After a few wobbles last week, Italy has a new Government in the form of a coalition between the populist, anti-establishment and Euro-sceptic Five Star Movement (5*M) and Lega.
While we believe an Italian exit from the Eurozone is unlikely, we are concerned that a period of confrontation between the Eurozone institutions and Italy could distract from the important work of building a stronger currency union. Furthermore, political disruption will be of concern to the European Central Bank (ECB) which is keen to end its asset purchase programme while the economy remains near the top of the cycle.
There is high level of belief among the population that much of what ails Italy is due to its membership of the common currency rather than Italy’s weak fundamentals and lack of structural reform. That said, an Ipsos poll at the weekend showed more support to stay in the Eurozone (49%) than leave it (29%). That compares with 41% and 33% respectively in February 2017.
The improved sentiment towards the Eurozone came off the back of Italy participating in the broad cyclical upswing in the Eurozone economy during 2017 and, more recently, increased awareness of the high cost of leaving the common currency. Both 5*M and Lega backed off calls to exit the Eurozone in the run-up to the election. But expect anti-Europe rhetoric to remain high in the period ahead as the new Government attempts to win concessions from the EU, mostly on fiscal policy.
Indeed, with exit off the agenda, at least for now, attention turns to policy. Expect a strong anti-immigration stance and a winding back of recent reforms, especially on pension entitlements. That means weaker fiscal settings, especially when combined with previous positions on introducing a flat tax and a guaranteed minimum income.
That immediately begs the question of how much fiscal room Italy has to move. We think not much. The International Monetary Fund (IMF) paints a reasonably sanguine outlook for Italy’s fiscal position. Rising primary (fiscal balance excluding interest costs) surpluses are expected to lead to a decline in government debt as a percentage of GDP.
These projections were already based on unstable foundations. Italy achieved a primary budget surplus of 1.7% of GDP in 2017. The IMF projects that to rise to 3.6% of GDP in 2022. Tight fiscal policy is expected to get even tighter. We have long questioned the political viability of that assumption.
Furthermore, the IMF is projecting Italy to improve on its recent economic performance and maintain that improvement. They expect Italian nominal GDP growth of between 2.0 and 2.5% per annum for the next five years compared with an average of 1.1% per annum since the Global Financial Crisis (GFC).
The upshot is there is at best only limited room for fiscal easing. Given the already fragile starting point, any attempts to ease fiscal policy seem to us to risk the prospect of higher borrowing costs, lower growth and a return to rising deficits. With that comes confrontation with the Eurozone’s institutions, and probably quite soon.
Confrontation with Italy would be an unwelcome distraction as the Eurozone’s leaders seek to retro-fit the institutional arrangements that would better enable the currency union to weather the next economic downturn, where fiscal policy will need to play a greater role in economic stabilisation.
This will be all quite worrying for the ECB, the Governing Council of which will be keen to make further progress towards monetary policy normalisation. Not that they’ve done a lot yet – all they have achieved so far is a reduction in the pace of monthly asset purchases (quantitative easing or QE).
It was only a few short months ago when markets were considering the possibility of an early exit from the QE programme. While acknowledging that risk, our base case was for the current programme to remain in place until September, followed by a tapering to end the programme by December.
Since then growth has slowed, core inflation has weakened and politics has become messy (in Italy and Spain). We think both the growth and inflation slowdowns are in large part transitory. For now, our base case assumption of an end to the programme by December remains. But politics has the potential to make monetary policy normalisation more challenging. We look to the upcoming EU summit at the end of the month for more clarity.
In the meantime, the mild strengthening in the euro over the last year, which saw the common currency rise from 1.06 per USD last April to 1.24 this January, has gone into reverse. The euro has been in existence since January, 1999 at around its current value of 1.16 against the US dollar. Over the past nineteen years, it has ranged widely between its all-time low of USD 0.83 in 2000 up to the peak of USD 1.58 at the beginning of the GFC ten years ago. Generally speaking, strong euro periods hurt the Eurozone budget as they crimp export earnings, with taxpayers like the German auto and pharmaceuticals industries, or French aerospace and tourism, losing out to cheaper global suppliers. Estimates are that every ten percent gain in the euro trims around six percent from European corporate earnings.
Thus, the six percent decline in the EUR/USD exchange rate this year will soon begin to impact positively on the corporate sector, and may alleviate some of the continental stresses building up due to fiscal slippage in Italy. However, the leading contender for succeeding Mario Draghi as the next ECB Chairman in 2020, Jens Weidmann of Germany, would be less tolerant of allowing a return to deficit tolerance. Especially if he is charged with winding down the massive quantities of Eurozone bonds that will still be sitting on the ECB’s balance sheet in two years’ time.
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