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Saturday, 16 December 2017

Rome syndrome

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Fears of economic turmoil following elections in Italy earlier this year have failed to materialise as markets shrugged off concerns of a reversal of reforms set in place by by Mario Monti. A short-lived sell-off has been reversed as ECB measures appear to have acted as a robust firewall to the political stalemate.

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For a country supposedly on the edge of political apocalypse, Italy’s bond market has held up well.  As politicians continue to try and reach agreement over the formation of a government following the electoral stalemate in February, 10-year government bond yields have snapped back to where they were before the election. Giovanni Zanni, an economist at Credit Suisse, said: “The election provided the worst possible result and yet the reaction in the bond markets was muted.”

The political gridlock promoted a 0.45 percentage points surge in the 10-year note to 4.81% and prompted a downgrade by Fitch amid fears that it may reverse the reform course set into motion by former Italian Prime Minister Mario Monti. But far from shaking the foundations of the EU to the core, the sell-off was relatively short-lived, leading many to conclude that backstop of the European Central Bank’s Outright Monetary Transactions programme delivered a robust firewall. Compared with the contagion that followed a similar election result in Greece last year, the fallout from the Italian election – and the subsequent rescue of Cyprus – has been contained.

Under control

Laurent Fransolet, head of European FICC research at Barclays, said:  “Italy has done well despite the uncertainty and no prospect of an imminent new government in the short term. It is not that investors believe in the ECB backstop, it’s a sign that the crisis is under control. We are in the fourth, fifth year of this crisis and people are becoming more inoculated against headline news.”

Italian 10-year benchmark bond yields have endured a rollercoaster ride since the summer of 2011, then recovered during the first quarter of 2012 following the introduction of the ECB’s three-year LTRO programme. Ten-year yields hit 6.68% in July, before Draghi’s announcement that he would do ‘”whatever it takes” to save the euro and the subsequent OMT programme brought yields under control.

“There’s no doubt that there is greater stability in the eurozone now,” said Peter Schaffrik, head of European rates strategy at Royal Bank of Canada capital markets. “People are no longer talking about a breakup of the eurozone.”

While it is impossible to rule out further upheaval in the eurozone as its third-biggest economy struggles to form a government, market participants believe the likelihood of an Italian exit is remote. 

Sensitive to sovereigns

The strength of the sovereign has knock-on benefits for CDS spreads and bond yields of Italian banks. An IMF working paper in March found “banks with lower capital ratios and higher non-performing loans were found to be more sensitive to swings in sovereign spreads. Credit supply constraints due to bank funding shortages from the sovereign debt crisis were a major factor behind the lending slowdown in late 2011, while in 2012 weak demand appears to have been driving changes in credit more than supply”.

“There’s no doubt that there is greater stability in the eurozone now. People are no longer talking about a breakup of the eurozone”

On the day that Cyprus’s banks looked for a bailout, Italian bond yields barely moved. The stability brought by the OMT has been accompanied by other actions such as  the move by the Bank of Japan to buy foreign sovereign debt, as well as a thirst for yield by other investors.

“Investors have also learnt that it does not pay to overreact. In 2012, Portugal, Ireland and Italy were the best performing sovereigns so it can cost a lot to be underweight or short in these kinds of markets,” said Fransolet.

The supply-demand dynamics are also in Italy’s favour. Net issuance by the Italian Treasury is expected to be US$30bn this year so investors are not being asked to absorb much more paper and that is creating stability. Much of the sell-off in 2011 was due to the withdrawal of liquidity from Asian investors, and around 30% to 35% of Italian paper is now held by a core group of domestic institutional investors.

“From a primary dealer perspective, it looks like international investors remained on the sidelines in the run-up to the elections. Hedge funds were short Spain, and they started to short Italy again. Real-money accounts weren’t selling,” said Fransolet.

Impasse

While electoral impasse has not had a detrimental effect on the bond market, its broader impact is harder to judge. The country’s supporters say the political instability is overdone.

“The political situation in Italy is different from, say, that in Greece, where there was a clear challenge to austerity. In Italy, there is no real debate about austerity, only about the speed at which it has been administrated to the country. Monti, Tremonti and Berlusconi have all embraced austerity and that is why the country has a primary surplus. While it’s important that Italy forms a government sooner rather than later, a main mitigating factor is that it does not need further austerity measures,” said Zanni.

Italy, Zanni says, has made strong progress on pension and labour reforms, and its biggest challenge lies in tackling corruption and reforming legal aspects of labour market reform, so that foreign investors will return to Italy.

Where the electoral impasse is having a serious effect is in the ability of Italy’s economy to return to growth. Fourth-quarter GDP fell by 0.9% quarter on quarter, while political uncertainty is weighing on household spending and delaying investment decisions by companies, which is acting as a drag on growth. Meanwhile, Italy’s national debt is 120% of GDP, the highest in Europe and the sixth-highest in the world.

In a note published on March 18, Credit Suisse’s economics team said that Italian growth was likely to record the second consecutive negative year in 2013, at –0.8% after the –2.2% recorded last year, before going on to say that absent a political shock in the coming months, “we expect the recovery to become clearer during the second half”.

The Italian election impasse has not triggered the apocalypse that many feared, but markets do not like uncertainty, so the quicker there is a solution the better. The picture changes on a weekly basis and it is impossible to predict behaviour at the ballot box, but a presidential election appears likely by the end of April, and depending on the result, that should pave the way for a workable coalition government in the short term and remove the need for fresh elections.  

Stark warning

Just as important is that Italy should be seen to be taking additional action. Antonio Garcia Pascual, chief euro area economist at Barclays, said Italy must boost competition in professional and public services, and show its commitment to reform to the watching world. “Germany’s commitment to preserve the monetary union requires in return policy conditionality, so Germany and the European Commission will be watching very closely whether Italy pursues a convincing reform agenda.

“If Italy does not push forward the structural reforms needed, it will die a slow death – it will not be able to survive with bond spreads at over 300bp more expensive than Germany for a long time. If it cannot reform itself it will be left behind in terms of European integration.”

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