Draghi and Italy

A key issue that will be addressed this week is how will the ECB respond to the electoral outcome of Italy. 

The outcome of the Italian election is not yet really known in the sense of the composition of the next government. There seems to be two potential paths going forward. The first was floated over the weekend of another technocrat government. 

The name of the Italy's central bank governor, who succeeded Draghi in late 2011, Visco has suggested to replace Monti as the technocrat PM.  There does not seem to be much support for this course, but may have been proposed to encourage a political solution. 

Indeed the shape of a potential political solution is crystallizing.  In effect, the senators elected under Grillo's 5-Star  Movement would abstain in a confidence vote, making it easier to secure a majority.  The 5-Star movement would support individual government measures that would include a limited agenda:  electoral reform, some provide some relief from austerity and the selection of a new president as Napolitano's term ended in mid-May.    

It appears that Grillo and the center-left could agree to new elections in around six months, in which case it would be interesting to see whether they are before or after the German elections slated for late September. There is much jockeying for position currently in the media as well as within the parties/movements.  Bersani meets with his party leadership in the middle of the week.   A move to bring into the Renzi, the mayor of Florence who lost to Bersani in a leadership challenge last year may help reinvigorate the base, which was disappointed in Bresani's weak campaign in which he seemed to snatch defeat from the jaws of victory, seeing a substantial lead all but disappear.  

Today and tomorrow Grillo will meet with the 165 lawmakers that were elected under his banner.  It is not clear the extent of party discipline or the extent Grillo can negotiate on their behalf.  Besides some political reforms, like term-limits, and conditional euro skepticism (if there is not a change), the 5-Star Movement's concrete, positive program is not obvious.  The idea of renegotiating Italy debt that has been floated is not very helpful insofar as the largest owners of Italian debt are Italian banks, other financial institutions and households.  If it was largely in foreign hands, it could be a different story.  Italy is the only euro area country running a primary budget surplus.  

Given the continued contraction of the Italian economy and the large protest vote against continued austerity, it is possible that a new government would find some modest way to offer economic stimulus.  Ultimately, Italy's problem is not its deficit, which is among the smallest in the euro area after Germany, and not really its debt, which while high is fairly stable.  Instead it is the continued loss of competitiveness, illustrated by high and rising unit labor costs.  

That brings us to the ECB.  A Reuters poll out last week found that 44 of 55 economists surveyed see Italy's election results increasing the likelihood that the ECB's Outright Market Transaction facility is activated.  Twenty two thought it would be triggered by Spain and 18 thought Italy.  A few thought Portugal or Ireland.  Meanwhile, a growing number, though still a minority expect the ECB to cut rates later this year (22 of 76 vs 18 of 76 in January).   However, a large majority (90%) do not expect a cut this week.   

The ECB will update its staff forecasts and, given the recent string of data, including forward looking indicators such as orders, it seems reasonable to expect the revisions to anticipate weaker growth and lower price pressures.  A more pessimistic outlook would be a necessary even if not sufficient condition to lead to a rate cut in Q2.  That said, with the EONIA below 6 bp, it is difficult to envisage the impact of a rate cut, where the zero deposit rate is the key rather than the 75 bp repo rate.  Although ECB officials have indicated they are technically prepared, a move to a negative deposit rate is seen as likely to be more disruptive than constructive. 

Separately, we note that Fitch's report on holdings of US money markets (with a one-month lag) showed that at the end of January, the top 10 held the highest level of euro area paper since Oct 2011 at 14.5%. The peak was in May 2011 near 30%.  In dollar terms, the January reading reflected a 90% increase since the low point in mid-2012. US money markets had become less risk averse as they seemed to be more willing to hold unsecured debt and long-duration paper.  Of interest, two of the largest single bank exposures, Fitch found, were Japanese banks, Mitsubishi and Sumitomo.   Earlier today, Fitch upgraded the viability ratings (VR) of several large Japanese banks, including these two.  It is thought to reflect improvement in the ability of institutions to absorb shocks.