Italy In-Depth: No Holiday for Rome
January 24th, 2018
With the World Economic Forum currently underway in Davos, Switzerland, some delegates are still just arriving due to delays following one of the largest snowstorms in decades to hit the resort village. Much like the weather outside, the mood on the conference room floor is reported to be gloomy and downcast, despite positive global economic growth figures that exceeded many expectations in the past year. World leaders and representatives from institutions including the IMF and the World Bank have expressed concerns over inequality, consumer-driven environmental destruction and unstable growth. During a recent talk, Canadian Prime Minister Justin Trudeau took a stab at aggressive capitalism and business practices stating they “just won’t cut it anymore.”
Only a couple hundred kilometers away in Rome, politicians are currently preparing for another potential source of European instability, namely the upcoming general elections to be held on March 4th. The elections, which were scheduled to take place after President Sergio Mattarella exercised his right to dissolve the Italian Parliament on December 28th, present yet another opportunity for nationalism to rear its head on the continent. Fortunately, there is a low probability Italy’s populist 5 Star Movement (M5S) will gain a majority and in Italy, business will likely continue as usual after the election. Unfortunately, business as usual in the European Union’s third-largest economy is not good enough.
In some ways, Italy has proven more resilient than some might have expected. Often cast in a negative light by economists and financial experts around the globe, in 2017 Italy’s economy grew at the highest rate since 2010. Italian banks seemed to have escaped a meltdown, despite holding some 175 billion euros in bad loans, exports and manufacturing are on the rise, and the country has managed to push through some key political legislation in the past decade. Former Prime Minister Mario Monti overhauled the pension system in 2011 and Former Prime Minister Matteo Renzi managed to partially liberalize labor laws during his time in office. Unfortunately, many of Italy’s woes are stubborn and deeply rooted in Italian political, economic and social structures.
For many Italians, these problems have serious implications in daily life, the most obvious being a general lack of jobs. The overall unemployment rate in Italy has climbed over 10% with youth unemployment rates settling around 35% levels. These challenges become more difficult to tackle given Italy’s unusually distinct north-south divide. Although Italy ranks just 42nd globally in terms of foreign direct investment (FDI), 1/3 of the positive capital flows it does receive go to the Lombardy region of Northern Italy, providing jobs and opportunities for local growth and development. On the other hand, Southern Italy consists of 1/3 of Italy’s entire population, yet accounts for just 20% of total GDP output. As shown in the graph above, regional unemployment rates reflect this disparity in opportunity. According to the OECD, the widening gap in economic prosperity between Northern and Southern Italy is partially due to a tangled political system in which central and local governments have overlapping responsibilities with increasingly poor communication and a lack of common goals. A recent report highlights infrastructure and labor issues as among the most difficult to make headway but also suggests that a disorganized legal structure compounds existing political problems. Southern Italy has fostered a remarkably unattractive business environment in which enforcement of contract takes on average roughly five years, further discouraging FDI. Given the issues currently facing Italy today, the question then becomes, is there a chance that any player the upcoming elections can truly make a change?
Unfortunately, the answer appears to be no. Opinion polls agree that the most likely result of the upcoming election is a hung parliament ultimately resulting in a coalition government or an unstable majority, a recipe for stagnation in the current political climate. Although the past two years have demonstrated the need to take opinion polls with a grain of salt, the predicted outcome is helped by the new electoral system approved this past October known as Rosatellum Bis. The new electoral rules represent a combination of first-past-the-post and proportional representation, ultimately rewarding coalition building, especially among smaller parties. Within this new system, a party would have to win over 40% of the vote to avoid deadlock, however, at the moment none of the three largest political parties look set to win more than 33%. Many view this new set of laws as a direct attempt by the current government to limit the chances of the anti-establishment 5 Star Movement (MS5) of winning a majority, at the expense of political ambitions. Both the Democratic Party, led by Matteo Renzi, and Forza Italia, led by former Prime Minister Silvio Berlusconi have formed alliances which would help them move past MS5 whose current leader, Luigi Di Maio has staunchly refused any form of coalition building. Unfortunately, lack of a clear winner come March is sure to result in deadlock and a continued inability for the Italian government to act decisively to end the troubles that affect its citizens.
Although a hung parliament and business-as-usual are no good for Italy, neither is a surprise upset. Although unlikely, there are factors which point towards a potential for instability and a single party emerging victorious. The first is historical precedent. Italy is a known hotbed of political risk. Some academics have claimed that Italy has experienced more political instability than any other democratic country in the developed world. According to Global Risk Insights, Italy was the most unstable democratic nation between 1970 and 2013, with an average of 1.2 governmental crisis a year. Lebanon, the runner-up, had 1.1. In the past five years, Italy has gone through three separate governments. This inconsistent voting not only limits the government’s ability to conduct effective and clear policy but also increases the challenge of constructing strong predictive voting models. Another factor which clouds the certainty of polls the recent fall in voter turnout from 90% a quarter century earlier to 70% in the last general elections. This change is important because it makes the number of people who turn out to vote for a political party more important than the number of people who say they support the party. Given these factors and the current polling data, there is a roughly 25% chance of a clear victory by any political party on March 4th.
Regardless of which of the three main parties were to win in a polling upset, the result would be detrimental to both Italy’s economy and to its citizens. This is because Italy is currently operating in a state of economic opaqueness. Since the Eurozone debt crisis, Italy has made some small gains and appears to be on a path towards a modest recovery. Unfortunately, it remains unclear whether the positive economic news is primarily a result of the European Central Bank’s (ECB) policy of quantitative easing (QE), or because Italy’s economy has truly begun a structural process of strengthening. Either way, the fact remains that Italy’s debt is worth over 130% of GDP, massive by all standards, and in the European Union a GDP/debt ratio second only to Greece. It is clear that Italian fiscal policy requires a light touch, however, pre-electoral promises by all political parties provide anything but. Under Berlusconi, Forza Italia has pledged to raise minimum pensions, implement a flat income tax and reintroduce the lira for domestic use. The Democratic Party has offered up to 50 billion euros (~$61 billion) in tax cuts, and MS5 head Luigi di Maio has frequently discussed the potential for a nation-wide universal basic income. Although economic theory shows that austerity is a relatively ineffective policy, the suggested policy measures will solely stand to increase government debt at a time when policymakers should be focused on relieving the debt burden through consistent GDP growth. This will put a strain on the national banking system and the EU as a whole.
The effect of Italy’s financial and economic problems, and the inability of government leaders to address them is going to have a dampening effect on growth and prosperity felt around the country. In capital markets, the day after President Mattarella exercised his right to dissolve parliament, risk premia on Italian versus German 10-year bonds reached the greatest spread in months. More troublesome for Italian policymakers is the ECB’s commitment to an unwinding of QE in 2018. As the program unwinds, the ECB will slash the purchase of Italian debt and Rome will have to look for new marginal buyers. Ultimately, there is a more than 50% probability of continued spread increases on Italian sovereign debt in 2018 as the country looks to refinance debt worth more than 17% of GDP.
These predicted trends are interesting solely from a capital markets perspective, but they are significant on a broader level as well. Rising risk sentiment in the bond market reflects overall investor sentiment towards the country. Due to Italy’s dysfunctional bureaucracy, overly complex legal system, slow justice system, unstable political landscape and debt troubles, FDI has a significant (over 50% probability) chance of dropping in 2018. This confluence of factors makes Italy a uniquely poor business environment for multinational corporations (MNCs). Of course, the true burden of a substantial drop in FDI will fall on working class citizens within the country. According to the OECD, even in a more developed country FDI can increase worker rights and raise wages, a much-needed outcome given an average Italian inflation rate of just 1.23% in 2017. Additionally, FDI can create job opportunities, again needed in Italy, and help kickstart regional economic development. As a result of lower FDI, Italy would also miss out on the multiplier effect, by which the overall increase on national income is significantly greater than the initial injection of FDI. All in all, Italy needs what it can’t have. FDI would help raise inflation and increase output, thus lifting the burden of a crushing debt. Unfortunately, in large part because of the potential for either extreme or predicted political outcomes, Italy is unlikely to attract many new greenfield investments this year. As a result, Italy will continue its slow crawl as a lagging economy in the Eurozone, the Italian stock market (FTSE MIB) is unlikely to break 26,000 (as shown below) and workers will continue to struggle to find jobs.
These resulting detriments will have very real impacts on the citizens Italy. Whether or not constituents will correctly attribute personal finance and broader economic struggles accurately remains to be seen. However, in line with deep historical trends, the most likely outcome is continuing political polarization driven by a pull on the right towards nationalism and isolationism. It will be up to French President Emmanuel Macron and Chancellor Angela Merkel to combat this forces and pull European states into a closer union. Regardless of the outcome of the elections in March, Italy provides a poignant example of the oftentimes ignored intersection of politics, economics and their resulting effect on quality of life.
Investing involves risk, including possible loss of principal. This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. Opinions reflect the market conditions when written.