by Niels Jensen, Absolute Return Partners LLP

There is a strong inclination in Europe to use the occasion to teach Italy a lesson. If the EU follows this line, it will dig its own grave.

George Soros

The new Italian government

Italy is now run by a coalition consisting of the populist party Movimento 5 Stelle (M5S) and the far-right party Lega Nord – an interesting cocktail to say the least. The coalition has threatened to throw fiscal prudence to the wind and to embark on a spending spree that will drive debt-to-GDP much higher from already elevated levels.

Financial markets didn’t respond kindly to the news. Bond yields rose sharply (Exhibit 1), and equity prices dropped. Banks performed particularly poorly in the aftermath of the formation of the new government (Exhibit 2).

Exhibit 1:	1-day change in 2-year Italian sovereign bonds
Exhibit 1: 1-day change in 2-year Italian sovereign bonds
Source: Bloomberg, The Daily Shot
Exhibit 2:	FTSE Italia all-share bank index
Exhibit 2: FTSE Italia all-share bank index
Source: The Daily Shot

Lega Nord is the smaller party of the two in the Italian parliament but the senior partner in the new government. It is definitely perceived to be far-right in nature but, in reality, it is more multifaceted than that.

It is indeed correct that some of the policies in its manifesto can only be characterised as far-right. Having said that, its desire to extend the social safety network of Italian society can best be compared with the social-democratic model of Scandinavia, so there is more to the story than what first meets the eye. M5S, on the other hand, is relatively straightforward. It is truly a populist party.

The coalition’s top three objectives are to:

1.     extend the social safety network;

2.     lower taxes; and to

3.     reduce immigration.

Should the new government succeed in implementing that programme, economic growth will almost certainly accelerate, and so will the public budget deficit.

That said, most people who follow Italian politics closely seem quite certain that the new government won’t last that long, but I note that those who are of this opinion are mostly part of the establishment, so no wonder they have their doubts.

If taxes are reduced as dramatically as the new government have indicated, and if the spending power amongst ordinary Italians suddenly start to rise again, you never know what will happen next.

A snapshot of Italy’s biggest problems

Italy suffers from some major structural issues that, even with the best of intensions, cannot be corrected anytime soon. In no particular order, I would consider the following issues to be the most important:

·         High government debt levels.

·         Consistently low productivity.

·         A large shadow economy.

·         A rapidly ageing populace.

·         Proximity to North Africa.

It is almost impossible to rank these problems from least to most important, so I won’t. Also, one could possibly argue that one or two of them are more cyclical than structural in nature; hence they can be dealt with through solid economic performance.

That is correct but only to a degree. Take Italy’s notoriously low growth in total factor productivity (TFP). If TFP has been slipping for almost 25 years, as it has in Italy (see more on this below), one can only conclude that there must be more than just cyclical factors at play here.

#1: High government debt levels

Let’s look at Italy’s reputation as a highly indebted country. It is indeed correct that sovereign debt-to-GDP is very high. It is now in excess of 130%, and total public debt is now in excess of 150% of GDP (Exhibit 3), making the public sector in Italy one of the most indebted public sectors in the OECD.

Exhibit 3:	General government debt as % of GDP (as of 2015)
Exhibit 3: General government debt as % of GDP (as of 2015)
Source: OECD

The EU’s Stability and Growth Pact is a set of rules designed to ensure that member countries pursue sound public finances. At 132% sovereign debt-to-GDP, Italy is already in breach of those rules (which limit government debt to 60% of GDP), and the policy programme presented by the incoming government recently could drive that number to 180% within 10 years, so the gloves have clearly come off.

On the other hand, if one looks at total debt-to-GDP (including all four economic sectors), in an international context, Italy is by no means an outlier, neither in absolute terms nor in terms of how much total debt has risen over the past decade (Exhibit 4).

Exhibit 4:	Total debt-to-GDP vs. change over last 10 years (%)
Exhibit 4: Total debt-to-GDP vs. change over last 10 years (%)
Source: J.P. Morgan (2018)

If sovereign debt-to-GDP is already 132%, and if the incoming government’s policy programme will drive that ratio to 180%, it is only fair to ask whether Italy can reasonably be expected to service all that debt?

Total sovereign debt currently stands at about €2.3 trillion. If we assume Italian GDP to grow by 1% per annum between now and 2030, and we assume that sovereign debt-to-GDP will grow to 180% over the same timeframe, sovereign debt will rise by approx. €1 trillion between now and then.

Some 80% of all existing Italian sovereign debt outstanding are fixed rate securities, yielding on average about 2.5%, and about €300 billion of the bonds outstanding mature every year (Source: The ECB); i.e. the cost of servicing existing sovereign debt will rise by (at least) €2.4 billion (or 0.15% of GDP) for every 1% rise in interest rates.

That is certainly manageable; however, if one instead tunes in on all the new debt the incoming government seems prepared to take on, a more troublesome picture emerges.

Assuming unchanged average borrowing costs by 2030 (i.e. 2.5%), the cost of servicing the additional debt will come to about €25 billion each year - about 1.5% of 2017 GDP.

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