A last chance for Italy

By:
Published on:

If the mainstream parties don’t reform now, they face much worse later, says Alberto Gallo, Head of European Macro Credit Research at RBS


Alberto Gallo, Head of European Macro Credit Research, RBS
Investors’ love affair with Italian debt is on the rocks and will face tougher tests ahead. Foreign money returned to Italy last autumn with the European Central Bank’s pledge to buy sovereign bonds from struggling countries in the eurozone’s periphery.

But this new confidence hangs by a thread, as Italy’s inconclusive election raises doubts as to whether it will form a credible government that could meet the terms of ECB support. Yields on Italy’s sovereign debt have already risen, but may get even worse as investors realize that a left-right coalition government is destined for failure. How then can Italy regain markets’ confidence? The country is almost certainly heading back to the polls in three to six months given the distance between the Democratic Party (PD) and Silvio Berlusconi’s People of Liberty (PdL) alliance on key areas such as labour reform and taxes. During this time, the political gridlock will give fertile ground to Beppe Grillo’s Five Star Movement, which pledged to ally with no other party. His anti-austerity, anti-euro message appeals to voters who are angry at the old generation of politicians – the ‘casta’ – responsible for the country’s slow economic decline. Yet Mr. Grillo’s rise also presents an opportunity to Italy’s mainstream political forces to finally wake up to Italy’s problems and change their strategy. Both the PD and the PdL should use their time before a second vote to radically shake up their approach to politics and return to the electorate with a more appealing choice. The PD should ask itself whether Pier Luigi Bersani is capable of achieving a decisive swing next time around, or if he should leave room for a younger and more dynamic leader. Just as pertinently, the PdL must assess whether Mr. Berlusconi is still an electoral asset or a liability. There isn’t much time – the economy is getting worse. In this interim limbo, companies uncertain on the direction of future Italian taxes and reforms will freeze investment decisions and delay new hires. Banks will hold up new loans. Consumers will further tighten their belts. The longer the instability lasts, the more the recession could deepen, generating higher unemployment, defaults and bad loans. Political anxiety could spill over to the banking system, too. In January, Italian banks lost €30 billion in deposits, according to the ECB. Unofficial news that Mario Monti’s interim government was reconsidering €3.9 billion of public support for Banca Monte dei Paschi di Siena pushed the bank’s bonds down more than 2 percentage points on the day. Finally, Italy’s situation can cast broader doubts on whether the eurozone’s austerity strategy is sustainable. It is a race between reforms and populism: reforms and austerity are painful initially, and if they do not re-start growth quickly enough, populism takes over. The risk is that this could happen to other countries too, weakening the ECB’s backstop even further. At that point, core European countries will face a dilemma – either give unlimited powers to the ECB and risk periphery countries free-riding on its support, or let populism rise and threaten the currency union. It looks like a Catch-22 situation. New elections today would pose an even greater risk to stability. Mr. Grillo’s Five Star Movement and Mr. Berlusconi’s PdL gained ground over the days immediately before the elections on tax-rebate promises, pushing the Monti camp’s support down to just 10 per cent of the vote. On the other hand, living with a government that is unable to act is not an option. The longer the economy deteriorates, the more tempting these populist promises are to cash-strapped Italians. Italians want change. They are right: Italy has seen little or none over the past 20 years of elected governments. Like a group of prima donnas, the existing old-school political forces continue to bicker around alliances, while bond yields rise and rating agencies threaten downgrades. Instead, all leaders should stop arguing and rethink their strategy from the start. They should focus on three key points: reducing public debt, reforming labor and product markets, and cleaning up Italy’s bureaucracy. They may soon lose their jobs if they don’t.

For more RBS Insight content, click here

Disclaimer

The contents of this document are indicative and are subject to change without notice. This document is intended for your sole use on the basis that before entering into this, and/or any related transaction, you will ensure that you fully understand the potential risks and return of this, and/or any related transaction and determine it is appropriate for you given your objectives, experience, financial and operational resources, and other relevant circumstances. You should consult with such advisers as you deem necessary to assist you in making these determinations. The Royal Bank of Scotland plc, The Royal Bank of Scotland N.V or an affiliated entity ("RBS") will not act and has not acted as your legal, tax, regulatory, accounting or investment adviser or owe any fiduciary duties to you in connection with this, and/or any related transaction and no reliance may be placed on RBS for investment advice or recommendations of any sort. RBS makes no representations or warranties with respect to the information and disclaims all liability for any use you or your advisers make of the contents of this document. However this shall not restrict, exclude or limit any duty or liability to any person under any applicable laws or regulations of any jurisdiction which may not lawfully be disclaimed. RBS and its affiliates, connected companies, employees or clients may have an interest in financial instruments of the type described in this document and/or in related financial instruments. Such interest may include dealing in, trading, holding, or acting as market-makers in such instruments and may include providing banking, credit and other financial services to any company or issuer of securities or financial instruments referred to herein.

RBS is authorised and regulated in the UK by the Financial Services Authority, in Hong Kong by the Hong Kong Monetary Authority, in Singapore by the Monetary Authority of Singapore, in Japan by the Financial Services Agency of Japan, in Australia by the Australian Securities and Investments Commission and the Australian Prudential Regulation Authority ABN 30 101 464 528 (AFS Licence No. 241114) and in the US, by the New York State Banking Department and the Federal Reserve Board. The financial instruments described in this document are made in compliance with an applicable exemption from the registration requirements of the US Securities Act of 1933. In the United States, securities activities are undertaken by RBS Securities Inc., which is a FINRA/SIPC member and subsidiary of The Royal Bank of Scotland Group plc.

The Royal Bank of Scotland plc. Registered in Scotland No. 90312. Registered Office: 36 St Andrew Square, Edinburgh EH2 2YB.

The Royal Bank of Scotland N.V., incorporated in the Netherlands with limited liability. Registered with the Chamber of Commerce in The Netherlands, No. 33002587.

The Royal Bank of Scotland plc is in certain jurisdictions an authorised agent of The Royal Bank of Scotland N.V. and The Royal Bank of Scotland N.V. is in certain jurisdictions an authorised agent of The Royal Bank of Scotland plc.