The Price Of Political Uncertainty In Italy: How Much It Costs And Why It Could Be A Bargain

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 |  Includes: EWI, FXE
by: Francesco Checcacci

Italy is in a political gridlock, with the odds of forming a government not looking particularly high, and markets are getting nervous about it. But how nervous? And how much is this going to cost Italian taxpayers?

The simplest way to try to calculate a price would be to compare the yield on government bonds before and after the election. However this might be too generic, as it does not isolate the influence of market dynamics that might not be linked to that specific event.

Looking at how Italian yields moved against yields of some other eurozone country looks better, but Germany might not be the right benchmark, as when risk perceptions rise, German yields tend to fall because of a flight to quality effect. Spain looks like the best benchmark, as it is the only other sizeable European country, apart from Italy, in the southern part of the continent.

In fact yields of Spanish and Italian bonds have moved in similar ways since 2008 and have responded to changes in relative perceptions of risk from bond investors.

ITA_ESP_yieldClick to enlarge
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Italian and Spanish 10 year sovereign bond yields 2008-2013

Therefore, isolating the dynamics of the yield since 2012 can help understand how much Italians are paying for political uncertainty. The curves, in the graph below, show a significant narrowing since the elections.

Italian and Spanish 10 year sovereign bond yields since May 2012Click to enlarge
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Italian and Spanish 10 year sovereign bond yields since May 2012

In fact, after a spectacular comeback in the beginning of 2012, Italian bonds were trading at an advantage between 50 and 100 bps against Spanish bonds. This better reflects, in my opinion, the economic fundamentals of the two countries, since the Italian economy has a stronger production base and a much lower level of household debt. The average spread since May 2012 has been 75 bps.

Italian-Spanish 10 year sovereign bond spread since January 2012Click to enlarge
(Click to enlarge)

Italian-Spanish 10 year sovereign bond spread since January 2012

Since the elections spreads have narrowed to 30 bps, with a loss of 45 bps towards Spain. In 2013, Italy will have to roll 2.73 billion euros of its sovereign debt (see Italian government debt distribution below)

Italian sovereign debt distribution 2013-2038Click to enlarge
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Italian sovereign debt distribution 2013-2038

Under the simplifying but not cavalier (especially since duration of Italian debt is now over 7 but the Treasury is working to increase it) assumption that refinancing moves like the 10 year yield across the curve, this leaves us with the easy math summarised below.

Essentially (about) 45 bps multiplied by the 2.73 billion Italy has to renew in 2013 gives a total bill of 1.2 billion euros.

This is no trivial sum. Let us remember that the new tax on housing introduced by the Monti government raised about 4 billion euros, and cost him dearly at the polls. However, let us put everything in perspective. Parliament is gridlocked because there are 3 main parties controlling each more or less 1/3 of the votes. One of those parties, the Five Stars Movement led by comedian-turned-politician Beppe Grillo, has been voted mainly by people who were disgusted by the many privileges politicians enjoy in Italy. Mr Grillo campaigned on a platform that, besides very vague and mostly worrying statements on economic policy, which are realistically never going to be pursued, included reasonable ideas to reduce those privileges and introduce transparency and accountability in the public administration.

These pledges are very likely going to be upheld by all parties, which belatedly seems to understand failure to do so would cost them a sound defeat at the next elections. More transparency is bound to reduce corruption, mainly based on cronyism or direct control of some parts of the economy by politics. If parties play along it will be because their political survival depends on it more than because they grew a conscience, but this is no matter. Provided they do their homework, Mr. Grillo's movement will likely see its voters progressively shrink or move towards a more reasonable political and economic platform.

Since corruption has been estimated to cost Italians 60 billion euros per year, even if this wave of moralisation succeeded to reduce it by 1/10th, it would be a structural saving of 6 billion per year. Clearly, even a sum double (in case the average spread narrowed further following the direction it seems to have taken now) the 1.2 billion euros Italians could have to disburse one-off, since reasonably after one year the situation should look better both because of an improving world economy and because of a more stable political situation nationally, is not too big a ticket seen in this light. At the moment the interests of Italian taxpayers and those of investors are perfectly aligned, so both should see it as a bargain.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article. The bank I work for might have positions in the securities referred to in the article