How Italy could go into free fall

LONDON, Sept 19 (Reuters Breakingviews) – Next month will mark 100 years since Benito Mussolini launched his fascist coup in Italy when his supporters marched on Rome. Later this month, the country is almost certain to elect Giorgia Meloni, a former post-fascist and eurosceptic, like its new prime minister. So far, investors have not blinked an eye.

Meloni is the favorite to replace Mario Draghi, the highly respected technocrat who helped save the euro a decade ago. Yet the spread between Italian and German 10-year government bond yields is 2.3 percentage points, the same level as when the “Super Mario” government began to crumble in July.

Italy is likely to manage under Meloni, the leader of the Brothers of Italy, which opinion polls predict will be the largest party after Sunday’s election. But there is also a medium-term risk that the country’s massive debt will spiral out of control. It could happen under his leadership or, given the short lifespan of most Italian governments, under another prime minister.

Meloni’s right-wing alliance promises lower taxes and early retirement. Yet investors are calm because she has abandoned its euroscepticism and said tax cuts depend on the state of the country’s finances, which she promises will be safe in her hands.

Italy’s next prime minister will want to avoid the fate of previous governments that fought with the European Union over fiscal policy. Silvio Berlusconi was ousted from power in 2011 after 10-year government bond yields soared 4.9 percentage points above those in Germany. The anti-austerity coalition led by Giuseppe Conte, which collapsed in 2019, faced a similar experience.

EU SOLIDARITY

Investors are also relaxed because the EU is showing more solidarity than during the euro crisis a decade ago. In response to the Covid-19 pandemic, it launched a Recovery and Resilience Facility consisting of cheap loans and grants. Italy will receive the biggest piece: 192 billion eurosi.e. almost 10% of the national income.

The EU also has suspended fiscal rules that require member countries to keep budget deficits below 3% of GDP – a suspension that could be extended due to the current energy crisis. As a result, Meloni won’t have to cut spending or raise taxes immediately.

Russia’s invasion of Ukraine has also strengthened EU solidarity. Meloni’s constant criticism of Vladimir Putin has earned her points in parts of the EU, although many disagree with her views on LGBTQ rights and immigration.

The European Central Bank also has a new tool stop the fragmentation of the euro area. It will buy government bonds that are under speculative attack as long as their debt is sustainable. Nobody wants Italy to collapse and drag down countries like France and Spain, which also have high levels of sovereign debt.

PRACTICALLY DURABLE

The problem is that Italy’s public debt, which the International Monetary Fund expects to end the year at 148% of national income, is close to being unsustainable. It fell from 104% in 2007 following shocks such as the global financial crisis, the collapse of the euro zone and the pandemic. What’s more, the country is struggling to get out of debt. In real terms, the country’s national income is almost exactly where it was 20 years ago.

Optimists point out that inflation and the rebound from the pandemic-induced recession helped drive down debt by 155% of GDP in 2020. But these are temporary factors. The ECB is determined to bring inflation back to its 2% target and soaring energy costs could push Italy into another recession.

Moreover, the era of near-zero interest rates is over. Italian 10-year government bonds are now yielding 4.1%, more than when alarm bells last rang in 2018 and early 2019. Rome pays on average 2.5% on her debt because she borrowed a lot of money when interest rates were low, but the average cost is now rising.

Consider what things will look like once the energy crisis is over and post-pandemic stimulus funds run out. Charitably imagine that Italy’s average cost of debt was then only 3% and its trend growth rate was 1%. If inflation fell back to 2%, Rome would have to run a primary budget surplus – before interest payments – year after year in order to reduce its debt ratio.

HOW THINGS CAN FALL

At Draghi’s plans predicted that Italy would run a primary deficit until 2025. So getting the country’s debt under control might not seem like the most pressing issue. But Meloni lacks Draghi’s credibility. She is an inexperienced leader whose only previous job in government was as youth minister.

Moreover, his decision to abandon Euroscepticism looks like a decision of convenience. As such, she might kiss him again if she thinks it’s in her best interest to do so. After all, the Italian electorate is fickle. In the last election in 2018, the Brothers of Italy came from 4.3% of the votes while the League, Meloni’s main ally, held 17.4%. Now opinion polls show Meloni’s party at 25%, compared to around half that of the League.

Even if the right-wing alliance looks set to win a large majority, it will be unstable, says political scientist Roberto D’Alimonte. The League has completely different policies from Meloni: its leader Matteo Salvini is sympathetic to Putin and wants to increase spending.

Salvini will not necessarily derail Meloni: his party may well replace him with a more moderate leader. There is also a slim chance that Meloni could join forces with some centrist parties if they succeed in the elections. In extremis, Draghi could even return to government.

But there’s also a scenario where Meloni reverts to more extreme policies to avoid being overwhelmed. She might think that the EU would continue to provide financial support to Italy because it would not have the courage for a confrontation. But if the ECB then refused to buy Italian debt, and if neither side blinked, there would be an explosion.

This is not the central scenario of the financial markets. Italy is far more likely to hobble. But if growth remains weak and interest rates rise, investors will become nervous again.

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(The author is a Reuters Breakingviews columnist. The views expressed are his own.)

Editing by Peter Thal Larsen and Oliver Taslic

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