Italian Election Stalemate Underlines Eurozone Problems

March has begun with Italy’s political future as undecided as the identity of the new occupant of the Vatican.

The stalemate between the main parties, following the inconclusive outcome of the Italian election last month, has renewed doubts on the future direction of the eurozone’s third-largest economy after Germany and France. Italy’s president, Giorgio Napolitano, has said that he is against asking voters to immediately return to the polls after none of the main political parties won a mandate to immediately form a new government.

However, reports at the weekend suggested that the Bank of Italy’s governor, Ignazio Visco, is regarded by many as a favourite candidate to succeed Mario Monti as prime minister, with the mayor of the city of Florence, Matteo Renzi, another name being mentioned. Among Renzi’s views is that politicians should retire once they have been in the job for more than 20 years.

Monti, once dubbed ‘Super Mario’ for the reputation he developed as the European Commission’s (EC) competitions minister for being a tough negotiator, took over as prime minister in November 2011 at the invitation of Napolitano. Heading a team of technocrats, he also achieved some success in improving Italy’s public finances which had steadily deteriorated under predecessor Silvio Berlusconi.

Figures released at the start of this month show that the austerity measures pursued under Monti’s reign were beginning to make a difference. Although the Italian economy sank deeper into recession, with gross domestic product (GDP) shrinking by -2.4% in 2012, the public finances improved with the budget shortfall declining to 3.0% of GDP against 3.8% in 2011. Italy’s exports rose by 2.3% last year and both the Bank of Italy and the government believe that an export-led recovery will be underway by the second half of this year.

Unfortunately for Monti, if any message emerged from the recent election it was that the Italian electorate has soundly rejected further austerity. Voters gave the previously little-known protest group Five Star Movement, headed by a former comedian, Beppe Grillo, a quarter of the total vote. The next leader faces an uphill battle even maintaining austerity policies, despite Italy’s debt load being the second largest in the Eurozone. Despite Monti’s efforts it rose last year to 127% of GDP, the highest level in more than 20 years, from 120.8% in 2011, while unemployment began 2013 at 11.7% and is expected to continue rising to more than 12%.

Italian business leaders reportedly share the public’s mood of impatience with politicians, although relatively few have been ready to say so publicly.

Further downgrades?

At the risk of stating the obvious, credit rating agency (CRA) Fitch’s note issued following the election result was ‘Political Instability is Negative for Italy’. As it noted, the prospect of a lengthy period of political instability ahead adds to the pressure on the country’s sovereign rating, has the potential to disrupt policy making and reduce policy continuity, and to weigh further on an already weakening economy.

Fitch, which has yet to follow its peer Moody’s in removing the UK’s AAA rating status, has been far harder on Italy, which it downgraded from AA- to A+ in October 2011 and a further two notches, from A+ to A-, only three months later. Affirming the rating at the end of last year, Fitch that government instability and prolonged uncertainty over Italy’s economic and fiscal policies as well as policy continuity could lead to further downgrades.

According to Salman Ahmed, fixed income strategist at Lombard Odier Investment Managers, the election result evidences the recent polarisation in Italy, which has triggered a surge of support for extremist elements at the expense of the mainstream parties.

“A grand coalition – albeit a highly unstable one – is clearly a possibility over the next few weeks,” says Ahmed. “However, it will certainly be a challenge to make it work for a sustained period of time and any meaningful progress on reforms is likely to be quite limited.

“The next possible scenario is further elections in few months’ time. The backdrop of a surge in political support for parties with extreme agendas and outlooks is likely to play a big role in shaping expectations for the results.”

Another big question is whether the European Central Bank’s (ECB) outright money transactions (OMT) programme will need to step in. To date the mere presence of the OMT programme has restored calm to the Eurozone bond markets, without requiring it to take action. For the moment, this remains the case – Italian 10-year yields spiked higher to around 4.74% when the election result was announced, but this still compares favourably with the figure of more than 7% reached in late 2011 before Berlusconi was ousted from office and replaced by Monti. A bond auction held on 27 February was still able to attract good demand from investors.

“We think periphery bond markets will have to sell-off considerably from current levels to bring the ECB in play: without market pressure the OMT is likely to remain dormant,” says Ahmed. “A pro-active response from the ECB remains an option, but we think that it is a tail-scenario at this stage rather a central one.

Colleague Stephanie Kretz, adds that longer-term however, the situation “remains fragile” as regards Italy’s future growth. “The seeds of Italy’s problems lie not in a contagion effect from other peripheral countries, but stem from a loss of competitiveness, resulting in zero growth over the decade and an inability to reduce its public debt ratio despite primary fiscal surpluses.

“This is not to say that Italy was unscathed by the euro crisis. With 56% of its exports of goods and services directed to the EU, any hopes for an export-led recovery are overdone.”

In the meantime, the centre-left Democratic Party under Pier Luigi Bersani has indicated that, having won a majority in the parliamentary lower house but not in the equally important upper chamber, it still has hopes of forming a minority administration, which Bersani dubs “a government of change”, if it can form alliances in the weeks ahead. However, he has ruled out doing a deal with Berlusconi and, in turn, has been rebuffed by Grillo who in the election campaign dubbed him a ‘Dead Man Talking’.

Force for change

In a white paper issued by Switzerland’s MIG Bank its chief economist, Luciano Jannelli, forecast that the next few weeks would see spreads likely to widen and the euro, as well as Italian and Spanish equity markets, continue to weaken.

“Persistent political uncertainty in Italy is a clear and present risk for the very survival of the euro, and thus global financial stability,” he wrote.

“Yet, often situations of extreme deadlock offer unexpected opportunities: the new political landscape might actually force Italy’s entrenched establishment to finally adapt some desperately-needed reform measures.”

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