Lega finished a sizeable distance ahead of their coalition partners, the Five Star Movement, in the recent European elections. Dennis Shen writes that although Lega’s leader, Matteo Salvini, has stated he has no intention of pushing for snap elections in the short-term, the prospect of instability in the current coalition, as well as a deteriorating fiscal picture, will be closely watched by markets and credit rating agencies. Despite the markets taking recent risks in their stride with Italian yields falling to multi-month lows, Italy remains a source of instability in Europe.
The European elections in Italy on 26 May saw Lega come out on top – with a 34% vote share – representing a significant victory over the party’s coalition partner, the Five Star Movement (M5S), which received just 17%. Recent posturing by the coalition government’s leaders has raised concerns surrounding Italy’s fiscal outlook. Lega’s Matteo Salvini stated after the elections that taxes ought to be cut even if it violates EU fiscal rules; Salvini argued previously in favour of a Trump-style ‘fiscal shock’ in Europe and has repeatedly expressed an interest in changing EU fiscal rules. Recent confrontational rhetoric – including controversial proposals from Claudio Borghi, president of Italy’s lower house budget committee, for the ECB to directly finance European infrastructure projects – alongside grandstanding around expansionary fiscal policy hark back to the lead-up to last year’s budget crisis.
The situation has led to the country’s sovereign rating being downgraded by rating agencies. In December last year, my organisation downgraded Italy’s sovereign rating to BBB+, from A-, and assigned a Stable Outlook. At the same time, it is important to recognise the likelihood of European lender of last resort support for Italy in worst case scenarios given Italy’s systemic economic and financial importance in the region, as well as Italy’s fundamental credit strengths – including a record of primary fiscal surpluses in each year since 2000 except for 2009 and recent current account surpluses. Going forward, however, at least three sources of uncertainty may challenge Italy’s credit rating outlook and be sources of regional instability more generally.
The first relates to the extent of fiscal deterioration. On 5 June, the European Commission stated that an Excessive Deficit Procedure (EDP) against Italy is ‘warranted’, owing to the latter’s violations of the EU debt criterion in 2018 (with a deviation of some 7.6% of GDP last year from the debt reduction benchmark) alongside an expected deviation in 2019 (of 9% of GDP under Commission estimates). So far, the Italian government has responded that it expects the 2019 deficit to come in instead at a more modest 2.1%-2.2% of GDP (compared to the Commission’s 2.5% estimate) – and that moreover any incremental fiscal correction forced into the budget this year threatens to strangle the weak economy.
Even if Italy makes a justified case that excessive fiscal consolidation now could be inappropriate, stressing an economy that is in line to record just 0.2 percent growth in 2019, it’s important to recall that the soft economy also stems out of uncertainty and tighter financial conditions rooted in government policies and confrontational rhetoric. So, Italy’s weak economy is in significant part self-inflicted. Importantly, a policy framework that brings confidence back to financial markets and the business community are critical in turning the corner so that Italy’s fiscal programme can avoid becoming an example of contractionary fiscal expansion. This could include, for example, gradualising future fiscal expansion plans – such as via the sterilisation of plans to remove or reduce scheduled 2020 and 2021 VAT tax increases.
The latest government forecasts for a declining debt ratio from 2020 onwards (to 130.2% by 2021) appear optimistic. While areas of the government programme are aligned with policy priorities Italy desperately needs, such as greater public investment, greater spending on innovation and more inclusive and sustainable growth, the reversal of earlier structural reform and testing of market confidence are the wrong routes to achieve desired outcomes for a reduction in Italy’s growth gap with the rest of Europe.
A second source of uncertainty relates to the probability of early parliamentary elections. Lega’s advantage in national opinion polls over the Five Star Movement raises the prospect of the former leading a new centre-right government if a snap vote were held before elections are due in 2023. Whether or when Italy will go to snap elections is unclear, however. Salvini has long resisted pressure from senior Lega advisers to immediately break up the coalition government with the M5S. This relates to a level of wariness towards an alternative that may require governing with ex-Prime Minister Silvio Berlusconi.
Salvini might prefer an alternative scenario of governing only with the far-right Fratelli d’Italia (Fdl) if support for the two parties grows (Lega and Fdl combine currently for around 42.5% in opinion polls – close to the required figures for an outright seat majority). However, there is no assurance that President Sergio Mattarella would immediately call fresh elections if Lega exits the existing coalition. Mattarella could, for instance, first explore whether an alternative coalition could be formed between the Five Star Movement and the centre-left Democratic Party.
While a hypothetical right-wing government after a snap election could prioritise less fiscal expenditure than the current government with the Five Star Movement, Salvini’s anti-EU rhetoric and intrigue in fiscal expansion via lower taxes mean that current market anxiety around Italian debt sustainability would remain far from resolved even if Lega heads a new government.
And as a third source of uncertainty, the Italian lower house voted unanimously on 28 May in favour of a non-binding motion to guarantee payment of the government’s commercial debts, including via issuance of so-called mini-BOTs. The Italian government has around EUR 53bn, or 3% of GDP, in outstanding arrears as of 2018. Only about EUR 10bn (0.6% of GDP) of these arrears were included in the public debt figures, on the basis of European statistical rules.
As such, the securitisation of these public sector arrears in and of itself is not bad. The formalisation around the terms of repayment via securitisation could indeed accelerate the debt’s repayment or, alternatively, facilitate conversion into a useable tax rebate. Moreover, the transition of arrears into a tradeable security would expedite their removal from the balance sheets of government suppliers, enhancing liquidity.
However, past rhetoric by Lega authorities that mini-BOTs are conceptually linked to their conversion into legal tender has facilitated a very negative market repute. The consequences of such a policy (if it ever becomes a reality), however, depend on whether theoretical mini-BOTs are securities or currency. If ambitions were to stretch to conversion into legal tender, that constitutes an illegal parallel currency and could hold clear negative implications for Italy’s sovereign ratings – inflaming an already extant confrontation with European authorities and amplifying market anxiety. If securities remain securities, however, implications are more modest.
Financial markets have taken Italian risks in stride in recent weeks: 10-year BTP yields have moderated back to just above 2% – a level not seen since May of 2018 – from 2.67% at the end of last month, owing to accommodative signals on ECB monetary policy. However, Italian risks have not dissipated – and could easily re-escalate in the months ahead in view of collective policy and political risks.