investment insights
Italy spooks investors again in EU budget clash
Lombard Odier Private Bank
Italy’s populist politics are again destabilising the Eurozone as the country’s new government prepares a domestic budget and threatens to withhold its payments to the European Union, undermining investor confidence.
Italy’s coalition government has been in place since June, after being elected on a promise to limit migrants landing from across the Mediterranean. Its rhetoric has sparked investor fears that it may set up a confrontation over its economic programme with the European Commission. The clash has intensified since the government last month prevented migrants landing in Italy and tried to link the issue with a threat to halt its EU budget contribution.
Since then, statements from the coalition (made up of the anti-establishment 5-Star Movement and right wing La Lega), have raised questions about the country’s commitment to Eurozone membership.
Deputy Prime Minister Luigi Di Maio, M5S’s leader, denied on 26 August that there are any plans to leave either the EU or the Eurozone. “We will look at all measures in discussions regarding the European budget and will block what doesn’t work for us,” he said. “The other states are not doing what’s not convenient for them,” referring to the refugee issue. Di Maio then gave an interview to La Stampa saying that Italy is prepared to “veto the budget and any dossiers where it’s possible,” Bloomberg reported.
An attempt by the Italian government to veto the bloc’s budget or postpone Italy’s contribution to the EU, in contravention of its commitments, would be sure to be legally challenged by the European Commission.
Leading budget indicator
Next month will illustrate the government’s commitment to its campaign pledges, and provide an early indication of what lies ahead in the country’s EU relations. Before the European Commission negotiates the EU’s budget, the coalition must publish its domestic 2019 targets for gross domestic product and public financing by mid-October. This will show whether the government is prepared to dilute its own economic ambitions and target lowering the country’s 2.3 trillion euro debt.
The coalition government’s policies include an overhaul of corporate and personal tax including a flat tax, lowering the retirement age and introducing a universal minimum wage. The measures would all increase the country’s debt and may cost as much as 126 billion euros, the equivalent of more than 7% of nominal GDP based on the International Monetary Fund’s 2018 forecast.
Joint deputy prime ministers, Luigi Di Maio and Matteo Salvini, have both argued that the country should be allowed to invest in expanding its economy, rather than prioritise lower debt levels. Italian economy minister Giovanni Tria has tried to reassure investors by promising that the government will reduce its debt. Under Italy’s ‘fiscal compact’, the country is committed to cutting its debt-to-GDP ratio of 132%.
Italy is also supposed to keep its government deficit within 3% of GDP. The budget will be “close to” that limit, Salvini said 3 September, adding that “I want to stay under that limit imposed by Europe”. Our projections below show that if the budget deficit were contained at 3%, the debt-to-GDP ratio would increase by around one quarter to approximately 167%, returning to levels last seen three years ago. In an extreme case, if the government’s budget pushed the deficit to more than 5% of GDP, Italy’s debt-to-GDP ratio would rise by more than a third to around 183%, levels that would raise concerns with the EU.
Any deficit higher than 3% would create “difficulties that we don’t want to imagine,” Pierre Moscovici, European Commissioner for Economic and Financial Affairs told Il Sole 24 Ore in an interview published 31 August. If Italy does not abide by the Eurozone rules, “it means wanting to leave the monetary union,” he added. At the time of writing, the League is said to be discussing a budget deficit below 3%, in a bid to reassure the EU.1
“Possible downgrade”
The current jitters are a political creation needing a political solution. For now, as we wrote in May and June, the issue isn’t Italy’s debt solvency, which remains sustainable thanks in part to its current account surplus and the continued low interest rates.
That solvency calculation would change if the Italian government pushed through a 2019 budget that undermines the sustainability of its debt. In such a situation, credit spreads would widen further with a possibility of rating downgrades. This would in turn affect financing costs, raising the likelihood of a government collapse and triggering another election, an outcome that neither coalition partner wants to provoke.
Fitch ratings agency held its ‘BBB’ credit rating for Italy unchanged on 3 September and cut its outlook to ‘negative’ citing the “new and untested nature” of the government. Moody’s has postponed its review of the country’s sovereign rating, marked as a “possible downgrade,” until the budget’s publication. A downgrade by all three major ratings agencies to below investment grade would force institutional investors to divest and the country’s government debt would no longer qualify for some indexes.
On 30 August, the yield on the Italian 10-year sovereign bond reached 3.21% while the spread between Italian 10-year paper and German sovereign bonds reached 284 basis points, the widest since July 2013.
Impact on Italy’s banks
The widening spreads have impacted capital held by Italy’s banks, and are raising their funding costs. This spread widening also increases volatility in stock movements. To date, we have not seen an impact on the non-performing loan market (NPL) and sales continue at reasonable prices. Were this to change it would undermine smaller banks’ capital as well as their NPL-reduction strategies.
Adjusting exposure
Investors should closely watch Italy’s budget build up, including the announcements and reactions from the European Commission that we will begin to see later this month. This will help us to anticipate any contagion from Italy’s new economic agenda into the wider Eurozone. As for European assets, we have adjusted our exposure to European equities to neutral as the region has become relatively less attractive. In addition to the political uncertainties surrounding Italy’s relationship with the EU, fears surrounding trade spats with the US could slow Europe’s momentum. There is also a risk that the cycle in Europe comes to a premature end if rising US interest rates trigger a fall in the markets.
Important information
This document is issued by Bank Lombard Odier & Co Ltd or an entity of the Group (hereinafter “Lombard Odier”). It is not intended for distribution, publication, or use in any jurisdiction where such distribution, publication, or use would be unlawful, nor is it aimed at any person or entity to whom it would be unlawful to address such a document. This document was not prepared by the Financial Research Department of Lombard Odier.
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