Daily Management Review

What do Italy’s problems mean for investors?


Italians are threatening their neighbors with exit from the euro area. Investing in European assets should be approached with caution.

In March 2018, parliamentary elections were held in Italy. Traditional political parties were defeated. The largest number of votes received the League of the North, the movement of euro-skeptics and opponents of the EU immigration policy, and the populist party Five Stars Movement, which promises to increase budget spending. After lengthy negotiations, the political leaders of the League (Matteo Salvini) and Five Stars (Luigi Di Maio) agreed to form a government in which they themselves held the posts of vice-premiers, giving the highest leading post of prime minister to a neutral figure - law professor Giuseppe Conte.

The new government has begun to implement campaign promises: approved introduction of a minimum guaranteed income and lower retirement age. These measures were included in the draft budget for 2019, but problems began when the budget was negotiated with the European Union. The previous government agreed on a plan to gradually reduce the budget deficit, in 2019 it should have been 0.8%. The presented draft budget of Italy suggests a deficit of 2.4%. The inconsistency of the country's budget at the European level will be an unprecedented event that threatens Italy with a set of sanctions and could lead to the country's withdrawal from the euro zone.

The increase in the budget deficit to 2.4% is really critical, because the level of Italy’s public debt is one of the largest in the world. After 2008, debt/GDP grew by 5% per year and in 2013 reached 129%. To solve the debt problem, the European Central Bank lowered its key interest rate to zero in 2014, launched a buy-back mechanism on its balance sheet of government and corporate bonds. Countries with high levels of debt are demanded to bring the budget to a deficit-free level in order to gradually begin to pay. However, Italy, despite the measures taken to save, including the unpopular increase in the retirement age, did not manage to reduce the debt. It only stabilized at around 130% of GDP.

How to resolve the conflict between Italy and the EU? Despite belligerent rhetoric, the parties understand that the main thing is not to delay the conflict. The profitability of Italian government bonds since the elections has already increased by 1.5–2% per annum. If investors are not quickly reassured, the increase in yields on the secondary market will turn into an increase in interest expenses of the budget. Then both sides will lose out: the Italian leaders will find that the funds meant for fulfilling their election promises were spent on debt servicing.

The European Commission officials, who initially took a tough stance (the European Commission rejected the draft budget of Italy, demanding that it be finalized) alsoneed to think about finding a compromise. If they play for time, the unacceptable draft budget will turn out to be a fait accompli due to the rising cost of servicing the debt, and then the further increase in the deficit will have to be negotiated once again. In addition, the ECB’s balance sheet now contains hundreds of billions of euro of Italian government bonds and loans to Italian banks. So, unlike the previous peak of the European debt crisis, Italy’s debt is now a much greater problem of the creditor, not the debtor.

The ECB plans to stop buying bonds on its balance sheet from 2019. This means that Italy, in any case, will have to look for buyers in the market for an increasing amount of its debt securities. At the moment it is difficult to predict what additional premium will have to offer market investors and whether it will be possible to convince them to increase their investments in Italy.

Finally, the active penetration of political marginals into the institutions of power in European countries is a signal that radical changes are not far off. EU authorities need to attend to a final solution to the debt problem. This can be done only by changing the direction of monetary policy by 180 degrees: to allow inflation to accelerate, save zero value of money, extend the asset purchase program and thus divert real rates even further into the negative zone.

Despite the fact that while the ECB promises to follow the course of the US Federal Reserve (first stop quantitative easing and then move on to a rate increase), investors are less likely to believe that this is possible. 

source: forbes.com

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