Another Italian Drama – Why It Matters

Government deficit out of control, irresponsible government policies, tumbling bond prices and bank share prices, threat of rating-agency downgrades, political instability – we have seen similar Italian dramas in the past that, in the end, did not lead to serious financial market contagion. Nevertheless, there are reasons to be concerned that this time the impact could be more adverse for European and global markets.

The populist coalition government of the anti-establishment Five Star Movement and the far-right League party, formed in late May, surprised markets last week by sharply increasing its government budget deficit targets for 2019–2022, including the Five Star election promise of a “citizenship income,” a form of universal basic income, and the League’s promise of tax cuts. The projected budget deficit of 2.4% of GDP for each of the next three years is three times the 0.8% deficit target for 2019 agreed with the European Commission last year, with improvements to 0.0% predicted for 2020 and a 0.2% surplus for 2021. The Italian government has to submit a draft budget to the European Commission no later than October 15. Tensions will likely increase between the European Commission and Italy over the fiscal measures included in this budget. Comments from the Commission already signal that they consider the draft budget to be incompatible with the stability and growth pact. Reactions of some of the eurosceptics within the government to the mounting pressure from Brussels are stoking market fears of increasing political strife.

A period of continued and possibly increased bond market volatility is looking increasingly likely. This could have negative effects on market liquidity and depth. The volatility limits many investors have on the assets in their portfolios would reduce market demand. Adding to this prospect, the European Central Bank (ECB) is expected to end its net asset purchases at year’s end. Since the beginning of this ECB program, the ECB has purchased 360 billion euros of Italian government bonds. The end of net purchases will coincide with a projected increase in the Italian government’s funding needs. That combination will lead to an increased supply of Italian bonds to the private sector.