The first thing you should note about news that the EU has officially started the debt disciplinary process for Italy is that this was expected – it was tipped more than a week ago, confirmed and then discussed at length by the relevant parties.
Still, it’s not what anybody would call a “welcome development”.
“[Italy’s] debt ratio to rise in both 2019 and 2020, up to over 135%, due to a large debt-increasing snowball effect, a declining primary surplus, and underachieved privatization proceeds”, the EU Commission says, adding that “newly adopted measures and adverse demographic trends partly reverse the positive effects of past pensions reforms and weaken Italy’s long-term fiscal sustainability.” The EU’s executive arm also notes that the rise in Italian bond yields only adds the problem. Although “Italy does not appear to face short-term sustainability challenges, vulnerabilities appear on the fiscal side”, the report continues, on the way to noting that “thanks to the ECB’s accommodative monetary policy”, broader risks are “limited”, but Italy is still “exposed to sudden increases in financial market risk aversion due to still large rollover needs (around 17% of GDP in 2019) related to its large public debt”.
Ultimately, Italy is exposed the familiar domino effect, where, in a risk-off environment, BTPs will suffer, driving up debt servicing costs and imperiling the financial sector.
Remember, the dreaded sovereign-bank “doom loop” is very much in play with Italy. “Italian banks were lenders of second-to-last resort last year and their holdings of BTPs are now close to a historical high”, Goldman wrote last month. “Foreign investors continued to be net sellers of Italian bonds until February, the most recent data available.”
Again, all of this was tipped late last month. Indeed, just a day after the EU elections, both Reuters and Bloomberg reported that the EU was set to move ahead with the process.
This is, of course, playing out against an extremely fraught domestic political backdrop, that finds Matteo Salvini pondering the merits of pulling the plug on his fractious coalition with what he considers to be a meddlesome Five Star.
Earlier this week, PM Conte threatened to resign if League and Five Star couldn’t stop bickering or “electioneering”, as he called it.
League logged more than 34% of the vote during EU elections last month, effectively confirming what everyone already knew: Italian politics belongs to Salvini. Five Star suffered a crushing defeat, managing just a third place finish, and Luigi Di Maio was compelled to resort to an online poll just to see if he should remain party leader. He survived, but the coalition won’t.
On Tuesday, Salvini said he’s fine with preserving the existing state of affairs for right now, but that depends on everyone supporting his agenda. “I have no intention of making the government collapse, but the government, premiers, ministers are paid to do things”, he told RTL 102.5 radio. “My reply [to Premier Conte] is yes, but there have to be many yeses [to League demands]”, he added.
Subsequently, Salvini and Di Maio had what was described as a friendly phone call. Conte was pleased with himself. “[The Premier] welcomes that after his press conference yesterday, the leaders of the majority’s two forces spoke again,” a statement from his office said. “The return to dialogue is a good premise to move in the right direction”.
Again, the only “direction” this is headed is towards new elections and, ultimately, rule-by-Matteo. Late last month, Salvini reportedly told party leaders he’s prepared to break up the coalition if there’s not movement on his priorities. UBS WM Italy said in a Wednesday note that the budget process and the tense situation between League and Five Star may well lead to an early vote within the next 12 months. A center-right coalition that includes Berlusconi’s Forza Italia could form a government on its own, UBS says, adding that a center-right government wouldn’t necessarily be a bad thing.
As we’ve noted previously, Salvini’s economic policies would arguably be more market-friendly than the current setup where Five Star’s electoral promises have to be incorporated into fiscal policy. On the other hand, Matteo is likely to push things to the brink when it comes to any standoff with Brussels and his social agenda is, well, a bit unpalatable, to put it mildly. He’s been pushing hard for a Trump-style fiscal package, going so far as to directly reference the US president on any number of occasions.
Read more: Trump-O-Nomics, Italian Style
For their part, Citi isn’t wholly optimistic about the prospects for a situation that finds Salvini running the show. The bank acknowledges that the market may initially like the idea of Five Star being relegated to the backburner in early elections, but in a scenario where League ends up dominating the field, investors would be confronted with an unshackled Salvini, whose recalcitrance vis-a-vis Brussels is legendary. Markets would also need to grapple with the prospect of mini-BOTs (i.e., a parallel currency) and an unwind of pension reforms. Citi goes on to say that Salvini would be kingmaker when it comes to electing Italy’s president. That assessment largely echoes our own, to the extent it suggests new elections would likely produce an Italian state that is beholden to Salvini.
That, ultimately, is the backdrop for the triggering of the budget disciplinary procedure. The euro dipped on the news and Italian yields surged. This basically negates the good vibes from decent services PMIs on Wednesday.
Italian equities are coming off a month that was even worse than last May, when Italian bonds went into meltdown mode. The BTP-bund spread has a date with 300bp and the constant downward pressure on German yields amid global growth jitters will help it get there fast assuming Italy continues to move wider on the back of budget concerns.
Predictably, League is already lashing out at Brussels in the same dismissive terms that Salvini often employs.
“We’re not concerned about the [excessive deficit] procedure, we will work so that there is no longer a political use of EU economic rules”, League’s foreign affairs chief Marco Zanni said Wednesday.
“For us, it’s a political procedure,” he added. “If we look at the numbers and at who doesn’t respect the rules, there are other states which preach to Italy and which don’t respect them.”