The recent bond market sell-off reinforced concerns that investors have over the populist government’s spending plans. Given the exposure domestic banks have to sovereign debt and the winding down of the ECB’s bond-buying program, the Italian government is likely to delay its promises to drastically increase spending and defy EU budgetary rules in order to calm these recurring market jitters.
The Context
Italian government bonds have borne the brunt of negative investor sentiment over the last few months. The first panic was due to the formation of a Eurosceptic populist coalition government. The government, comprised of the populist left party, the Five Star Movement, and the populist right party, the League, came to power pledging to defy the EU by taking a harder line on the influx of migrants and flouting EU budgetary rules. Given the incendiary rhetoric of both parties in the lead up to the election and the uncertainty surrounding government formation, market volatility was understandable and is often commonplace around election time. However, government bonds have been hit again with bond yields soaring last week. This negative investor sentiment reflects real fears about the consequences of a showdown between the Italian government and the EU over the former’s fiscal expansion plans.
Soothing Market Jitters Likely to Take Precedence Over Fiscal Expansion
The Italian government’s economic agenda is centered around the introduction of a Universal Basic Income, promoted by the Five Star Movement, and the introduction of a flat tax, advanced by the League. Overall, these spending plans are estimated to cost around 126 billion euros. Leaders of both parties have made clear that the EU spending cap will not come in the way of implementing their economic agenda. However, the most recent market volatility means that they might eventually have to moderate their spending plans in this year’s budget for three principal reasons.
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First, Italian banks hold large amounts of government debt, raising the danger of a sovereign debt loop. Italian banks hold approximately 400 billion euros of government debt and therefore act as a conduit for contagion between bond markets and banks. At the height of the Eurozone crisis in 2011, sell-offs in government bond markets depleted the capital of banks, freezing the interbank lending market and further depressing Eurozone economies. With Italian banks still holding large amounts of government debt, this “doom loop”, triggered by a severe panic in the bond markets, is still a realistic possibility.
Moreover, the European Central Bank (ECB) recently announced it would end its quantitative easing program by the end of this year. The programme has involved buying government bonds in the secondary market from high street banks, pension funds, and other institutional investors. Therefore, it has alleviated some of the risk associated with banks holding large amounts of government debt. Now that the program is winding down, it is unclear whether banks will be willing to soak up the government bonds that the ECB will no longer buy. Investors will be more focused on the possibility of a sovereign debt loop reemerging and will be closely looking at the holdings of Italian banks. The combination of Italian banks holding large amounts of sovereign debt and the ECB ending its QE program means that a fiscally reckless budget plan is highly likely to trigger more serious government bond sell-offs.
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Lastly, panic in the bond market can easily create a self-fulfilling liquidity crunch, especially in the Eurozone countries as they do not have their own currency and central bank. A small rise in bond yields can make it difficult to roll over short-term government debt because the ECB is forbidden to explicitly finance government spending and cannot step in to buy up short-term government debt to stave off a cash squeeze (Under the Outright Monetary Transactions Program, the ECB can intervene in an emergency only if the member state submits to a bailout program with strict budgetary restrictions attached). The fear of short-term cash squeeze can lead investors to demand higher interest rates which in turn worsens the fiscal situation of the government. Therefore, it is even more important to reduce concerns about the rolling over of short-term government debt in Eurozone countries than it is in countries with their own currency and central bank.
Economic Risk Outlook
The appeal of both the Five Star Movement and the League stemmed from their Euroscepticism, with the League tapping into the anti-immigrant sentiment in Italy and the Five Star Movement claiming to defy EU budgetary rules for enacting its Universal Basic Income scheme. So far, the government has already established its Eurosceptic credentials by taking on the EU over the issue of migration. It turned back the migrant ship, Aquarius, and rebuffed the EU’s monetary incentive of 6000 euros per migrant taken in. Therefore, further disregarding the EU by proposing a fiscally expansive budget will have diminishing political gains, while the economic costs would be real and potentially long-lasting.
The Italian government is now likely to pursue a more prudent budget and shelve some of its key spending pledges, especially after the second major bond market sell-off last week. The technocratic Finance Minister, Giovanni Tria, is unlikely to support a budget plan that could spook the bond market yet again. If this approach is taken, market risk is likely to decrease over the medium term in Italy.
