RaboResearch - Economic Research

Italy’s political crisis continues

Economic Comment

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  • Almost three months after the elections, Italy still has no government
  • At this moment, the anti-establishment Five Star and the far-right League are again trying to work things out
  • If they make it, Italy has to prepare for a government with the intention to go on a spending spree, intensify opposition against European budget rules, and to take harsh actions against refugees
  • If they don’t make it, new elections in September are likely and a Five Star – League government could still emerge in a few months
  • The short-term economic impact of the current turmoil is expectedly limited. Longer term predictions are difficult to make at this point given the large uncertainty over future policy. Yet if a Five Star – League government would emerge, Italy’s debt sustainability and longer term growth prospects could be severely damaged
  • We don’t think the next government will deliberately ditch the Euro, but the relationship with Brussels will expectedly worsen. And in case of a Five Star – League government, the risk cannot be fully neglected

So really, a new government was imminent?!

More than two weeks ago, we were told by Salvini and Di Maio that a new Italian government was imminent. Only a few hours more were needed to create a government that planned to go on a major spending spree and challenge European treaties and budget rules (see box 1). Well, the leaders of the far-right League and the anti-establishment Five Star ended up telling us that almost every day since, until last Sunday. On Sunday, both parties pulled the plug. President Mattarella had rejected to install the very Eurosceptic Mr. Savona as Finance minister, whom the coalition had put forward for the job. The President feared that Savona’s appointment would lead to severe repercussions by the markets, which in his view could endanger financial stability and household savings. As the coalition-to-be was unwilling to compromise on this minister, the League and Five Star pulled the plug. That decision seems to have been a very tactical move, especially by the League.

The League has seen its support rise steadily in the polls since the elections and is likely to benefit the most from fresh elections. And Mattarella’s decision to veto Savona could certainly help. While Mattarella has acted within his, albeit stretched, mandate, both Five Star and the League claim that the decision is undemocratic and that the establishment is simply working against them. Going forward, both parties are expected to intensify their anti-establishment rhetoric.

Figure 1: The League going strong in the polls
Figure 1: The League going strong in the pollsSource: Macrobond, Political Thermometer, Rabobank
Figure 2: Confidence slides, but is still high
Figure 2: Confidence slides, but is still highSource: Macrobond, Rabobank

So now what?

After the coalition broke down, Mattarella asked former IMF-director and economist Cottarelli to form a technocrat government, which would need to pass the 2019 budget and lead the country to new elections. Yet Five Star and the League have already said to vote against such a government when it will face the Parliament for a confidence vote. As the populist parties have a majority, the technocrat government would not make it. For a few days, early elections in September seemed most likely. But, as we have seen before, the political situation is a rapidly moving target. At the moment of writing, the installation of a technocrat government has been put on hold, as the populists might give it another try. If they make it, Italy has to prepare for a government with the intention to go on a spending spree, intensify opposition against European budget rules, and to take harsh actions against refugees.

If new elections will be called, the League will expectedly further radicalise during the campaign, while Five Star will reverse its recent shift to the centre. The campaign will be tough, but is unlikely to focus on ditching the euro. Based on current polling, Five Star would again win the elections, but the League would gain the most votes compared to the March 4 elections. A stronger League and a larger combined majority for the populists would increase the risk that the next government endangers the Italy’s public debt sustainability and Euro membership.

To be sure, it is not a given that if both parties fail to make it work now, they will be able to make it work next time. Especially not if a large increase in support for the League would imply that Five Star has to make an even larger shift to the right to please Salvini. Instead, a right-wing coalition might become possible if not all of the League’s gains are the result of losses by the centre-right Forza Italia. And we also should not completely neglect the possibility of a Five Star – PD coalition, as the centre-left PD might decide to drop its opposition to a coalition with Five Star, ‘for the good of the country’. That would certainly pave the way for more prudent policy.

Still, the risk of a government with large spending intentions, possibly leading to a Euro exit has increased lately, and this has rattled markets after they had turned a blind eye for months.

Figure 3: Bond spread spurs to recent year highs
Figure 3: Bond spread spurs to recent year highsSource: Macrobond, Rabobank calculations
Figure 4: The stock market suffers large losses
Figure 4: The stock market suffers large lossesSource: Macrobond

Would a Five Star – League government start printing Lira’s?

While we recognise that the risk of a Euro exit has increased, we still think that the probability is small. Even a Five Star – League government with a stronger majority and a stronger League is unlikely to deliberately leave the Eurozone. We also think that they would eventually cave in to pressure from the financial markets and the constitution, if they try to push their too expansive policy agenda (see box 1), by watering down the measures or breaking up the coalition. That said, the risk of a crisis and eventually an accident that pushes Italy over the edge would significantly increase under such a coalition. While euro exit is not the goal of the current leadership of Five Star nor of Salvini, there are certainly flanks within both parties that are in favour. Hence, should the country end up in a situation with untameable market turmoil, the euro exiteers within the parties might be able to convince the coalition not to accept conditional financial support from the Eurozone, not to step aside and that in fact printing Lira’s and a euro exit is the only way to go. It needs no explanation that this would cause major problems for both Italy and the Eurozone. Even if it does not come to the point of actual Euro exit, the populist coalition could severely damage Italy’s debt sustainability and longer term growth prospects. Yet at this point, future policy is too uncertain to be able to make long-term predictions about the impact of recent political developments.

Will the economy care?

In the short term, we expect the Italian economy to suffer a bit from the current uncertainty. Manufacturing sector and consumer confidence are under pressure, though still (fairly) high in historical context. Italians have become quite used to political uncertainty, so overall confidence effects could be limited. But especially foreign investors might choose to wait and see. Meanwhile, rising interest rates could constrain credit growth and have a small dampening effect on economic activity this and next year. Yet credit demand by businesses has on average remained rather limited in the past years due to the uncertain economic outlook and because quite some business investments have been funded with internal funds. As such, the impact of more expensive credit on investments could be limited. All in all, our forecast of 1.3% of growth this year and 1.1% next year has come under pressure, but we need to see more disappointing data before we will decide to lower our forecast. 

Is the Eurozone (economy) in trouble?

In the short term, the impact of transient Italian political turmoil on the economy of the Eurozone is rather limited. The extreme budget proposals of Five Star and the League could have an impact on investment intentions in other Eurozone countries if businesses believe the monetary union and financial stability are being put at risk. But it seems too early to reach this conclusion. The probability of actual execution of the programme needs to increase before we should expect some sizeable effect.

More in general, as long as there is no mandated Italian government in place, this could somewhat slow Eurozone reforms, as Italy cannot really take part in the discussions. But also after a government is installed, the situation does not necessarily improve. It might even worsen. We think that the next government will strike a more defiant tone towards Brussels and will try to stretch flexibility of the European budget rules even more than in the past, especially if Five Star and the League are in the next government.  Their budget proposals are completely out of line with the European budget rules (box 1), even if only implemented in a watered down version. Furthermore, the two parties have mentioned in their draft government contract that they want to radically reform the stability and growth pact and the fiscal compact. With such a government in place, plans for more risk sharing within the EMU, such as the European Deposit Insurance Scheme, also become even more unlikely than under a less Eurosceptic government. The probability that they would significantly lower government debt and improve banking sector stability is very low, and that is the least that should happen to convince Northern Eurozone Member States into more risk sharing.

Importantly, we stick to our view that it is unlikely that Italy will actually leave the Eurozone. Although the risk cannot be neglected if a Five Star – League government is in place.  

Box 1: The expensive government contract of Five Star and the League

Prior to the breakdown of the coalition talks, Five Star and the League had published a government contract. In this box we look at the most expensive fiscal and economic policy measures.
We have looked at the estimations of the costs by several institutions and economists of the flat income tax, the so-called citizens’ income, and a reversal of the 2011 pension reform. The two-tier flat tax rate is estimated to lower government tax receipts by between EUR 50bn and EUR 102bn a year. Estimates for the cost of a citizens’ income of EUR 780 a month range from EUR 15bn to EUR 30bn a year. A reversal of the 2011 pension reform, known as the Fornero law, would effectively imply a fall in the retirement age, leading to additional pension spending of around EUR 20bn a year. These costs would come on top of the deficit-reducing measures of around EUR 12bn the coalition would need to implement to prevent the VAT rate to automatically increase in January 2019, which both parties have pledged to do. In a ‘worst case scenario’, the government would need to find additional financing of between EUR 100bn and EUR 152bn a year, i.e. between 5.8% and 8.8% of GDP.

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