Political upheaval in southern Europe poses greater risks for Italy than Spain

Spain swings back to the left

A vote of no confidence in Spain has resulted in the dismissal of Prime Minister Mariano Rajoy. Pedro Sánchez, leader of the opposition Spanish Socialist Workers’ Party (PSOE) will take over, with the backing of the hard-left alliance and anti-establishment Unidos-Podemos.

Rajoy’s centre-right People’s Party has been in power since 2011 and is credited with implementing important structural and fiscal reforms, and for managing to steer Spain through the European Sovereign Debt Crisis without resorting to a formal bail-out.

The People’s Party has been mired in corruption allegations for years but anger erupted last week after a former party treasurer along with 28 other officials were found guilty of receiving bribes, money laundering and tax crimes between 1999 and 2005. This ultimately led to the vote and change in government.

Following the stalemate election in the summer of 2016, markets were relieved to see Rajoy remain in power, even with a minority government. The concern was that a leftist coalition of parties could unravel many of the important reforms undertaken, and put in danger the fiscal consolidation that was still in progress.

Today, investors are more sanguine about developments, with little reaction in Spanish markets. This could be because, compared to Rajoy’s party, Sánchez is even more dependent on the backing from other parties to push through any significant change. Most expect the new minority government to struggle, eventually leading to early elections. This would benefit the liberal Ciudadanos or Citizens party, which finished fourth in the last election, but has since doubled its standing in opinion polls and is projected to finish first in the next general election.

The other reason for relative calm on events in Spain is that the kingdom has enjoyed strong growth in recent years, a significant improvement in its annual deficit, and its debt sustainability is not in question.

Italy on the other hand is not only in a perilous situation with regards to its public finances, but its sheer size means it is simply too big to bail out.

Italy’s new government to be judged by markets

After a week of heated negotiations, Italy’s president has finally approved the new cabinet of the League and Five Star Movement (M5S) coalition government.

President Mattarella had rejected Paolo Savona as Economy Minister last week due to his strong anti-euro views. This led to Prime Minister-designate Giuseppe Conte withdrawing from the coalition. Mattarella then proceeded to instigate the formation of a technocratic government, only for the coalition to replace Savona with Giovanni Tria, another economics professor, but with more tempered anti-euro sentiment. Interestingly, Savona is still included in the cabinet as European Affairs Minister.

The coalition of anti-establishment parties will now enter government with a fragile mandate to implement an economic programme that is likely to see Italy’s public deficit increase. For more details of the proposed programme, see the latest Economic & Strategy Viewpoint.

The degree to which the government damages the sustainability of its public finances will depend on three factors: the president’s ability to veto excessive giveaways; the willingness of markets to allow Italy to borrow more; and the influence of Brussels and the European Commission.

We expect Mattarella to delay, but not deny the coalition from implementing its tax and spending plans, while Brussels will take between 12-18 months to take effective action against Italy for breaching its excessive deficit rules. This therefore leaves the market to be judge, jury and executioner, which is far from ideal.

At the time of writing, Italian equities are rising while government bond yields are falling (i.e., prices are rising) in reaction to events. It seems that the avoidance of another election has pleased investors as some had seen the contest turning into an indirect referendum on Italy’s euro membership.

In our view, this is totally misguided. First, while both parties harbour significant anti-euro sentiment, both have an official policy of remaining in the single currency and avoid talking about the issue.

This is because past campaigns that had focused on leaving have resulted in disappointing performances. Earlier this week, two polls were taken by Euromedia and Piepoli organisations for state television Rai’s “Porta a Porta” programme, which showed that 60-72% of those polled want to remain in the euro, against 23-24% that want to leave.

The second factor which the market has ignored is Italy’s constitution, which does not allow for changes to international treaties - this includes even holding a referendum on euro or EU membership. Therefore a change in Italy’s constitution would be required; while not impossible, this would be almost as difficult as, for example, the US changing its second amendment for the right to carry arms.

The key point is that the markets’ pricing can sometimes be a poor signal of true underlying risk. The new Italian government poses little risk to Italy’s membership of the euro through a desired and organised exit. However, its economic programme, if fully implemented, is likely to put Italy’s public finances on an unsustainable path, which could in turn lead to another sovereign debt crisis that may end in a messy Italian exit.

This is still some way off and in the near-term, though bond yields have risen to reflect the growing risk in Italy, the increase in funding costs is likely to only have a small negative impact on economic growth. Meanwhile, the additional fiscal stimulus may even cause growth to accelerate for a limited period.

For a crisis to escalate, we would need to see a failed auction, which would raise questions over Italy's ability to refinance its maturing bonds. This could certainly happen; however, Italy has already sold more than half of the bonds it planned to issue for the year. Moreover, the steep yield curve on offer in Italy for investors is very attractive when compared to other G7 markets.

For Europe more widely, the impact from an Italian debt crisis would be severe. As the third largest member state, Italy would simply be too big to bail-out for any significant period of time. Cross-border lending would be called into question, and the European Central Bank's (ECB) exposure of almost half a trillion euros to Italy through the Target 2 system would put its loans at risk, and may eventually require a recapitalisation if Italy was to default on its debts.

It is too soon to worry about such a scenario, but it is important to note that there is no quick fix on the horizon for the current situation.

We will continue to monitor political developments in Italy, but for the time being the Italian bond market is reasonably steady, with a small increase in risk premium being demanded by investors.

What are the implications for ending QE?

Some commentators have concluded that the current political turmoil could lead to the ECB extending its quantitative easing (QE) programme beyond September. We disagree. ECB president Mario Draghi is likely to face pressure from the Germanic press to show that QE policy is not being set to bail out his home country.

The ECB has always been clear that QE was introduced to fight the risk of deflation, and not bail out governments. The fall in bond yields was a happy side effect. With annual eurozone inflation jumping to 1.9% for May, the ECB has already met its inflation target, which will put it under intense pressure to bring QE to an end.

Instead, the ECB is likely to highlight the other policy tools that are still available for bailing out profligate governments. However, the rules state that the government in question must request the bail-out, and agree to a reform programme, in the same way as Ireland, Portugal and Cyprus did. However, it also requires other member states to agree to bail out Italy, which in our view is simply too big to bail out.