Not so long ago a document as radical as the draft Italian coalition program that surfaced on Tuesday night would have sent the markets into meltdown.
It revealed that the 5 Star Movement and the League were still discussing this week proposals that included a demand that the European Central Bank cancel €250 billion ($297 billion) of Italian government debt. They sought tax cuts and welfare spending increases that could raise the government deficit by as much as 6% of gross domestic product, and wanted to renegotiate Italy’s contributions to the European Union budget and change the bloc’s treaties to allow countries to quit the euro.
The draft deal, leaked to Huffington Post Italy and now out of date, both parties say, was a recipe for eurozone turmoil.
Yet the market’s reaction was remarkably muted. True, Italian 10-year bond yields and the spread over comparable German bonds made their biggest one-day moves since 2016, but both measures remained below their levels at the start of the year. Italian equities fell by 2.3% but are still 8.6% up on the year.
If anything, traders seems to have greeted the proposals with incredulity rather than anxiety. The demand for a unilateral €250 billion ECB debt write-off in particular is so preposterous—it would be entirely illegal under EU law and put the ECB in breach of German constitutional law—that its inclusion has only highlighted the naiveté and inexperience of Italy’s new political leaders. “It’s a joke,” says one Italian investor.
The markets have reacted calmly largely because they remain doubtful how much of that stuff will really make it into a future government program. Both parties have now said any new government won’t put Italy’s euro membership in question.
In any case, there is no guarantee the two parties will actually succeed in forming a government given their difficulties in agreeing on a program—or even settling on a new prime minister. Markets are also reassured by President Sergio Matterella’s insistence that he would use his considerable powers under the constitution to ensure that any new government is committed to honoring Italy’s international obligations.
Even so, investors have certainly been shaken out of any complacency about Italian political risks. The draft program was a reminder that the coalition partners’ instincts are deeply euroskeptic and that populist parties want to do populist things to deliver on their pledges to voters.
The key question for investors now is whether and how quickly the new political forces can be brought into the EU’s democratic, institutional processes—recognizing the need to balance promises to voters with obligations to investors and partners. Or will Italy first go down the path of confrontation, as Greece’s Syriza did in 2015?
Fortunately, Italy today is in a very different place from Greece in 2015; there is no immediate flashpoint since Rome isn’t currently negotiating with Brussels. In 2015, the new Greek government needed to agree a new bailout to keep the economy and banking system afloat; it took six months before Athens acknowledged that its demands for what amounted to unconditional loans were impossible and that the price of EU support was a commitment to modernize its economy.
As long as any new Italian government can maintain market access—which should be easier with Rome running a budget surplus before interest payments and the ECB still buying government bonds—there is less risk of an imminent clash.
Any crisis in Italy would more likely emerge from a new government’s fiscal policies. A move by Rome to reverse past labor-market and pension reforms would be sure to spook the markets, raising doubts about future growth and long-term debt sustainability. So too would any new budget based on the two parties’ current spending plans, which include a guaranteed minimum income promised by 5 Star to appeal to its core voters in southern Italy and a flat tax of 15% to appeal to the League’s core voters in the North. Such a budget would not only set Rome on a collision course with Brussels, but also and perhaps more damagingly raise fresh political questions about the ECB’s bond-buying program—particularly market doubts about the availability of a crucial safety net for Italian debt.
Ultimately, the market may be betting that the feedback loop from the financial markets will ensure that any politically driven shock quickly becomes self-correcting. Faced with the challenge of funding Italy’s vast government debt or the need to raise capital for its banking system, Rome may quickly learn that it pays to keep investors on side.
After all, as the Greek crisis exhaustively showed, there is no simple way out of the euro. An extreme crisis in Italy would most likely result not in euro exit but a debt restructuring. And the costs of that wouldn’t fall on the ECB, as the coalition partners fondly imagine. They would fall on the Italian savers and pensioners—and, yes, voters—who hold 70% of the country’s debt.
Write to Simon Nixon at email@example.com