Italy Defies Gravity and Risk to Fiscal Rectitude

Italian asset markets continue to fare better than many expected.  The political uncertainty following the March election has been followed by confidence that the Five Star Movement and the (Northern) League will be able to put together a government in the coming days.  If so, Italy would have taken half the time Germany did to cobble a government together after inconclusive elections.  

Politics makes for strange bedfellows, the saying goes, and Italy is not an exception.  The Five Star Movement campaigned against being in a coalition with any of Italy's political parties, and the center-right campaigned hard against it.  Since the election, the Five Star Movement has managed to peel away the League from Berlusconi's Forza Italia.  At first, the League resisted and then Berlusconi relented.  

Recall that Berlusconi was banned from holding electoral office for past misconduct.  He appealed to the European Court of Justice, but before it could rule, the Italian judiciary cut short Berlusconi's prohibition by a year for good behavior.  He is allowed to hold office now.  However, the support for his party has waned, and the League has consistently outpolled it.  Given that the center-left PD has done poorly in the polls, and split between a realos and fundos wing, Forza Italia may be the largest opposition party.  Moreover, with a poor track record of finishing a term, Italian politics remain fluid, and Berlusconi remains a force with which to reckon.  

It is tough to classify the Five Star Movement.  It has toned down the anti-establishment and anti-Europe rhetoric.  Perhaps Greece's experience dissuaded it from repeating the same confrontational approach. Its anti-corruption thrust distinguishes it from others.  In some ways, it is within the social democrat tradition.   The League is not populist, but nationalist and nativist.  It is trying to rebrand itself so it is not seen as a party of the wealthier northern Italians.  It too has de-escalated its rhetoric regarding ditching the euro or antagonizing the EU.  

The M5S and the League economic agenda is the likely flashpoint with the EU.  There are three planks.  First, and the most costly of the initiatives, is what is being called a flat tax.  It is tax simplification to be sure, but it is more progressive than flat.  What is being proposed is a 15% tax that is boosted to 20% for households with annual income more than 80k euros (~$96k).   The current tax schedule ranges from around 23% to 43%.  

The tax initiative comes from the League.  The M5S pushed for a universal basic income scheme.  However, like the flat tax, what they appear to have in mind is a new transfer payment program that is aimed at the unemployed, but also for those that have been unable to secure a job.  

The M5S and the League agree on reversing the increase in the retirement age.  This may be the most controversial for the EU to accept.  The cut in the tax burden is thought to stimulate growth.  Arguably, the lack of growth in Italy has played an under-appreciated role in the sovereign indebtedness and strains on the banking system.  A new social program may not sit well with the EU, but this too can bolster aggregate demand.  Pushing the retirement age lower could ostensibly encourage more participation by younger cohorts, but there may be other more efficient ways, and it goes against the adjustments being made among high-income countries.  

Of course, the M5S and the League play down the costs of their program, but private sector estimates put it at the upper end of the 65-100 bln euro range, according to the local press.  It is not clear if there will be an offset or a way to enhance revenue.  Stronger growth can help but is unlikely to be sufficient, even using some dynamic accounting.  There is also a little flexibility given that its budget deficit has been gradually falling.  The last time it was above 3% of GDP, the mandate in the Stability and Growth Pact was 2011. Before the election, many economists had anticipated a deficit this year below 2%.  

Italy is expected to grow around 1.5% this year, which would make it the weakest of the large countries in Europe.  Unemployment remains stubbornly high.  If a new government boosted the anticipated deficit to 3% (c.f., Spain 2017, 3.1% deficit, France 2016, 3.4% deficit), the bulk of the government's economic initiatives could be funded.  

This suggests a more benign view than many observers offer.  Italy does not need to blow out its deficit, as some suggest.  Reaching the Stability and Growth Pact cap may not set right with the entire EU, but a "blow out" seems exaggerated.  This may help explain why the markets have not reacted more dramatically.  Italy's debt is among the highest in the world as a percent of GDP,  but the best way to address it is to increase the denominator--growth.  

If one takes for granted that the M5S and the League will not eschew the euro or not push for a referendum on EU membership, then there may not be a reason for investors with Italian exposure to panic about a non-traditional government.  There is also a backstop as the ECB continues to buy bonds, and will reinvest maturing proceeds for another year at least.  Also, under-appreciated is the progress being made in addressing the bad loan legacy problem.  

The banks have been under pressure to boost provisions and sell-off bad loans.  There is still more work to be done, and some estimates suggest that at the current pace it may take until the middle of the next decade to reach the average of other EU countries.  Italian banks have also reduced their holdings of Italian government bonds.  Reports suggest that five years ago, Italian banks owned about a third of Italy's sovereign bond market.  Now it is estimated at a little more than a quarter, which matches the long-term average.  The ECB's holdings have increased under the asset purchase plan.  Capital ratios have increased.  Tier 1 capital has doubled to more than 15% over the past decade.   

Lastly, we also note that as one of the consequences of the flow of funds to passive bond funds.  Unless Italy is downgraded, many of these asset managers are unlikely to deviate much.   Italy's 10-year yield is near 1,.93% presently, and past three months it has performed better than Spain and Portugal.  Being underweight Italy because of the political risk would have likely meant under-performance and a lower yielding portfolio.  

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