The First Signs of Financial Contagion Spread out from Italy

- The policies of Italy's new coalition government are starting to make waves in financial markets

- The fabric of the European Union and the ongoing programme of integration at threat

- The Euro has fallen on the new political risks but now holding current levels remarkably well 

© Stadtratte, Adobe Stock

The Euro is holding up very well considering the seismic shifts in Italy's political landscape. 

It is now almost certain that the next Italian government will be composed of a coalition of the two least EU-sympathetic parties in Italian politics, the northern league (Lega Nord) and the 5-star movement (M5S).

Yet despite this, the single currency is trading at 1.1825 against the US Dollar at the time of writing - back up above the key 1.1800 level. Against Sterling, it has risen to 0.8750, and versus the Yen to 131.20. Although it is down versus SEK, NOK and AUD, it is firmly higher versus the majors - surprising considering the new Italian government poses the greatest threat to the integrity of the Eurozone since the Macron-Le Pen presidential election.

Whilst a fullscale 'Italexit' is not on the cards just yet, the coalition's joint agreement has a list of policies which will place it in direct opposition to Brussels on many points - leading to potential estrangement in the future.

The most controversial are those associated with the nation's finances and the treatment of immigrants.

The coalition's economic policies are radical: they want to cut taxes and raise public spending bringing an end to the economics of 'austerity'.

The poorest in society will receive a basic income of 780 Euros a month. An extra 2bn Euros will be invested in job centres. Pension rules will be relaxed and free childcare provided to help working parents.

On the tax front it wants to lower the basic rate of tax to 15% and simplify the system into just two tiers of 15%, and 20% for higher earners. It wants to increase the tax-free allowance for families by 3,000 Euros, scrap a controversial new VAT law, and reduce or eliminate duty on petrol and electronic cigarettes.

Lower taxes and higher spending will probably increase the Italian budget deficit to above the 3.0% limit tolerated by the EU, however, the coalition is not concerned about this as it believes the EU should reform its fiscal rules to make them more socially-orientated.

On the immigration front the coalition wants to establish temporary stay facilities for half a million immigrants with a view to expelling them over the next 18 months. Ideas have also been floated to withhold emergency help for illegal immigrants being trafficked in boats from North Africa who find themselves sinking in Italian waters. The coalition want reforms of agreements such as the Dublin agreement which force member states to take in a share of immigrants but at the same time want the rest of the EU to sign up to an agreement sharing responsibility for immigrants from the Mediterranean landing on Italian shores.

In addition to the immigration and economic reforms they also want a review of the rules governing the single market, change the EU's trade deals with Canada (CETA) and the US (TTIP) to make them more EU-protective and renegotiate Italy's contribution to the EU budget.

The coalition plans to foot some of the cost of their expensive social policies by reducing the country's debt repayments, by requesting that the European Central Bank (ECB) write off 250bn of Italy's 2.1tn debt pile, in a deal which will not be dissimilar to Greece's debt haircuts and write-offs with the Troika.

Another policy idea from the coalition is to raise money by issuing a novel type of Italian government bond, called mini-BOTs, however, these would not be non-interest bearing, a factor which led to turmoil in bond markets on Monday.

Contagion Starting to be Felt

While Italian politics are yet to be considered a major headache for the Euro, there are worrying signs for the broader financial markets, which reminds us that the Euro won't necessarily always be immune.

"A proposal to issue “mini-BOTs” – notes that would be backed by expected tax receipts in the future – sent Italian yields soaring. (BOTs are Buoni Ordinari del Tesoro, a common Italian Treasury bill or short-term credit note.)," says Marshall Gittler, senior strategist at ACLS Global.

"The move is seen as a way of both getting around the EU’s rules on bond issuance and also in effect creating a parallel currency that would trade at a discount to the euro, since the “mini-BOTs” wouldn’t pay any interest," adds Gittler.

"The very idea sent investors rushing out of Italian bonds and into German Bunds, with the result that the Italy-Germany 2-year spread widened out by 21 bps in one day!" Says the strategist. 

Most of the action has been in the Italian debt markets and marginally - due to the effects of 'contagion' - in neighbouring country markets such as Portugal and Spain.

"Furthermore, the authorities in the euro-zone will be alarmed by the emerging signs now of contagion. The 10yr Portugal spread over Germany widened by 19bps yesterday while the Spanish spread widened by 12bps, albeit from very low levels," says Lee Hardman, an analyst at MUFG.

Holders of Italian government bonds have seen the value of their IOUs collapse as fears spread that the new Italian government may rescind on its commitments.

The difference between the price of Italian bonds and relatively stable, benchmark German bonds widened steeply on the news.

"Yesterday marked four days since the 10yr Italian spread over German bunds began to move sharply – most worryingly, the move we had yesterday was the largest widening yet and indicated increased concerns over the contents of the policy document that forms the basis of the possible coalition agreement between Five Star and The League," says Lee Hardman.

"In this four-day period, the spread has widened by 56bps fuelled by fears that the contents of the coalition pact may, in fact, turn to reality," adds Hardman.

From Hardman's perspective, the main threat to the Euro comes from contagion.

"The best-case scenario for the euro would be evidence in the macroeconomic data that indicated limited contagion from Italy to elsewhere in the euro-zone that then allowed the ECB to withdraw QE. Financial market contagion evident yesterday suggests this scenario is not particularly realistic at present," says the analyst.

This makes the recent strengthening in Euro-pairs all the more baffling - surely the single currency should be falling like a stone, under the weight of such drastic reforms, rather than rising?

Whilst it is possible to place the cause of this unexpected strengthening at the door of weakness in the Euro's partners - the USD due to easing protectionism; Sterling due to Brexit fears and the Yen from the collective sigh after the US-China agreed an entente cordial - it is also a fact that the single currency has shown remarkable sui generis resilience.

The reason may lie in the past, for harken back to Greece's most recent debt jitters in June 2017 when it was at risk of defaulting again. Whilst there was no actual default the Euro remained resilient all through the crisis because of fundamental changes made to the Eurozone financial system in the interim, to shore it up and make it less vulnerable to shocks.

Even when the Troika wrote-down Greek debt in 2015 the effect on the Euro was muted as the extent of contagion and the weaknesses in the Euro-area banking system had been addressed.

Although the Italian economy is much larger than Greece and the effects of a default more far-reaching, the Eurozone financial system is a very different sort of animal to the one it was during the financial crisis.

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