Weathering the storm: assessing political uncertainty in Italy
The fears over the political stability in Italy, as the populist Five Star and League coalition is now back on the scenes to form a government, come against major structural hurdles including high public debt, a poor productivity growth record and an ageing population. Italian risk assets have been sold off as a result. In this blog we assess the impact on the economy of this sell-off and also the impact of the fiscal expansion programme proposed by the coalition partners.
Unsurprisingly, investors are nervous about holding Italian bonds and the 10 year BTP yield has risen by 125 basis points over the past month to around 3 per cent. Italian risk assets have lost value and banks which are large holders of sovereign bonds have suffered disproportionately. The large volumes of government securities on Italian banks’ balance sheets create a potentially dangerous feedback loop between the sovereign and banks. As sovereign debt yields rise due to the reaction of financial markets to the political uncertainty shock, the value of bank securities erodes, triggering collateral risk and capital losses. This additionally feeds through to credit availability to firms and households with damaging consequences to the real economy.
We deployed NiGEM, our global macroeconomic model, to simulate the effect that financial distress, if sustained, would generate on economic activity and growth prospects in Italy. To account for that, we applied a shock to the investment premium of 200 basis points, similar to the increase observed during the sovereign debt crisis. The investment premium shock adds to the user cost of capital for companies and therefore discourages investment spending directly subtracting from aggregate demand as well as potential economic growth. Additionally, we assumed a shock to the exchange rate of around 4 per cent, similar to the euro depreciation of the past month, as well as a shock of 10 per cent to equity prices, and a rise in the nominal long-term yield to 3 per cent.
The simulation shows that GDP would contract by 1 to 1.5 percentage points within the first two years and that would put pressure on the unemployment rate. The currency depreciation improves the current account balance as exports are cheaper and export volumes increase, while the lower domestic demand decreases imports. Additionally, the depreciation of the euro pushes up inflation, as the exchange rate pass-through in Italy is high – in particular if we compare it to other European countries.
Should the Five Star and League coalition be handed back the mandate to form a government, and should they go forward with the fiscal stimulus they proposed, we assume that the reaction of markets would prove to be even stronger. The magnitudes of the fiscal shocks proposed, which are assumed to be exogenous and permanent, are as follows:
- A fall in the tax rate to 15 and 20 per cent for households and 15 per cent for firms – which is around a decrease of 10 percentage point from the effective tax rate.
- A rise in government spending by around €40 bn (around 2.5 per cent of GDP) on the back of greater public consumption as well as social transfers.
On top of that, we assume that the fiscal plan would be even more detrimental to Italian markets than the current political deadlock. We impose additional shocks to risk premia to reflect the potentially greater reaction of markets. The size of the shocks include an increase to nominal bond yields to 3.5 per cent, a rise in the investment premium of 250 basis points, as well as a negative shock to equity prices of around 30 per cent.
As shown in figure 3, the stimulus to economic activity that the fiscal package should provide is offset by the reaction of markets on the returns of Italian assets. Not only the fiscal package would not yield the desired effects to growth, with the benefits to growth dissipate within a year and unemployment increases, but also, based on model multipliers, the fiscal stimulus would increase the deficit by around 5 percentage points and the debt to GDP ratio, which stands at an already elevated level of 132 per cent, will rise further to 135 per cent in 2020 – from our forecast of 123 per cent.
As discussed above, there is plenty of political and economic uncertainty and in the first exercise we simulated the risk generated by the political uncertainty shock of the past months, which peaked over the past few weeks, on the growth prospects in Italy. Secondly, we presented a baseline scenario where Five Star and League end up forming a government and pursue the fiscal expansion that they have proposed. The overall risks to that scenario are skewed to the downside especially if the corrosive link between the sovereign and the bank magnifies. In this case the Italian government and banks will likely seek support from the ECB and European Union. Also worth noting, the benefits from an isolated shock to fiscal spending in Italy are lower compared to a synchronised boost to government spending by the Euro Area as a whole, according to the NiGEM simulations of Pain et al (2018) published in our May Review. They find that collective policy actions are more effective than actions taken in isolation.
On the flip side, the new coalition could negotiate more fiscal space with the European Commission. The Commission on its part might demand a programme that includes micro and macroeconomic reforms to boost productivity and growth. This type of scenario, although unlikely, represents an upside risk to the central case described above.