Business

Italy – the populist agenda

Political developments in Italy seem to have taken a turn for the worse

POLITICAL developments in Italy seem to have taken a turn for the worse. The country's populist parties – the Five Star Movement (FSM) and the League - are inching closer towards forming a coalition government.

An initial draft of both parties' proposed economic policy calls for new, unrealistic spending programmes that will likely go beyond what the government can afford. As a result, the spread between Italian and German government bond yields has widened, as investors start worrying about the Italian government's ability to pay all that it owes.

The coalition's economic programme calls for all sorts of goodies such as a universal basic income, income tax reductions, and a decrease in the mandatory retirement age.

Unfortunately, the Italian government doesn't generate enough revenue to fund all this extra spending. It will be unable to pay for these spending proposals without borrowing money from investors to fund this shortfall. Italy's already massive debt pile currently stands at a worrying 130 per cent of GDP, the second largest in Europe behind Greece.

The extra spending would significantly widen Italy's ‘budget deficit' – the amount by which the government spending exceeds its revenue. No EU country is allowed to have its budget deficit exceed 3 per cent of GDP, and all EU countries are required to keep their public debt levels at a maximum of 60 per cent of GDP.

Unsurprisingly, markets now fear the prospect of Italy's new government blowing a hole in its budget, prompting a surge in Italian bond yields and provoking a dangerous confrontation with the EU. If the EU objects too much, Italy's new leaders may attempt to spook the EU and markets with veiled threats to exit the eurozone.

According to Italy's constitution, a referendum on its membership in the EU/eurozone requires a two thirds supermajority vote in both the upper and lower houses of parliament. This appears unlikely for now.

An exit from the currency union would see investors pulling money out from its domestic markets and banks, decimating Italy's banking system in the process. It would also mean having to set up a new currency that would likely be of less value that the euro, instantly resulting in high inflation and sharply cut wages.

The cost of borrowing for Italy's government would also spike, given that Italian bond yields will no longer be kept down by the ECB's quantitative easing programme, thus killing off the coalition's proposed spending plans anyway.

For us, the ultimate constraint on the coalition's unrealistic spending plans is the bond market itself. No investor would lend to the Italian government if they deem it as being unable to pay back its debt. This would cause the cost of borrowing to soar for the Italian government, thus leaving it unable to fund its spending plans.

The ongoing political situation in Italy is no doubt discomforting for investors, and the risk of an Italian disruption on the European bond market has certainly risen. However, there remain significant hurdles to the coalition's proposed spending.

As a result, we think the repeat of a 2012-style Euro crisis remains a small possibility, at least for the time being. We remain positive on growth prospects for the eurozone economy, choosing to express this view through a preference for European ex-UK equities.

These are our current opinions but the future, as ever, is uncertain and past performance of investments is not a reliable indicator of future performance.

:: Claire McCombe is a private banker at Barclays Wealth & Investments

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