Asset management

1 March 2013

Economist Insights Italian grill
The indeterminate result of the Italian election earlier this week has re-ignited uncertainty. The centre-left coalition secured a majority in the Chamber of Deputies but no party has a majority in the Senate. The most likely scenario is that PD will form a minority government supported by M5S but new elections may be called within the year. Whatever government is formed, the worry is that it could roll back the austerity measures and reform programmes introduced over the past year. Market reaction to the election result was very muted; either the market is optimistic about the chance for a viable government, or it still thinks the ECB will stand behind Italy regardless of the outcome. Joshua McCallum Senior Fixed Income Economist UBS Global Asset Management joshua.mccallum@ubs.com

Gianluca Moretti Fixed Income Economist UBS Global Asset Management gianluca.moretti@ubs.com

Just when you thought it looked like the market was settling into a decent risk-on rally, we get an event like the indeterminate Italian election. Defying the opinion polls, there was a big protest vote in the form of support for the anti-establishment Five Star Movement (M5S) and its figurehead, comedian Beppe Grillo. There was also a strong anti-austerity vote that went to the centre-right coalition of Silvio Berlusconi’s Popolo della Libertà (PdL) and Lega Nord (NL), after Mr Berlusconi promised to roll back recent unpopular (but necessary) taxes. The centre-left coalition formed by the Partito Democratico (PD) and Sinistra Ecologica Libertà (SEL) under Pier Luigi Bersani disappointed in the polls, and the technocratic Mario Monti, beloved of the markets, saw his centrist alliance come in fourth. Markets had been hoping for Mr Bersani and Mr Monti to get enough votes to form a coalition and continue most of the austerity and reforms of recent years. The complexities of the Italian electoral system mean that Mr Bersani’s PD secures just over half the Chamber of Deputies by virtue of having the most votes. But the Senate is equally powerful in Italy and no party has a majority there. After parliament convenes on 15 March, Mr Bersani will get the first opportunity to form a government. To avoid getting into bed with Mr Berlusconi, he will need to look for support from M5S. Mr Grillo has announced that M5S will not support any coalition government, but some sort of deal between PD and M5S still looks most likely. Mr Grillo has long insisted that he is the figurehead rather than the leader of M5S. Unfortunately for him, the whole point about not being leader is that you do not get to lead. Now that the

independent-minded senators of M5S have got seats, they will want to do something. It is the first time in Italian history that the outcome of the polls has been so fragmented and it is hard to predict how the political debate will evolve. However, the most likely scenario could be that Mr Bersani will entice M5S with some of the legislation that they want – an anti-corruption law, a conflict-of-interest law, electoral reform – in exchange for providing support for PD as a minority government. Such a move would be good for PD and M5S because it would be very bad for PdL: amongst other reasons, such legislation could actually prevent Mr Berlusconi from standing for election again. PD might also be able to woo back some of their more left-wing voters that defected to M5S.
Pizza pie chart Composition of the new Italian parliament
Monti M5S

PD+SEL

PdL+NL

Senate Others Deputy Chamber PdL+NL PD+SEL Monti
Source: UBS Global Asset Management

M5S

Still, a minority government would be fragile and unlikely to outlast the year. A less likely outcome that could be just as fragile would be a grand coalition between PD and PdL. This would be a terrible outcome for PD. On the one hand, they would be held to ransom by Mr Berlusconi threatening to remove his support at any moment. On the other hand, M5S would be able to cement their position as the antiestablishment party and continue to attract support from PD voters who vehemently dislike PdL. If M5S are too internally divided to enter into a formal coalition, the only alternative for Mr Bersani would be to aim for new elections, but these would need to wait to be called until after the current President of the Republic’s term expires on 15 May. In the interim PD would probably have to attempt to run a minority government, but this would almost certainly fail to pass any notable legislation – which would not paint the party in a favourable light. Market grill Whatever government is formed, it is hard to see any of this as being market friendly. The worry is that a new government could roll back the austerity measures and reform programmes that Mr Monti introduced over the past year. A roll-back in austerity is actually the least concerning of the two. For a start, Italy’s 2013 budget law has already been passed, so changes would probably be about next year. Of the periphery countries in the Eurozone, Italy’s near-term dynamics are actually the strongest because it is already running a primary surplus. The current budget law already has about 1% of GDP worth of fiscal tightening, so a slowdown here might actually leave the deficit unchanged rather than worsened. By the time Italy gets round to discussing the budget law for 2014, a slower pace of austerity is likely to be the norm in the Eurozone. After the IMF acknowledged that too much austerity can backfire, there have already been moves in many countries to slow down their fiscal consolidation. This is not confined to the periphery: both France and the Netherlands are not going to reach their targets this year. The knock-on effect from Italy joining this group will be less important. More concerning are the risks to the structural reform programme and, in particular, to Italy’s competitiveness. Many of the reforms by the previous Monti government are still to be implemented, which is now unlikely to happen until after the next election. It has to be mentioned that there are a few structural reforms that a minority PD government could introduce with the support of M5S, such as some liberalisation of infrastructure

investment and breaking up some of the artificial monopolies that are seen as exploiting everyday people. However, M5S are very much against flexibility in labour markets, calling for removal of the flexible labour law, reducing working hours and increasing financial support for the unemployed. This last idea, the ‘citizenship salary’ of EUR 1000 per month for each unemployed person, would easily cost Italy almost 20% of its GDP once everyone who is currently out of the labour force realises it pays off to register as unemployed. While such ideas are more about idealism than policy, this would likely be a government focused on regaining votes ahead of the next elections, and they could easily unwind some of the reform progress of the past year. ECB picks up the bill? The initial reaction of the market to the Italian election was, if anything, very muted given the uncertainties that resulted. Either the market is more optimistic about the potential for a viable government, or it still thinks that the European Central Bank (ECB) will stand behind Italy regardless of the outcome. According to the ECB’s stated position, the market is being complacent. For a country to access the Outright Monetary Transactions (OMT), the ECB requires a formal agreement on austerity and reforms with the European Stabilisation Mechanism (ESM). The ECB wants to avoid the moral hazard that would come from putting a ceiling on borrowing costs without the country doing its bit to deal with the underlying problems. If Italy runs into problems with markets and has trouble financing its debt in the near term, the current caretaker government (the old Monti government) would not have the authority to sign up to an ESM programme. If Italy runs into problems after the new parliament starts on 15 March, it is hard to see any government being able to sign up to an ESM programme. Even if a government did manage to agree to join a programme, the negotiations with the Eurozone could be very tense because of the anti-euro position of M5S. It is easy to envisage the market panicking in the meantime and bond yields spiking, leading to contagion in the rest of the periphery. But perhaps the market is not being complacent and is simply relying on the idea that the ECB will not let that happen if push comes to shove. One option for the ECB is to re-open the old Securities Market Programme (SMP), which was basically the OMT without the strings attached. To preserve a bit of credibility the ECB could choose to set the ceiling for interest rates higher under the SMP. This would be enough to maintain Italian access to the market but would be unsustainably painful in the long term. This would put a lot of heat on Mr Grillo and M5S to either support a programme or push for a more radical option such as default or exit. That thought should really be enough to give the market a dose of post-election indigestion.

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