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Italy – A European struggle

It has been quiet for a couple of months now in Italy, but scratching the surface discloses that the best bet is that turmoil returns in one way or the other.

The importance of Italy should not be underestimated, because when United Kingdom leaves the European Union (EU) next year, Italy moves up as a clear number three within the EU measured in size of the economy. The Italian economy is actually more than 40 pct. larger than number four, which is Spain. For the European economy, it means something if Italy continues to underperform. Politically, it also has a consequence, as the EU is harder to manage if the third largest country simply follows its own track, which can then again unnerve the financial markets.

It is fair to judge the Italian economic development and the global financial crisis for about 10 years ago as “underperformance”. When 2018 fades out and becomes 2019, Italy’s GDP in nominal terms (measured in U.S. dollars) will still be 10 pct. smaller than it was in 2008, based on the forecasts from The International Monetary Fund (IMF). As a comparison, the Philippine economy will by end of 2018 almost have doubled during the same 10 years. The failing Italian recovery is a poor performance, and it’s natural that it moves voters to new and other parties that promise a better world.

So far, not a lot has happened in Italy since the parliamentary election in March. Many would probably characterise the biggest coalition partner, The Five Star Movement, as a centre-left party while the other partner, The League, certainly is right-wing. This increases the risk for the government to work in two groups, rather than a team.

The League, headed by Matteo Salvini, has set the agenda by focusing on the migration challenge that Italy faces. This resulted in very good election results for his party in the local elections last month. The outcome confirmed what the opinion polls are indicating, that The League would get the most votes if Italy were to hold a parliamentary election now.

This has built pressure on Luigi Di Maio, the leader of The Five Star Movement. Lately, he tested the waters with one of the many reforms that both parties promised the voters during the election campaign earlier this year.

Within the past week, Di Maio proposed what was announced as a labour market reform. It has been criticised from both labour unions and different businesses, which does not necessarily make the reform bad, and on the contrary, could indicate that is a true reform.

The analysis of the reform that I have seen so far, is that it might add to the cost burden for companies and won’t really bring workers a lot. It mostly looks like an action from The Five Star Movement to show some action in a response to The League’s popularity among voters, but far from a real reform. So what is the new Italian government doing?

Nothing.  Apart from doing the same as the prior governments – which is drawing on the credit facility at the mutual Eurozone central bank, the European Central Bank (ECB).

After the financial crisis, the ECB also introduced the extreme monetary policy “quantitative easing”. But the ECB is not conducting the market operations itself, this is still done by the national central banks within in the Eurozone member states. To facilitate the market operations and to get the quantitative easing process rolling, the ECB introduced the “Target 2” system.

It provides immediate liquidity to member state central banks and commercial banks in very large sums that can be transferred at any time. In the extreme, it’s an unlimited credit facility where the funds for example, can be used to purchase member states government bonds. In theory, the aggregated Eurozone central bank balances in the Target 2 system should equalise, which is very likely to occur if all Eurozone members stay together forever.

Since the introduction of Target 2, Italy has drawn on the facility for example, to purchase its own government debt. Last year in June, the balance stood at EUR 430 Billion (USD 500 Billion), but now the Italian debt to the ECB stands at EUR 480 Billion (USD 560 Billion) or equal to around 30 pct. of the total Italian GDP.

As long as the Eurozone stays intact, and the member countries stay together, there is no risk for the ECB. But the countries cannot just decide to stay together forever, especially if macroeconomic factors or the voters force the country in another direction.

The risk for the ECB is that the government bonds lose dramatically in value, or the Italian government can’t repay the debt, then the bondholders are not able to repay the ECB.

This is by no means a risk right now, but in a couple of months, the negotiations about the Italian fiscal budget for 2019 will start, and it will be a classical Italian drama.

The two parties in the new government have promised their voters to roll-back a few prior reforms that limited the government spending, and further introduce new public spending programmes, thus further increasing the government debt.

During this process, I am very convinced that it will bring EU Budget Commissioner Günther Oettinger to the boiling point, and I expect him to articulate his view very clearly. A possible response from the Italian government is that they might not be able to service the debt to the ECB, then the turmoil hits the financial markets yet again – it is after all EU’s upcoming third largest economy, so the happenings cannot be neglected.

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