Italy’s rebel alliance to restore the republic?

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Italy’s rebel alliance to restore the republic?

In one of our previous economic reviews (Italy’s rise of the Populist) we wrote about each of the political parties challenging for political control of the country. The outcome of the election was that no one party had sufficient votes to form a government.

However, since the election, Italy’s two emboldened populist parties, The Five Star Movement and far-right The League, have been locked in discussions trying to form a coalition government. As confirmed today, a coalition has been agreed and Italy is now the first significant EU member state with an anti-Euro movement at the heart of government.

Understandably, this partnership is ringing alarm bells in Brussels, with the coalition government looking to return Italy to a pre-euro setting; reversing agreements made in the Maastricht treaty and adopting policies that could potentially reintroduce the Lira.

Most of the details emerged on Tuesday night but the ground keeps shifting. A draft version of the negotiation text between the two parties was leaked highlighting a €100bn fiscal stimulus programme and the potential for the country to run a dual currency system. The so-called “mini BOT” is a fiscal currency which can be used to pay taxes and public sector entities but cannot be exchanged for Euros. In theory, it would increase the amount of money in the system oiling the wheels of commerce.

The fiscal stimulus would mainly be delivered through income tax cuts, social security giveaways, the abolishing of pension reforms and a break in VAT rises due to come into effect in 2019. These rumours have caused concerns for investors with Italy already being one of the most indebted economies within Europe. Currently, its debt to GDP ratio is sitting at 130%, so extra fiscal stimulus would add to its debt pile.

In bond markets, the yield on Italian government debt is 2.2% with the spread between Italian 10-year government debt and German bunds at 157bps. Despite scary headlines about ‘spikes’ in Italian bond yields we can see from the chart that the reaction of the bond markets does not convey undue distress or panic, it simply shows a heightening of risk.

German Bund Yields vs Italian Government Debt Yields

Source: Bloomberg, 16 May 2018

Most commentators say such a dual currency system would be very hard to implement politically. The introduction of a dual currency system would compromise Italy’s position within the Eurozone but even so, Italy’s overall exit from the European Union is not considered likely.

The EU has had to deal with an issue like this before. In 2015 Greece proposed a dual currency strategy but it was quashed. This is an intriguing new development because Italy is in a very different situation to Greece. For a start it is a net contributor to the EU, something Brussels will have to consider carefully.

Each new challenge to the status quo in Europe chips away at its fabric. The current challenges may convey some advantage for the UK. With Italian discontent in the background the EU could find itself on the backfoot and more desperate than they portray to avoid the UK crashing out of Europe without a deal.

With investing, your capital is at risk. Investments can fluctuate in value and you may get back less than you invest. Past performance is not a guide to future performance. Tax rules can change at any time. This blog is not personal financial advice.

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