Fra BNP Paribas:
Italian politics: Time out
After last week’s deep uncertainty in Italy, the formation of a government has represented a forward step that has reassured the markets.
However, we believe the new government’s fiscal programme presents challenges to EU
rules that open up the prospect of tensions with Brussels and potential rating downgrades.
The relationship of the Five Star Movement and the League in government seems inherently
unstable, raising the spectre of an imminent general election – perhaps as early as October.
We expect political leaders to remain in campaign mode and headline risk to stay elevated.
Our central case is that the BTP–Bund spread will stabilise at about 200bp, but with
occasional bouts of higher volatility testing these levels.
Last week, Italy seemed close to an institutional crisis after President Sergio Mattarella vetoed the cabinet proposed by the designated premier, Giuseppe Conte, and the government parties reacted with anger. The Five Star Movement’s demand that the president be impeached reflected a significant and unprecedented fracture between the president and part of the parliament.
The League, too, while distancing itself from calls for impeachment, presented a
narrative that the president had attempted to block a legitimate government to serve the
interests of financial markets.The eventual compromise offered some positives, in our view.
The president’s ability to block the appointment of a Eurosceptic personality to a key
position – namely, Paolo Savona as finance minister – demonstrated the strength of Italy’s
institutional framework as a potential obstacle to a Eurosceptic drift.
President Mattarella’s patience in favouring the formation of the government is evidence of his impartiality. He favoured the formation of a government that – unlike the potential
caretaker administration under Carlo Cottarelli – looked highly likely to win a confidence vote in the parliament and thus secure the legitimacy to govern.
The cabinet is a mix of political and technocratic appointments. Four of its key members are technocrats: Prime Minister Conte is a law professor; Foreign Minister Enzo Moavero
Milanese is a long-serving diplomat who held ministerial positions in the technocratic
governments of Mario Monti and Enrico Letta; and Finance Minister Giovanni Tria and EU
Affairs Minister Savona are both economics professors.
Instrumental to the solution was a moderation in tone from both Five Star (which withdrew its impeachment motion) and the League.
We think this was partly tactical: Five Star did not want to go to an election and the League did not want to be seen as responsible for a persistent political stalemate. But we believe it was also a response to the tensions in financial markets. The anti-establishment parties’ initial stances belied an apparent sensitivity to market responses that is likely to have reassured investors somewhat.
Key members of the new government have expressly declared that they have no intention of taking Italy out of the euro. Note, too, that most League voters come from northern Italy and have high savings and a strong interest to preserve them. These factors partly explain the recent market retracement. We see a number of remaining challenges, however.
The fiscal plans of the new government potentially challenge EU rules. The deal between
Five Star and the League includes measures whose costs amount to as much as EUR 100bn
or 5% of Italian GDP. It is unclear at the moment how the plan can be reconciled with the
commitment to keep the public deficit below 3% of GDP.
Even if it could be, the path would contravene the Stability and Growth Pact, which requires Italy to narrow its deficit (once adjusted for the cycle) by at least 0.6pp of GDP per year. So while we do not see the programme as a plan to leave the euro, it does look inconsistent with the EU rules.
Key cabinet appointments leave scope for further tensions with Brussels, in our view, which would very likely unnerve the markets.
– Prime Minister Conte is likely to be heavily influenced by the two party leaders as his
deputies. In addition to their ministerial portfolios – Matteo Salvini at internal affairs and
Luigi Di Maio at economic development, labour and social policies – they are likely to
play an important role as deputy prime ministers in influencing the overall political
direction of the new government.
– While Finance Minister Tria opposes the idea of a euro exit, he is quite critical of the
eurozone’s institutional framework and favours a strong fiscal stimulus (possibly
financed by money creation) in Italy and elsewhere as a response to subdued growth
and persistently high unemployment.
– Mr Savona may have missed out on the finance portfolio, but as minister for EU affairs
the convinced Eurosceptic will play a key part in Italy’s relationship with its partners.
A near-term risk of credit rating downgrades persists. Virtually all rating agencies have been calling for Italy to stick to the reform path embarked on under Mr Monti and followed by Mr Letta and Matteo Renzi, with a continued effort towards fiscal consolidation. Judging by the government deal, they are unlikely to get either more structural reforms or further fiscal consolidation.
The economic backdrop has changed. When the Italian parliament was dissolved in
December to trigger a general election, leading indicators in both the eurozone and Italy
were close to historical highs and consistent with exceptionally strong growth. Although still
consistent with above-trend growth, most of these indicators have come off their peaks
since.
To be sure, our central case is for persistently solid growth: we expect Italian GDP to rise by 1.4% this year and 1.2% in the next, in both cases well above its potential rate. But we see risks to the downside: a new adverse shock might transform slower growth into a deeper and more enduring economic downturn.
The European Central Bank’s regular purchases have acted as an insurance policy for
Italy’s bond markets. By varying its capital keys, the ECB has scope to compensate for
potentially adverse shocks, reducing volatility and thus the risk premium needed to hold an
Italian bond.
The threshold for the ECB to continue its net asset purchases into 2019 looks high,
however. While the economic outlook is cloudier than it was, part of the slowdown underway in the eurozone seems to be due to emerging capacity constraints.
The latest inflation data were a timely reminder that inflation is not dead, with a number of indicators pointing upwards even if the underlying trend is still subdued. Add to that the risk that some might attribute political motivations to any decision to prolong QE at this stage.
We therefore continue to expect the ECB to end its net asset purchases in December after a
short tapering. While the central bank will continue reinvestment and should keep sounding
dovish and reassuring that rate hikes are still far in the future, the ECB will cease to be the
purchaser of last resort.
