern about Italy certainly still does.

And Italy's moment may be about to arrive.

[Note— Added 29 May: Last week I believed that lurid headlines about “investor panic” around Italy were somewhat overdone. However, thanks to President Sergio Mattarella’s vetoing Paulo Savona as finance minister, we do now appear to be on the brink of a real crisis. Consider.

  • It is all but certain that Mr Matterella’s technocrat choice for prime minister, Carlo Cottarelli, will not be able to win the necessary vote of confidence in the parliament.
  • This almost certainly means another election early in the autumn (with consequent disruption to the annual budget debate) where Italy’s future membership of the eurozone may be a central campaign issue.
  • The two populist parties which, just a few days ago, seemed set to be in government by now — ie the M5S and the LN — may campaign together and seem likely to win at least 60% of the seats between them (up from 52% in the last election).
  • They would then have another go at forming a government, this time with a bigger mandate; and they may also set about trying to oust Mr Matterella (whose right to veto Mr Savona is legally questionable) in favour of a president who shares their euroscepticism.
  • Furthermore, they may try to hold a referendum on euro membership. This would remain a constitutionally difficult and likely lengthy process. But the seemingly greater threat alone may be enough to make the current market reaction to developments seem mild by comparison.]

Alastair Newton