Italy: Salvini’s Game

Published on May 30, 2018

In rejecting the Northern League/Five Star Movement selection of the fiercely Euro-skeptic Paolo Savona to the key position of Finance Minister, Italy’s President Sergio Mattarella may have intended to avert a fundamental crisis between Rome, Frankfurt, and Brussels.

But in the process Mattarella threw the country into a new crisis, with the specter now of a new round of elections, and may have played right into the hands of the fiery Northern League leader, Matteo Salvini.

*** There is, nevertheless, method to Mattarella’s madness. Political observers believe that Mattarella’s rejection of Savona and scuppering of the Conte-led coalition cabinet proposed by NL/5SM was with the full expectation that the alternative Cottarella technocrat government would not last, leading to early elections. It is suspected Mattarella nevertheless forced it through to flush out both the 5SM and NL’s fundamental positions on Italy’s membership in the Euro in another round of elections. ***

*** On that front, markets need not fear a new round of elections as a dreaded proxy “referendum on the Euro” as neither party will include that in their platforms by any stretch of the imagination – despite market chatter about mini-BOTs, alternative currency regimes, and other nonsense. There is, and will be, no redenomination risk, from either party, perhaps through incompetence, but at least not deliberately. ***

*** And over the last days, a divergence of interest has started to open between the two leading parties. Salvini, with an eye to locking in the 10-point jump in the LN polling since the March 4 elections, is now actively maneuvering for fresh elections as soon as feasible, explaining his intransigence on adjustments to his proposed cabinet. The leadership of the Five Star Movement rightly suspects the LN will use new elections to push for a reconstituted coalition at a minimum led by Salvini as the head, rather than as current junior partner, and if feasible constructed with Silvio Berlusconi’s Forza Italia and center-right, leaving the 5SM in the cold. ***

Di Maio’s loss may well prove to be the market’s gain, however, as a center right coalition would focus on a pro-business platform and tax amnesty, if not the entire extent of promised cuts, as opposed to the social spending of the 5SM. And Salvini appears to be playing his cards right, for now, having backed off his most aggressive calls for the prosecution of Mattarella and immediate elections.

All sides we expect are settling in now for elections in September or October to allow for a caretaker government to take office, perhaps pass legislation on a case by case basis, but more likely defer all major budgetary issues and specifically ask the EU to postpone the planned VAT increases till after a democratically elected government takes office.

On that basis, redenomination risk aside, the nightmare scenario for Italian markets for fiscal sustainability would be if the 5SM and NL were to choose to run on a united platform, or re-unite in a coalition again after elections. Salvini may choose to play the 5SM against Berlusconi yet – and he will be hard pressed, and may not want entirely, to dissociate completely from the LN’s most virulent anti-EU rhetoric.

But an alliance with 5SM clearly is not his preference, nor, from what we understand, in Salvini’s current game plan.

The Damage to Banks, and the Economy

That, of course, in no way implies that even the current political standoff and market jitters come without a cost. A prolonged budget fight with Brussels on top of tighter funding rates already will most certainly further strain the Italian economy and banking sector that had just started to recover.

EU officials do believe that while Italy has been driving all the Eurozone sovereign markets, the contagion risk from weakness in the Italian BTP bond markets for now is far smaller than it was during the European debt crisis of 2012-2013. And the Italian government should, they believe, be able to meet its financing needs even at the new, higher sovereign yields.

But that funding will almost certainly need to rely increasingly on the continued arm twisting of Italian banks to support the markets.

EU officials are concerned that the Italian banking sector, already under severe strain, has if anything deepened what is a potentially dangerous sovereign and bank balance sheet loop, against EU policy objectives since the debt crisis, and indeed against the positive trend in other countries away from that reliance across the Eurozone.

That downwards pressure is almost certain now to be accelerated through the ratings agencies, where Italian banks do not have much room for maneuver.

Italy’s current sovereign ratings are a couple of notches above junk and Moody’s and Fitch have indicated these will be under review. ECB rules require an exception for ECB liquidity to Eurozone banks if the highest of four ratings agencies (the other two being S+P and DBRS) was to fall below investment grade.

That is what happened to Greek banks that subsequently had to be funded by the Greek National Bank’s ELA lines, until they were recapitalized and had recovered their credit ratings. And that is what could lie in store for Italian banks were this crisis to continue and take a toll on the real economy, as well as on the banks’ immediate funding costs, and ability to further dispose of non-performing loans.

Indeed, many EU officials believe a banking sector program for Italy should have been put in place long ago already, under former Prime Ministers Berlusconi, Monti, or Renzi, none of whom was ready to take the political hit it would have entailed.

Very rough, back of the envelope estimates are that such a program could require a loan or line of as high as 80 or 100 billion Euros – Spain borrowed 30 billion and ended up with some room to spare – and the European Stability Mechanism has some 400 or so billion Euros in its coffers.

A sovereign run on the funding markets would be a different ball game altogether.

Goodbye Euro Banking Union

And in almost all cases we believe the political turn of events in Italy will prove the death knell to any hopes at this point for a Macron/Merkel push for any deeper Eurozone integration, even on the most modest, almost micro levels.

First, the EU has been pushing for sovereign bond concentration limits for European banks, intended to make banks more resilient by reducing the sovereign-bank debt loop risk. While Spain, for example, in practice has taken steps to address those risks, all signs are that Italy, the biggest offender by far, will now go even deeper in the other direction.

Second, any ambitions to transform the ESM (European Stability Mechanism) into an ESF (European Stability Fund) will now almost certainly have to be put on hold. The objective behind this idea has been to transform the ESM bailout mechanism into a more robust fund mimicking the IMF that could independently assess and make recommendations on bailouts, debt structures, and address sustainability issues. That will be politically impossible to achieve without the third largest Eurozone economy on board.

Finally, and perhaps of most immediate relevance to markets, the backstop to the Single Resolution Fund for Eurozone banks will now come under threat.

EU officials have long aimed for an EDIS (European Deposit Insurance Scheme) to backstop bank failures, but under the objections by Germany and other Euro countries, this has been all but dropped for a more modest, and arcane, insurance scheme drawing entirely on premiums collected from the banking sector to provide a tiny bailout fund for the industry.

Backstopping that as currently suggested with public loans, if needed, may now no longer be an option, with German Chancellor Angela Merkel already facing intense suspicion of such a “loan” plan from her Christian Social Union partners, and the right-wing of her own Christian Democratic Union.

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