Government actions eroding investor trust
After the briefest and weakest of economic recoveries, Italy has succumbed to its third recession in a decade. This risks further undermining Italian support for the euro, particularly considering that Italian living standards today are below those enjoyed 20 years ago when the country adopted the single currency.
Italy's Prime Minister Giuseppe Conte arrives to address the European Parliament during a debate on the future of Europe in Strasbourg, France, February 12, 2019. Reuters/Vincent Kessler
Ahead of European Parliament elections in May, Italy's populist government is becoming more radical. This is unlikely to revive investor confidence in the country. The government is openly attacking Banca d'Italia independence. Deputy Prime Minister Matteo Salvini has called for the central bank's leadership to be removed for failing to prevent Italy's banking crisis. This week, he threatened to seize control of the country's gold reserves and sell them to fund further government spending. This followed reports that several ministers from the Five Star Movement want to block Luigi Federico Signorini, Banca d'Italia's deputy director-general, from renewing his term.
Rome is engaged in a major diplomatic row with Paris, which resents Italy's encouragement to France's 'gilets jaunes' opposition to President Emmanuel Macron. At the same time, its weakening public finances are likely to again put the Italian government on a collision course with Europe over Italy's 2019 budget.
With public debt at around 130% of GDP, the economy must grow if investors are to be persuaded that the country's finances are sustainable. This is crucial for the Italian government now that its gross borrowing needs are close to a staggering $275bn a year.
Similarly, Italy's banks need the economy to grow if they are to work their way out of their still large non-performing loan problem. They also need growth if they are to reduce their vulnerability to a 'doom loop' caused by their excessive government debt holdings.
Judging by its disappointing record of rolling back its predecessor's labour market reforms, Italy's government is highly unlikely to undertake those economic reforms that might jumpstart the moribund economy. On the contrary, in the run-up to the European elections, it will probably become even less market-friendly in an effort to garner electoral support.
Stuck within the euro straitjacket, the Italian government lacks the macroeconomic tools for stimulating the economy. As part of a single currency, it is the European Central Bank - not the Banca d'Italia - which manages Italy's interest rate and exchange rate policy. As such, Italy is precluded from devaluing its currency to restore international competitiveness. At the same time, with a budget deficit that will be swollen by recession, the Italian government cannot resort to fiscal pump priming without destabilising its bond market and incurring the ire of its European partners.
Markets have taken note of Italy's diminished economic prospects by demanding higher interest rates for lending to the government. These rates risk further slowing the Italian economy, which will in turn raise fresh questions about the country's ability to service its debt.
All of this is of the utmost concern for the global economy. The Italian economy is around 10 times the size of Greece's and it has a government debt in excess of $2.5tn. In addition, it has a populist government whose economic policies are at odds with those of its European partners. That will make it all the more difficult for the Italian government to obtain a bail-out package if investor appetite for its debt evaporates.
Hopefully, the Italian government will heed the early warning signs coming out of the market and start seriously reforming the economy. If not, the world should brace itself for another, more vicious round of the European sovereign debt crisis.
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.