Occasionally, there is a major change of government that should command the attention of investors. The election of Donald Trump as US president was such an event. Most European continental elections make little difference to markets, as the economies in the Eurozone are strictly controlled by the European Central Bank (ECB) and the rules of the euro scheme. Newly-elected governments accept they have to limit spending, keep tax revenue up, and ensure their annual deficit is not more than 3% of their national output. They accept the general parameters of value-added tax (VAT), corporation tax and income tax, where the EU plays an increasing role in influencing how these taxes are defined and levied.
The likely formation of a new Italian government from a coalition between Five Star and Lega aims to be a government people do notice. From the Five Star side, they wish to boost welfare programmes and pay a basic state income to those in need. From the Lega side, they want to cut the rates of Income Tax and Corporation Tax. The extent of their ambition will put Italy in conflict with the euro scheme, as the first round effects will be a substantially larger budget deficit.
In a common-currency zone this is a matter of concern to the other members of the scheme. Italy wishes to borrow more in the single currency. She wants to take advantage of the ultra-low rates of interest that prevail in the euro area. Germany will be concerned about the scope for free ridership as the anchor helping provide the low rates and a generally favourable view of euro credit worthiness. Through large quantitative easing programmes, the ECB has bought substantial quantities of Italian state debt. This has helped keep Italian borrowing rates down. There is, however, no ECB guarantee on the credit of individual member states, so the borrowing rates of the less credit worthy members can deviate substantially from the average of the zone, as we have seen in the case of Greece.
The Italian coalition did suggest in its preparatory stages that it ignores the state debt that has been bought up by the ECB in calculating the disciplines of the euro scheme. Whilst there is an argument that in the US or Japan where the state has bought up its own debt it is no longer a liability, as they pay the interest on the debt to themselves, this is not the case for euro members. The Italian state owes the money to the ECB, not to itself. The Italian Coalition seems to have backed down from this proposal, and from the stronger version that the ECB should simply cancel the debt. As the more extreme case of Greece demonstrated, the EU was not willing to bail the member state out by cancelling state debt owed to the rest of the zone.
There are three possible outcomes from the likely clash between such a new Italian government and the EU over its budget rules. Italy may have to climb down and pass a budget which does comply with the financial disciplines. The EU might see the damage a prolonged row could cause, and might offer some temporary flexibility or respite in return for some concessions from Italy. Italy might decide to proceed, ignoring the EU’s demands that it sets a compliant budget. This could then escalate with the EU imposing fines on the delinquent state.
The budget dispute is not the only way the new Italian government might be in disagreement with the EU. The Lega side of the coalition has pressed for much tougher controls on the borders, with repatriation of illegal migrants and a change of EU approach to people seeking to come by boat to Southern Italy from Africa and the Middle East. Again, there are three possible outcomes to the dispute. As these arguments are going to rage at the same time it makes finding a compromise that meets the wishes of both Italy and the EU more difficult.
Our base case assumes the new government will be formed and will mobilise opinion behind a more reflationary economic policy. We therefore expect there to be some further widening of Italian credit spreads with people seeking a higher interest rate on Italian debt, with worries spreading to the wider Eurozone. These types of rows do open difficult issues about the backing for the euro, the way money is shared around the zone, and how stable is the political support for the scheme. We also assume Italy will stay in the euro and the disagreement whilst serious will not destabilise the currency as a whole.
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