International Finance
coverstory July - August 2018 Magazine

Italy, a test for the European Union and its financial stability

Following the appointment of Conte as the new prime minister, what lies ahead for Italy?

Italy is once again in uncharted territory despite having filled its political vacuum with the appointment of ‘unknown’ law professor Conte as the country’s new Prime Minister, ending a three-month deadlock after Italians voted in an election marked by a far-right and populist surge. During his prime minister’s inaugural programmatic speech, Conte has attempted to reassure investors and both the national and European political establishment that there are no plans in place to leave the Euro. However, experts believe the country remains on a collision course with its eurozone partners and with financial markets.

James Newell, professor of Italian politics at the University of Salford, notes “what is more likely to unsettle investors is less any plan to leave the Euro than policies in relation to the public debt which might result in Italy being forced to leave the Euro against its will”. The new government has indeed failed to give any specifics over the timing and the costs of the core economic and fiscal measures contained in its programme, including a new flat-tax, universal basic income scheme and roll-back of pension reform. “I think that investors and the markets are for the moment adopting a wait-and-see attitude, we shall have to wait and see what happens in the light of more specific plans when they emerge”, Professor Newell added.

Undoubtedly, Italy’s high public debt combined with a weak growth and persistent structural problems of its economy due to the lack of needed reforms justify mistrust by some of its European partners. Professor Newell’s views are shared by Mario La Torre, an economist and finance professor at Rome’s La Sapienza University, who said: ‘the government has announced an aggressive fiscal policy but it is now explaining that not all the goals will be reached in the short term’. However, he expects a new set of goals to be unveiled before the end of summer.

Giuseppe Conte, Prime Minister of Italy
Giuseppe Conte, Prime Minister of Italy

The new government’s spending plans have rattled markets, although the risk of a Greece-style crisis doesn’t currently seem to be on the cards at least yet, it cannot be totally ruled out in the near future due to growing financial pressure Italy has come under. Robert Sinche, chief global strategist at Amherst Pierpont, notes the markets are ‘well aware’ of the pitfalls in the programme. He said: “the markets realise the programme is not sound and, if actually implemented as proposed, would likely cause a further widening of spreads”. In his view, a full implementation of all the outlined proposals could push the spread between Italy’s BTP 10-year bonds and the 10-year German Bunds into the 400-500bp range.

This risk could be further exacerbated by the end of European Central Bank’s quantitative easing (QE) programme as the bank’s policymakers have given their strongest hint that they are preparing to phase-out its bond-buying programme later this year. Italy has undeniably been a beneficiary of the QE, and its end combined with the end of Italy’s Draghi’s era as the Bank’s President could cause further problems for the country. Moreover, Draghi’s likely successor, Germany’s Bundesbank President Weidmann, has widely criticised the effectiveness of the programme and has a different stance on what type of monetary policy Europe needs.

Robert Sinche, chief global strategist at Amherst Pierpont
Robert Sinche, chief global strategist at Amherst Pierpont

The Centre for Economic Policy Research (CEPR), in a recent paper, suggested that “in normal times, debtors have a stronger incentive to default to induce more expansionary monetary policy”. This could be well the case of Italy, which new government has unofficially called on the European Central Bank to cancel the repayment of the €250 billion it holds in Italian debt. On the other hand, the CEPR also highlights “constraints on monetary policy, may act as a disciplining device to enforce repayment of sovereign debt”, something Germany has constantly insisted on with its demands for a more market discipline policy. The question is would sovereign default risk induce countries with a preference for tight monetary policy to accept a laxer policy stance?

Another important factor to watch in global markets is the sustainability of Italy’s highly-indebted and fragmented banking sector. Trust in the country’s banking sector has once again been undermined by a self-reinforcing and contagious cycle of financial pressure stemming from banks’ large holdings of government bonds and non-performing loans (NPLs), which could deeper existing problems during periods of market turmoil.

The banking sector has already gone through some dramatic and controversial bailouts, in particular the government-led recapitalisation of Monte dei Paschi, the world oldest bank and Italian third largest lender. The other two biggest lenders, Intesa and Unicredit, have €130bn of non-performing loans among their assets. Professor La Torre, however, notes “Italian banks have put in place important actions in order to clean their balance sheets from NPLs and have increased significantly their capital”. According to the Italian Banking Association (ABI), NPLs stood at around 14.5% in December 2017 and its ratio is expected to be further halved to around 7.9% by 2020.

Nonetheless, these figures are likely to be revised under the new administration which has already unveiled plans to undo or change some of the measures implemented by the previous government, for example a much debated cooperative banks reform. The government has pledged to present new economic forecasts and goals in September, meanwhile its. ‘hazardous’ fiscal policies coupled with the end of quantitative easing and a vulnerable banking sector could pose a serious threat to Europe as the continent’s economic future and financial stability face unprecedented challenges.

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