Italian election stalemate

The Italian election of February 24 and 25 had a surprising result in which none of the favourites came out as a clear winner. The inconclusive result is reigniting fears relating to the resolution of the euro crisis.

The country has actually been doing quite well in terms of controlling its deficit

This uncertainty shook markets. Italian government bond prices dropped, with yields rising in the secondary market. The yield on the 10-year bond rose by around 40bps to 4.90 per cent. Equity markets across Europe lost value, with the Italy’s FTSE MIB shedding almost five per cent in one session. The euro dropped to the lowest level against the US dollar in seven weeks. However, while investors certainly did show their discomfort with Italy’s election results, so far markets have not panicked.

The centre-left coalition, led by Pier Luigi Bersani, came first with 29.6 per cent in the Lower House – representing a much tighter-than-expected margin over second placed Berlusconi’s centre-right coalition, which got 29.2 per cent. However, the biggest surprise was the performance of Beppe Grillo’s Five Star Movement which obtained an impressive 25.6 per cent. The outgoing Prime Minister and leader of the centrist coalition, Mario Monti, obtained a disappointing 10.6 per cent.

This vote resulted in what is basically a split Parliament without an outright winner. The centre-left has the majority of seats in the Lower House, where seats are allocated according to share of the votes obtained. However, in the Senate, where seats are allotted by region, there is a stalemate with no side being able to secure a working majority.

The most salient message from voters is that there is general dissatisfaction with the austerity and reform measures being adopted. Political movements (from across the political spectrum) that are opposing austerity did well. They are clearly now a force to be reckoned in the eurozone’s third largest economy. In the case of the Five Star Movement it is more generally an ‘anti-establishment’ party – however, the hardship caused by austerity measures made it more attractive to the electorate.

The current impasse is likely to lead to new elections within a few months or alternatively a weak government with a very limited mandate. With respect to financial markets, for now it seems that investors remain willing to give Italy the benefit of the doubt. Only a few days after the election, Italy actually had a successful government bond auction. The country borrowed a total of €6.5 billion, in 10-year bonds at 4.83 per cent and in five-year bonds at 3.59 per cent. Even though borrowing costs were higher than the previous issue, the better bid-to-cover ratios reflected good demand for Italian debt.

Beyond benefiting from the Outright Monetary Transactions implicit support in recent months, generally there is the perception that Italy is, potentially, in a better position than other peripheral countries. While the massive debt burden of above 120 per cent of GDP attracts considerable attention, the country has actually been doing quite well in terms of controlling its deficit.

The European Commission is forecasting that the deficit will fall this year below the three per cent of GDP limit, and the country is running a primary surplus (deficit excluding interest payments on outstanding debts) of above two per cent. This trend was further enhanced by Monti’s policies. Other economic strengths include a solid manufacturing base, relatively competitive exports, and high domestic savings compared to other developed nations.

However, there is also agreement that the country needs further structural reforms to revitalise economic growth and fulfil such potential. Necessary reforms involve increasing flexibility in labour and product markets, downsizing the public sector and reducing the tax burden. Therefore, in the long term, the greater underlying concern related to the new political scenario (assuming a severe deterioration in stability during the coming months can be avoided) is the extent to which it will create obstacles to implementing the required reforms.

If the anti-austerity (or potentially the anti-euro) message is seen to be gaining momentum during the period of political impasse, doubts will grow on the willingness of Italy to adhere to conditions relating to the European Stability Mechanism and hence on the ability of the country to access OMT bond-buying programme. On this basis, we would expect the outlook for Italian government bonds and credit to be slightly weaker in the coming months, even though yields are unlikely to return to pre-OMT levels, where a ‘tail-risk’ event was being priced.

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This article is the objective and independent opinion of the author. The information contained in the article is based on public information. Curmi and Partners Ltd. is a member of the Malta Stock Exchange and is licensed by the MFSA to conduct investment services business.

Karl Falzon is a credit analyst at Curmi and Partners Ltd.