Italy political funk heaps on bailout risks, testing Draghi circuit-breaker
The resounding Italian rejection of the austerity agenda, started 13 months ago by the technocratic government led by Mario Monti, has sparked fears that the eurozone’s crisis firewall will be tested in the months ahead, while Italian bailout risks remain elevated, analysts warned on Tuesday.
Former prime minister Silvio Berlusconi, whose centre-right anti-austerity party won a greater-than-expected 117 seats in the Senate, flatly ruled out an alliance with former PM Monti, saying the austerity agenda lacked democratic legitimacy. Yields on Italy’s 10-year benchmark bond rose to 4.79% on Tuesday from 4.2% in mid-January, which was the lowest level in more than a year, as markets priced in the prospect of a Monti-led coalition holding firm to a fiscal consolidation plan.
A second election, potentially buttressing Berlusconi’s coalition, now looks likely in the months ahead, analysts say, leaving Italy’s fiscal consolidation agenda hanging in the balance and threatening the calm installed late-2012 by ECB president Mario Draghi through the announcement of the outright monetary transactions (OMT) scheme.
The OMT programme is for sovereigns that request a macroeconomic adjustment programme, subject to conditions, principally structural and fiscal reforms, in return for a bond-buying programme by the ECB in the secondary market. However, the election throws into sharp relief a political vacuum at the heart of Europe and a popular rejection of the austerity agenda, increasing Rome’s solvency risks.
Morgan Stanley analysts conclude: “To activate the OMT, political authorities will have to apply and accept additional conditionality. This is what Italy’s electorate appears to have rejected. Other peripheral nations may also be concerned about contagion effects. Subsequently, bond spreads could widen, pushing the EUR lower.”
Analysts at Mediobanca predicted in a February 18 report that bond market pressure, after an inconclusive election, was likely to force a bailout. “Paradoxically, the worst-case scenario could actually become the best case, in our view,” they state. “A booming success of the Five Star [a populist comedian that has captured more votes than any other single party] or a last-minute Berlusconi victory would scare the market sufficiently to put pressure on the [BTP-Bund] spread. “[This would] offer Italy the perfect excuse for what we keep seeing is the only viable way out, given the unsustainability of the country’s high public debt: applying for Draghi’s OMT programme.
“This would naturally end up putting pressure on Germany ahead of its September elections, and add renewed pressure to the EU convergence project.”
Michala Marcussen, chief Europe economist at Société Générale, adds: “The Draghi backstop is still relevant, and yields indicate a correction rather than anything more ominous. However, if Italy rejects a reform programme, it will become a problem for Europe.”
It is possible a new government could be formed, perhaps with an awkward marriage-of-convenience between leftist Pier Luigi Bersani and Berlusconi, however, the crisis circuit-breaker – an ECB backstop in return for fiscal consolidation – has been overwhelmingly rejected, threatening an all-too familiar eurozone domino effect, analysts conclude.
Markets fear that in Italy, like Spain, the real rate of government debt interest payments will leap above the real rate of growth, exacerbating the economy’s high debt-to-GDP ratio at around 120%, compared with 90% in France, which forces Rome to pay €80 billion to €100 billion in interest per year.
Berlin and the ECB have rubber-stamped the medium-term fiscal objectives set by the Monti government, which holds the structural fiscal balance in 2013 steady until 2015. This plan sees the primary surplus increased to 4.8% of GDP, from the 2.9% the government had estimated for 2012, a target challenged by the economy’s disappointing performance in 2012 with a 2.2% contraction. Italy is forced to run primary budget surpluses to cover the high interest service on its debt.
However, the tone of the Berlusconi campaign reveals little commitment for fiscal reform and debt sustainability, with the former PM pledging to refund an unpopular property tax while cutting taxes for lower-income individuals, ostensibly funded with tax hikes on the very rich and greater anti-tax-evasion efforts.
Although Italy has few near-term financing risks, and a modest fiscal deficit, it has one of the biggest debt burdens in Europe at around €2 trillion, which requires growth-inducing reforms to boost medium- to long-term potential growth rate, and a stable political climate, at least in the short-term, says Marcussen.
Even if markets digest Italian political risk and a new government is formed, analysts doubt any coalition would rule for a full five-year term or have the mandate to bite the fiscal bullet, a prospect that threatens to hold the eurozone under siege.
Analysts at Mediobanca reckon markets are too sanguine over Italy’s unsustainable and growth-hobbling debt burden. They estimate that, to bring Italy’s debt-to-GDP ratio down to a Maastricht Treaty-compliant 60%, cutting the debt by €950 billion over 30 years, Italy’s political system would need to embark on a “Herculean task”, while populist leaders have spent most of the past 20 years pledging recurrent spending commitments in pension, education and healthcare.
Although Italy’s yield curve can endure short-term pain and the country boasts abundant household wealth, analysts at the Italian bank concluded in the same February 18 report “that Italian debt would be better off under some sort of ‘EU ring-fencing’ and the potential worst-case scenario of this election could provide the perfect excuse for Italy to apply for the OMT – to the disappointment of Germany, we suspect”.
In other words, even if political stability is established, yields stabilize and any would-be coalition commits to fiscal consolidation, Berlin-financed debt mutualization, through the European Redemption Fund, is the only game in town for decades to come. And yet the Italian electorate has just rubbished Berlin’s blueprint for eurozone reform.