On the 25th September Italians will once again be returning to the ballot boxes to vote for their next Prime Minister, the victor will be their 8th in as little as 10 years.
The collapse of Mario Draghi’s centrist coalition earlier this summer discontinued Italy’s rare 18 month period of stability. Under Draghi Italy had become more influential in Europe and bond yields had remained stable and low. Draghi, a previous president of the European Central Bank (ECB), is a giant of European politics, he is widely respected and seen as the man who saved the Euro; his resignation has had a destabilising effect across Europe.
Italian-German spreads (an instrument often used to measure risk) have widened as bond markets price-in the forthcoming political uncertainty of new government. Along with this, the foreboding macroeconomic outlook is eroding bond prices keeping Italian yields high, currently above 4% surpassing peak pandemic levels.
Polls Point to Right Wing and Eurosceptic Coalition
Fratelli d'Italia (Brothers of Italy) a right-wing 10 year old Eurosceptic party looks set to win the largest vote share. Their leader Giorgia Meloni, a fierce right winger with extreme views, is set to become Italy’s first female PM. The coalition will also include Matteo Salvini’s Lega (League) and Berlusconi’s Forza Italia which will provide an alliance with a comfortable majority.
Meloni and Salvini both strong Eurosceptics, the latter even more so, disagree on many areas of government but seem to have put difference aside for power. However both bullish politicians ultimately want to be the successful leader of Italy’s right and their rocky relationship indicates the possibility of instability within government in the future.
Italy’s Two Decade Misfortune within the Euro
In 2012 as ECB president Draghi was successful at restoring confidence in capital markets through unlimited sovereign debt purchases. However he failed to successfully address the fundamental issue within the Euro - ranging competitiveness between nations.
A conclusive 2019 paper from Germany Think Tank CEP shows that Italy has lost €4.3trillion since the introduction of the Euro. Italy has not found an area to specialise in and be competitive within the Euro and with the inability to devalue their currency within the Euro, Italy has evidently suffered.
Source: CEP STUDY
Italy’s two decades of sluggish growth has led to vast government borrowing to finance costly and inefficient social welfare programmes. Italy’s debt to GDP ratio is now at 150% having increased by 20% after the Covid pandemic.
Italy has lacked strong leadership and guidance to implement meaningful structural change to reverse its misfortunes and become more competitive.
Europe’s Hamiltonian Moment?
The phenomena of joint borrowing introduced by the ECB in 2020 has been dubbed Europe’s Hamiltonian moment. A reference to the United States 1st Secretary to the Treasury, Alexander Hamilton (1775-1804), who instigated a deal that converted individual wartime debts of former colonies into joint obligations of the new Federal Union in 1790.
Italy is the largest recipient of the ECB’s €800bn Covid recovery fund. It is financed by ECB issued ‘Eurobonds’, Italy is therefore able to borrow €200bn at a reduced rate as the EU can borrow at a better rate than Italy.
However, the package is conditional requiring Italy to meet timely targets in order to receive incremental funds. The requirements focus on structural reform such as competition laws, tax reforms and procedures to accelerate court trials. The conditions are aimed to ensure the sustainability of Italy’s high public debt and finance its debt through growth.
A second new instrument introduced by the ECB is the Transaction Protection Instrument (TPI) which gives the ECB the ability to buy unlimited bonds when spreads between two countries become undesirable. The mechanism is designed to help countries keep borrowing costs low in the face of rising inflation and interest rates.
Italy has already benefited from the joint borrowing venture saving €3bn in borrowing costs. This can explain why Meloni has had a more constructive approach to Europe in her election campaign.
Source: Trading Economics
Will a new government uphold the ECBs conditionality?
In the short term it seems Meloni will continue to accept the ECB conditions to gain credibility amongst Italians to prove she can provide stability. Nevertheless Meloni has already stated she believes the conditions of the recovery fund do not target Italy’s most competitive areas.
Europe will strongly discourage any renegotiation of the 644 page recovery deal as any leeway could set a dangerous precedent to rogue states such as Hungary and Poland, who are pushing for renegotiation of sanctions over Rule of Law violations.
Pressure from Germany over joint borrowing
The Pandemic Recovery Fund has been renamed to the Next Generation EU Fund suggesting it is moulding into a more permanent joint borrowing scheme much to the dismay of richer nations such as Germany.
It will become very tempting for governments like Italy to avoid paying for EU joint loans and to partake in another round of joint EU borrowing in order to finance their older more expensive borrowing costs.
The primary issue here is as the process is repeated it will ultimately reduce the creditworthiness of more stable and less risky nations like Germany angering their populations potentially, provoking a reaction in the future.
Salvini has pushed for more borrowing to take place at 2% of GDP to fund new measures to help businesses struggling from the energy crisis, whereas, Meloni has stayed on the more cautious side referencing Italy’s vast public debt in her election campaign.
The new government will have very little time to construct a new budget (before 2023), Thinking.com believes ‘it would be hard for Meloni to derail from the set track’ in such a short space of time.
Outlook for Italian Bond Market
The probability of a firm majority and the likelihood of Meloni sticking to previous commitments offers short term relief and the potential for a rally in the Italian bond market after the elections.
The future is not overly visible but the bond market will remain on a knife edge of stability as it faces extreme risks from either side:
a. Draghi had tremendous soft power over Europe enabling him to be a strong negotiator. Any early attempt from a new leader to renegotiate the terms of the recovery package with a stubborn ECB will likely fail. If this leads to a restriction of €200bn of funds from the ECB, the market will be sent into turmoil.
b. An outright refusal of any renegotiations in the near future from Brussels will have consequences. Meloni will want to prove herself in government and it will be in her nature to make commitments more efficient and focused. Complete loss of democratic control over conditionality will anger a new coalition and hardline Euroscepticism will possibly creep back in. The ECB has hinted that qualification for TPI may be determined according to compliance with the recovery package conditionality.
c. A future backlash from richer northern states over joint borrowing will sharply increase yields depending on Italian reliance on ECB funds at the time
d. A collapse in coalition government cooperation will evidently widen spreads and may lead to inability to reach ECB structural targets.
Overall with the current macroeconomic outlook and with a coalition involving strong Eurosceptic roots likely to come to power, the Italian bond market has strong potential to incur increased risk in the future, thus making Italian debt even more unsustainable.
References/ Further Reading: