19 September 2022

Hugo Dixon: How Italy could tip into a tailspin

Next month it will be 100 years since Benito Mussolini launched his fascist coup in Italy when his supporters marched on Rome. Later this month the country is almost certain to elect Giorgia Meloni, a former post-fascist and eurosceptic, as its new prime minister. So far, investors haven’t blinked.

Meloni is the favourite to replace Mario Draghi, the highly respected technocrat who helped save the euro a decade ago. Yet the gap between yields on Italian and German 10-year government bonds is 2.3 percentage points, the same level as when “Super Mario’s” government started to collapse in July.

Italy will probably muddle through under Meloni, the leader of the Brothers of Italy, which opinion polls suggest will be the largest party after this Sunday’s election. But there’s also a medium-term risk that the country’s massive debt will spin out of control. This could happen under her watch or, given the short life of most Italian governments, under a different prime minister.

Meloni’s right-wing alliance is promising lower taxes and early retirement. Yet investors are calm because she has abandoned her euroscepticism and says tax cuts depend on the state of the country’s finances, which she promises will be safe in her hands.

Italy’s next prime minister will want to avoid the fate of previous governments which picked fights with the European Union over fiscal policy. Silvio Berlusconi was ejected from power in 2011 after yields on 10-year government bonds shot up to 4.9 percentage points above Germany’s. The anti-austerity coalition led by Giuseppe Conte, which collapsed in 2019, faced a similar experience.

EU SOLIDARITY

Investors are also relaxed because the EU is showing more solidarity than during the euro crisis a decade ago. In response to the Covid-19 pandemic, it launched a Recovery and Resilience Facility made up of cheap loans and grants. Italy will receive the biggest chunk: 192 billion euros, equivalent to nearly 10% of national income.

The EU has also suspended fiscal rules which require member countries to keep budget deficits below 3% of GDP – a suspension that may be extended as a result of the current energy crisis. As a result, Meloni will not have to cut spending or raise taxes immediately.

Russia’s invasion of Ukraine has also strengthened EU solidarity. Meloni’s consistent criticism of Vladimir Putin has won her brownie points in parts of the EU, even though many disagree with her views on LGBTQ rights and immigration.

The European Central Bank also has a new tool to stop the euro zone fragmenting. It will buy the bonds of governments that come under speculative attack so long as their debt is sustainable. Nobody wants Italy to go into a tailspin and drag down countries such as France and Spain, which also have high levels of sovereign debt.

VIRTUALLY UNSUSTAINABLE

The snag is that Italian government debt, which the International Monetary Fund expects to end the year at 148% of national income, is close to being unsustainable. It has risen from 104% in 2007 following shocks including the global financial crisis, the euro zone meltdown, and the pandemic. What is more, the country has found it hard to grow out of its debt. In real terms, the country’s national income is almost exactly where it was 20 years ago.

Optimists point out that inflation and the bounce-back from the pandemic-induced recession have helped to bring the debt down from 155% of GDP in 2020. But these are temporary factors. The ECB is determined to bring inflation back to its 2% target and soaring energy costs may push Italy into another recession.

What’s more, the era of near-zero interest rates is over. Italian 10-year government bonds are now yielding 4.1% – higher than when alarm bells last rang in 2018 and early 2019. Rome is paying an average of 2.5% on its debt because it borrowed a lot of money when interest rates were low, but the average cost is now rising....

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© Reuters