Italian limbo obscures economic risk

Debt servicing demands improbable policy fix

The Italian electorate has split parliament into three incompatible blocs, none of which have a majority. Turnout for the 4 March election, at 73%, was an all-time low by Italian standards since mandatory voting was abolished in 1994. Polling data indicate that those who did not participate were typically mainstream voters disillusioned with the political process. This helps explain the success of populist parties such the League and the Five Star Movement (M5S). In areas where turnout did increase – mainly in the impoverished southern regions – voters were motivated by protest and largely supported M5S.

The only stable coalitions, in terms of the numbers of seats, would involve M5S and the League, or M5S and the Democratic party. Many observers believe the allure of power could lead to an M5S-League coalition sharing a policy programme of fiscal expansion, immigration pushback and EU obstruction. But M5S takes pride in not striking coalition deals and competes directly with the League for a similar voter base. Coalition negotiations are likely to last months, and the durability of any government is questionable. Italy is likely to be in political limbo until at least the summer, opening a chance for France and Germany to push through long-overdue reforms in Europe, such as on banking union.

Markets responded relatively calmly to the election result. Italian government bond yields added just five basis points to reach 2% the morning after the election, and the Italian stock market dropped just 1.3%. This suggests investors have become more tolerant of political uncertainty against a backdrop of better European growth. In the short term, the outcome of the election is immaterial, as there will probably be no policy developments of any kind for many months. A short-lived coalition or new elections could extend the life of an ineffectual government into 2019.

However, this benign view ignores the medium- and long-term risks of an Italian economic breakdown. The government of Italy remains the world’s fourth largest borrower, raising around €38bn in 2017 alone. The Italian debt management office has skilfully taken advantage of the low yield environment to extend the average maturity of government debt to nearly seven years. This has reduced the pressure of managing the country’s €2tn of debt stock, yet Italy still needs to roll over sovereign debt worth around 16% of GDP every year – the highest rate in the euro area.

Such debt servicing capacity demands a prudent policy framework. Fortunately, Italy has been fiscally responsible in recent years. The debt overhang is a legacy issue from the 20th century, while Italy has run the largest primary surplus in the euro area since 2008 at an annual average just below 1.5% of GDP.

The League and M5S believe this creates room for fiscal stimulus to help poor Italians. Apart from Greece, Italy is the only country in the euro area which, adjusting for inflation, recorded a lower GDP per capita in 2017 compared to 1999, when the euro was created. If the government introduces stimulus policies, it is likely to come into greater conflict with the European Union’s fiscal rules.

While the populists have ruled out a referendum on euro membership, they have little in common at an EU level on other issues central to their campaign, namely the migration crisis and forming a banking union – weak Italian banks have been a major reason for the country’s disappointing economic recovery. However, to be effective at obstruction in intergovernmental negotiations in Brussels, one needs to have a steady government at home.

A politically uncertain, economically weak and increasingly anti-EU Italy could eventually become too great a problem for the euro area to manage.

Elliot Hentov is Head of Policy & Research, Official Institutions Group, at State Street Global Advisors, and a Member of the OMFIF Advisory Board.

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