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August 11, 2017

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Italy's coalition is being remarkably candid about its views on Eurozone budget rules, but does that make breaking them any less serious ?

August 29, 2018

 

ref :- "Italy Bond Traders Aren't Sitting and Waiting for Next Storm" , Bloomberg Markets

 

The Eurozone has a plenty of form when it comes to breaches of its own budgetary rules, and it's not just the so-called peripheral nations that step out of line. France and Germany were the first to step out of line with the Growth and Stability Pact that states that no country's budget deficit should exceed 3% of GDP.  France, along with several others, still has issues on that subject, whilst Germany now faces very different criticism, namely that it ignores global (not just European) pleas to boost domestic demand and address its enormous current account surplus. Not rule-breaking as such, just an example of saying one thing and doing another.

 

Back at the inception of the Euro, it was this kind of "fast and loose" attitude to the rules that prompted puritan sceptics to declare that if the demands of membership could simply be ignored when it suited members to do so, then in the long-term the Euro project must be doomed. Some of them are still saying that, even though the Euro is alive and (relatively) well. Ultimately, only time will tell if the problem really will become an existential one for the Eurozone, or if it is to remain a reoccurring, even constant sore that may induce significant bouts of both discomfort and hand-wringing, but is not life-threatening.

 

When it comes to breaking the budget rules, the nation firmly in focus at the moment is of course Italy, where the populist Five Star Movement / League coalition is due to present their first budget next month. Unless the bean-counters can miraculously persuade Italy's men-in-the-hot seat to perform  a 180 degree about-turn, the 3% budget deficit - to - GDP ratio will be exceeded by a considerable distance. As we say, that wouldn't exactly be unique but to our knowledge it would be the first time the government of one of the EU's key nations has made clear their express intention to disregard the restrictions that their predecessors signed up to.

 

Back in May, there was a frantic sell-off of Italian assets as the new coalition under the leadership of Five Star's Luigi Di Maio and the League's Matteo Salvini stumbled to find the candidates for the roles of both Prime Minister and Finance Minister that the President would find acceptable. Calm was restored once they'd chosen Giuseppe Conte and Giovanni Tria for the roles, and Mr Tria had promised to respect the deficit targets set for this year by the previous government. Given the rhetoric emanating from Mr Salvini in particular that was openly dismissive of Eurozone constraints, that always looked like it was going to be more than tough to achieve, and when rumours started filtering through in the second half of July that Mr Tria and the two Deputy PMs were not seeing eye-to-eye, Italian assets came under pressure once again.

 

Perhaps the best measure of how the market's level of confidence in Italy has waned is to look at the yield of its 10yr sovereign debt, and how it has been faring in comparison with that of Spain, with which Italy is so often bracketed. Spain is of course on an opposite path to Italy fiscally speaking, it's finances on the up after emerging from a very painful depression and period of austerity required as a condition of its economic bailout.

 

Anyway, in early December last year Italy's 10yr debt yielded 1.55% and the premium that investors needed to choose Italian debt (BTPs) over that of its Spanish counterpart (the spread) was just 22 basis points. On May 2nd, the yield was still just 1.74% and the spread was 47 basis points. Today, the 10yr BTP yields 3.17% and trades at a premium to Spain of over 170 basis points.

 

At its simplest level, this is hardly surprising and it doesn't require any great skill to see why the rating of Italian debt might be falling . The two main cornerstones of the coalition's fiscal policy are :  1. A universal and much-increased minimum wage (a promise from Mr Di Maio) , and 2. A substantial tax-cut for the poor and self-employed and pension reform (a promise from Mr Salvini). Both will be very expensive and there is little in the way of plans to boost government income to pay for the new outgoings.

 

In response to observers who point out that such plans would certainly put Italy in breach of the Eurozone budget rules, Mr Salvini in particular has been very clear : the rules need to change. You could say that at least he's being admirably frank, but whatever fudges may have taken place in the past such a blatant challenge to EU orthodoxy from such a major cornerstone of the EU project must provoke serious concern. So too will Mr Salvini's apparent willingness to cosy up to Russia's Vladimir Putin in his search for economic support . Such a step by definition would seem to undermine Italy's solidarity with an EU that is currently imposing sanctions on Russia.

 

 

Painful for all though it would have been, the Eurozone could have survived the loss of Greece, say. Any suggestion that Italy's populist leaders might make Italy's position untenable would be a problem of much bigger proportions. But hey .... we're a very long way from that and it's important to recognise that important though they are, disagreements over budgets are not the same thing as a fundamental desire to exit either the Euro or the EU. But taking into account the confrontational nature of some of the personalities involved, there's potential for this to get a lot worse before it gets better. Watch those bonds !

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