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Changes of governments in Italy and Spain have prompted warnings of fresh political turbulence in Europe. Yet neither event is likely to pose a near-term challenge to the integrity of the euro zone or the EU.
For most of this year, investor concerns on political risk have been mostly centred on the escalating tensions between the US and China and the game of brinkmanship between Donald Trump and Kim Jong Un. But in May and June, attention switched again to Europe, where two potentially-significant developments in key European Union member states raised questions over the stability of the euro zone.
In Italy, the anti-immigration and eurosceptic party Lega and the anti-establishment 5-Star Movement (M5S) formed a governing coalition on 31 May, ending nearly three months of political deadlock following inconclusive elections. The new government’s plans to cut taxes, boost welfare spending and overhaul EU rules on budgets and immigration, if fulfilled, seemed like a sure way to put it on a collision course with Brussels.
Meanwhile, Mariano Rajoy on 1 June became the first Spanish prime minister to lose a no-confidence vote in parliament since the country’s transition to democracy in 1975. The Socialist party of Pedro Sánchez, Rajoy’s replacement, commands just 84 seats in the 350-seat parliament. The new government’s commitment to fiscal stability should ensure Sánchez is received warmly by EU representatives in Brussels. However, the new administrations in Italy and Spain appear unstable, are likely to prove short lived and will face difficulty in passing legislation.
Italian coalition changes track (already)
The Lega-M5S coalition quickly realised how difficult it would be to make good on its promises. A potential clash between Brussels and Rome over economic policy already appears less likely than when the coalition first took office, with the government watering down its fiscal plans, as well as jettisoning any talk of leaving the euro.
The administration “could struggle to get Lega’s proposal for a two-tier flat tax of 15 and 20 per cent, which would cost around 50 billion euros alone, through parliament given its slim majority”, explains Geoffroy Lenoir, head of European sovereign rates at Aviva Investors.
Moreover, MS5’s proposed Universal Basic Income of at least 780 euros a month for people over 18 who are out of work and have an income below the poverty line, which would cost Italy tens of billions of euros every year if enacted, no longer appears a priority.
Ben May, director of global macro research at Oxford Economics, believes political checks and balances will ensure that fiscal policy is likely to be loosened only by around one per cent of GDP and that the debt-to-GDP ratio will remain on a downward trajectory in the medium term.
“There is currently only a two per cent chance of Italy leaving the eurozone, with the country and the rest of the eurozone very keen to avoid this scenario,” adds May.
Both Lega and M5S wanted to appoint Paolo Savona, a fierce critic of the stability and growth pact and the euro, as finance minister, only to have the move vetoed by President Sergio Mattarella. The new finance minister, Giovanni Tria, wants Italy to remain in the single currency.
Lenoir points to figures from the latest Standard Eurobarometer, a survey of public opinion by the European Commission, showing that 61 per cent of Italians favoured staying in the euro in March (compared to 76 per cent in Spain)1.
While eurosceptics blame the euro and say Italy would be much better placed if it had kept the lira, “the economy’s underperformance largely reflects Italy’s failure to pass the structural measures adopted by Madrid,” argues Lenoir.
Immigration is another potential flashpoint between Italy and the EU. Lega and MS5 want to reform the Dublin Regulation, which says immigrants can only claim political asylum in the country where they arrived in the EU. The coalition argues Italy’s proximity to North Africa means the country is unfairly burdened by the migrant crisis.
It is likely to receive considerable support among some member states for reforming the EU’s migration policies. Polls show migration has become voters’ number one concern across the bloc. The issue has influenced elections in France, Germany, Austria, Italy and Hungary and even threatens to end Angela Merkel’s long stint as German chancellor2. The new government appears to have achieved some of its objectives in reforming Brussels’ migration policy during an EU summit held in June3.
While the Italian coalition may have some success on migration, Lenoir cites various reasons why it is unlikely to remain in power for long.
“Lega and M5S were bitter rivals during the election campaign. The lengthy talks before they could form a government highlight the scale of the differences and the distrust between the two sides,” he says. “In addition, the new prime minister, Giuseppe Conte, has never held political office. His ministerial appointments highlight tensions within the coalition over the euro, with the eurosceptic Savona now overseeing relations with Brussels, while other key ministers want to remain in the single currency.”
Peter Ceretti, analyst at the Economist Intelligence Unit, believes the government would do well to make it to 2020, and that a snap election is possible as soon as the first half of next year.
“In addition to fiscal, legal and EU constraints, the parties may face opposition from President Mattarella,” he says. “It would be very unusual for the president to block legislation and the government is unlikely to pursue a strategy of direct confrontation with the president, as it did when it sought to appoint Paolo Savona as economy minister. But the tensions between the government and Mattarella over Savona also show that if pushed, the president is willing to use the full weight of his authority to protect the constitution.”
Ceretti adds: “M5S and Lega also have a fairly small majority in the Senate (the upper chamber of parliament), meaning that defections or a breakdown in discipline — both typical in Italian politics — could very easily lead to paralysis.”
However, Ceretti believes that confrontation with European partners or an inability to deliver on policy pledges may not damage the popularity of either the Lega or M5S.
“Italian voters do not expect full implementation of electoral promises, and both parties could plausibly blame the EU and the country's institutional architecture if they under-deliver,” he says.
The reign in Spain stays mainly the same
Meanwhile, Spain’s change of government is unlikely to trouble the EU or investors, says Julien Rolland, rates portfolio manager at Aviva Investors.
“All of the major Spanish political parties, including the socialists, are pro-euro, while Sánchez has pledged to adopt a conservative approach to economic policy. Indeed, the new government is committed to implementing the previous administration’s budget,” he says.
The Socialist’s precarious position in parliament also blocks major policy shifts.
Managing the Catalan crisis is likely to present the toughest test of Sánchez’ leadership skills, according to Ángel Talavera, lead euro zone economist at Oxford Economics.
“The newly-appointed Catalan government, led by a fervent proponent of independence, Quim Torra, will be tempted to test Sánchez's resolve early on in his premiership. How Mr Sánchez responds to this challenge will in large measure determine his political future,” argues Talavera.
Rolland believes a new election is likely next year, given Sánchez pledged when taking office to trigger elections before the current parliament ends in July 2020. He believes this would prove positive for markets.
“According to current polls, a centre-right coalition featuring Ciudadanos and the PP, both of whom are strongly pro-euro, is the most likely outcome. But a strong showing by the Socialists, also ardent europhiles, would also be good news for investors,” he says.
Sánchez's task over the next year will be to occupy the centre ground, where elections are traditionally won and lost in Spain, while simultaneously pushing a progressive social agenda that neutralises the left-wing Podemos party. Furthermore, some form of open-ended negotiations on a reform of the country's territorial framework will be a focus, with a view to defusing (if not resolving) the Catalan crisis.
“To succeed, Sánchez will need to overcome lingering reservations about his leadership from within his own party, win over an unsympathetic media (which has shown much more favour towards Albert Rivera – the leader of Ciudadanos) and somehow strike a balance in his dealings with both Podemos and the Catalan nationalist economic parties that does not alienate mainstream pro-unity Spanish voters,” Talavera says.
Economy the key
Against a rapidly-improving background, political risk in Spain appears to be easing although relations between Madrid and Catalonia remain a potential flashpoint. In Italy, the overthrow of the political establishment appears to hold less dangers for the EU than might have been expected at least in the short term.
Longer term, however, there is a risk that if Italy’s economic performance does not improve, more and more voters may question whether the country might not be better off out of the eurozone. They may also migrate to even more extremist parties or policies if this appears the only way to challenge the status quo.
1 ‘Euro remains popular in Italy’, European Commission Standard Eurobarometer, March 2018
2 ‘EU migrant summit’, BBC News, 29 June 2018
3 ‘EU’s migration crisis’, Reuters, 24 June 2018
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