Italy: the new populist government poses a threat for the Eurozone

After weeks of negotiations, the anti-establishment 5Star Movement (M5S) and the far-right League reached a deal on a government platform and common candidate for prime minister, which will likely put a populist alliance in charge of the third-largest economy in the eurozone.

On the 23rd May, Giuseppe Conte – a lawyer and university professor with scant political experience – received a formal mandate to become Italy’s next prime minister from President Sergio Mattarella. The mandate is not yet final: the new Prime Minister will have to return a list of names to fill key cabinet positions to Mr Mattarella. In a brief acceptance speech that seemed aimed at reassuring nervous investors and the European Union, Mr. Conte committed to implement the M5S and League agenda. This “government contract” between the M5S and the League, which backs away from some of their more controversial proposals, promises to ramp up spending, raising concerns about a new European crisis. Bond markets have reacted anxiously to the prospect of the populist coalition and the nomination of minister. The 10-year bond yield rose by 20 basis points to 2.42%, taking its total rise in the past two weeks to 64bp.

Why

Since the 4th March elections, M5S and the League, have tried to form a government based on similar proposals included in their political platform. Both party leaders have withdrawn from the race for Prime Minister: M5S leader Mr Di Maio is set to be minister for labour and/or economic development, allowing him to oversee the proposal for a minimum basic income, while Mr Salvini, leader of the League, is likely to become interior minister, enabling him to take charge of immigration.

Although anti-European measures (such as the European Central Bank’s cancellation of EUR 250 billion of Italian government debt and the proposal to discuss a mechanism for Italy to leave the euro) have been put aside, the choice of the Minister of the Economy, who will implement the program, will likely be decisive. Paolo Savona has been was mentioned in the Italian press. This 81-year-old economist and company executive, who has repeatedly called on the Italian government to plan for a possible euro exit, awakens fears of a policy in confrontation with the EU. The program reflects a large part of the League’s proposals, which seem to have emerged victorious from inter-party negotiations.

The coalition’s reform plan consists mainly of expansionary measures. Economic policy would rest on three pillars: a change in the social security system, a cut in income tax through the flat tax (originally proposed by the League), and some roll-back of the 2011 pension reform. According to the Public Accounts Observatory, the estimated cost of all these measures is more than EUR 100 billion In addition, the coalition would have to find EUR 31billion in 2019 to halt an automatic increase in VAT – but their savings measures do not exceed EUR 500 million.

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Risks

Markets reacted quickly to the government’s formation. The spread between the benchmark 10-year Italian government bond yield and the German one, which broke 190 basis points, came under pressure, while Milan’s stock exchange lost almost 2% in two days.

The coalition’s expansive measures should normally boost Italian growth by stimulating household consumption, but the benefit of the public spending increases will likely be offset by deterioration in financing conditions and a fall in confidence. Also, doubt about the sustainability of the Italian debt would risk dragging the country into a spiral of rising interest rates, further limiting the government’s room for manoeuvre and its borrowing capacity. The upturn in activity in 2017 enabled Paolo Gentiloni’s government to bring the public deficit down to 2.1%, in line with the target set by the Stability Programme, but the expansionary measures planned by the government would risk significantly widening the deficit. According our estimates, cumulative measures could increase the government deficit by more than 6 percentage points of GDP, up from 1.8% in 2018. The blatant failure to respect the EU’s stability program in terms of deficit could also lead Europe to sanction the Italian government, and at the same time strengthen the euro exit camp, which considers European regulation as illegitimate.

The banking system also remains under pressure. In 2017, the Italian government rescued Monte dei Paschi di Siena, the world’s oldest bank, which had to agree to a restructuring programme with EU authorities that included branch closures. The M5S and the League declared that they would “redefine the missions and objective” of the bank. These statements have led to sharp selling of Italian bank debt, as new policies threaten to raise the cost of future funding for the sector.

Another area of concern is the risk of contagion within the euro zone, which could weaken the most vulnerable countries of the European Union. The 10-Year Government Bond Spreads increase by 2-3% since the nomination of Italian prime minister.