Italian populism gives investors another fright

European populism is becoming a permanent feature of the continent’s post-crisis political landscape. More than two months after an Italian general election, which provided another unlikely political outcome, the country’s majority coalition is close to forming a government that may exacerbate Italy’s economic weaknesses.

Negotiations to agree common policies between the anti-establishment Five Star Movement (M5S) and right-wing La Lega, slowly scrapped a series of controversial ambitions. What remains are plans for corporate and personal tax overhaul, a universal minimum salary and undoing 2011’s pension reforms. In addition, the parties have made statements pointing to spending more to expand the Italian economy. All of which may cost the country as much as 126 billion euros, equivalent to more than 7% of nominal GDP, based on the International Monetary Fund’s 2018 forecast.

“The recipe for lowering the debt is through investments and expansionary policies,” Luigi Di Maio, head of the 5-Star Movement, said on 16 May.

Italy’s government debt-to-GDP (gross domestic product) is 132%, second only to Greece in the Eurozone. Under the EU’s ‘fiscal compact,’ which limits government deficits to 3% of GDP and debt to 60% of GDP, for example, Italy is technically committed to cut that debt.

In response, markets witnessed the spread between Italian benchmark government 10-year notes widen the most against German sovereign debt since February, to 162 basis points. Five-year credit default swaps, the price of insuring Italian debt, increased to 128.5 basis points at the time of writing, a level not seen in more than seven months.

Investors are justifiably jumpy. Ambitions to renegotiate EU treaties and exit the euro probably haven’t gone away. La Lega had floated, then quietly dropped, a request to exclude 250 billion euros from Italian government debt calculations because the debt is held by the European Central Bank. That would cut 10% of Italy’s debt-to-GDP ratio, do nothing for relations with Germany and in any case, doesn’t change the fact that the debt was issued by Italy.

Also not mentioned in the coalition agreement is anti-immigration rhetoric nor the common goal to end the EU’s sanctions on Russia.

‘A real danger’?  

Still, for the first time a founding EU-member state is led by an overtly EU-critical government. So, the more moderate tone, for now, should not lead us to conclude that where there’s bark there’s no bite. At some point, those policy pledges may be revived, putting the Italian government at odds with much of the rest of the EU.

The European Commission seems to be on its guard. Rightly so, as La Lega and M5S may find that their friction with the European Union becomes the cement for their alliance.

“There is a real danger that the new Italian government could, through its irresponsible economic policies, set the stage for the next euro zone crisis,” Reuters reported on 17 May, citing a “senior official involved in Eurozone policy-making”.

Compared with earlier Eurozone crises, the scale of Italy’s economy and its political weight makes for a very different kind of threat than already experienced with Greece, an economy seven-times-smaller. And a fiscal threat from Italy couldn’t be managed using the European Stability Mechanism.

Size matters

Still, Italy’s debt profile is sustainable since maturities are rather long and the outlook for the Italian economy remains sound. GDP is forecast to rise, unemployment to fall, Italy still has a primary surplus (tax income is higher than spending excluding interest on debt) and the European Central Bank is holding interest rates low while the worst of the Italian banks have been sanitised. In the short run, scale will shield Italy from the worst of investor backlash, while ‘real politik’ is likely to temper the coalition’s more extreme election pledges.

We are following developments closely and will update our views once a new Italian government is formed and a Prime Minister appointed.