Italy Ups The Risk And Resurrects Some Ghosts

Italy's new government programme difficult to reconcile:Borsa de Milano

Bankia Estudios |The alliance between two parties with extreme ideologies which are poles apart has created an unorthodox programme for government in Italy, which could heighten financial instability in the EMU. In any event, there are too many unknown factors and it’s too soon to draw any conclusions.

Two of the points which generated the most concern in the markets, when they were leaked last Thursday, have been eliminated from the final programme: (i) there is now no reference to finding a way to leave the euro; and (ii) the idea of asking the ECB for an aquittance of 250 billion euros of the Italian debt on its balance sheet (a little over 340 billion euros) has been shelved.

That said, the government programme is difficult to reconcile: it aims to cut taxes, increase public spending and, at the same time, lower public debt as a percentage of GDP. The main points are:

  • Reduce fiscal pressure via a reform of personal income tax, with the introduction of just two tax rates (15% and 20%) and a deduction of 3 billion euros for households. For companies, the tax rate is cut to 15% from the current 24%. The cost of these measures is estimated at 50 billion euros.
  • The introduction of a minimum income of 780 million euros for the unemployed and pensioners. In the first case, the payment will be conditional on the person actively looking for work. In the second, it will be a supplement so lower pensions can reach 780 euros. This measure would mean a cost of some 15 billion euros per year.
  • Lower the pension age (currently 67) and backtrack on the last public pensions’ system reform. For example, there would be new points system: (i) “100” which allows someone to retire when the sum of his/her age and years of contribution reaches at least 100; (ii) “41 points”, which allows someone to retire after contributing for 41 years.
  • Reduce the huge public debt pile (currently at 132% of GDP) via greater economic growth, based both on policies to stimulate domestic demand (spending and investment), as well as the implementation of measures to boost exports.
  • Revise the criteria for the contribution and share of the European budgets so they can be consistent with their government programme: in fact, the budgets which will be in force for the next seven years have to be approved this year.
  • Revise bank bail-in regulations, as they believe the current format is an important source of financial instability, with negative consequences for households, which may see their savings substantially eroded. In the specific case of Monte dei Paschi di Siena, they propose a review of its purpose and strategy to bring it more in line with a public bank model.
  • Repatriate 500,000 immigrants who are in an irregular situation.
  • Issue mini-BOTs, which would be a new short-term financing instrument for the Treasury, for the bearer and in a non-electronic format. This type of asset could be negotiated and used to pay future taxes: in short, the government would be anticipating the collection of future taxes. The intention is for this not to be computed as public debt.

It’s impossible to adequately quantify the cost of these measures. That said, a relatively literal interpretation would lead to an increase in public spending of close to 100 billion euros (almost 6.0% of Italian GDP). This would make it almost impossible for the fiscal deficit to come in below 3% and cut public debt, despite being one of the new government’s objectives. In this case, a confrontation with the EU would be guaranteed.

Going back on the previous reform of the pensions system, which at the time was well received by the markets, could make one of the biggest problems in the Italian economy even worse: the excessive spending on pensions, which currently accounts for 16% of GDP (the highest figure in the OECD). It’s a problem which, presumably, will get worse, given that it’s expected the dependence ratio (the population over 65 in relation to the working population) will rise from the current 33% to over 57% in 2040.

The ambition of redesigning the banking regulations so they are tailor-made for Italy does not seem viable within the EMU framework. Its banking system is one of the most vulnerable in the region, with a NPLs ratio of over 16% and a volume of bad loans which represents a quarter of total bad loans in the EMU.

The creation of the mini-BOTs does not just compromise future public accounts, but also involves the risk of being turned into a “parallel” currency which, at the same time, would spark fears it was a first step towards exiting the euro.

The commotion caused by the announcement of the measures is a further obstacle to fresh progress being made in European integration. In this context, it’s very difficult for northern Europe to accept bigger doses of mutualisation.

The markets’ reaction

Uptick in bond yields. The IRR on the Italian 10-year bond rose over 40 bps in the last week, sparking a contagion affect on the other peripheral countries’ bonds: 20 bps in the case of Spain and 25 for Portugal. A warning sign of a more significant deterioriation in the situation would be if the IRR on the Italian 10-year bond exceeded 2.40% (it’s currently at 2.29%).

Declines in equities, more acute in the Italian stock market and, particularly, in the banking sector. That said, the FtMibtel has not broken the upward trend which has defined its rises since end-2016. It has important support levels between 23000 and 22000 points. It should not lose these levels if some of the proposals in the programme do not materialised or are softened.

There is no visible impact on the euro since it was previously weak against the dollar and other currencies.

It’s still very soon to evaluate the consequences of the new Italian government and the programme it wants to implement. We need to follow events very closely because Italy, unlike Greece, is a systemic country for the EMU.

It’s come at an inopportune moment because it coincides with certain doubts about the strength of the European economy and with debt yields in an upward trend. Whatsmore, there will be a meeting of the ECB in a few weeks, where it should not change its road map for Italy and fuel uncertainties in the area of monetary policy for the remainder of this year.

The markets, which up to less than a few weeks ago were fairly complacent, could now over-react. To some extent, this could serve as a kind of “discipline” for the new government and make it more pragmatic.