June 4, 2018//-After a week that roiled financial markets, the deal to form a coalition government between Italy’s populist Five Star Movement (M5S) and the far-right Lega party is likely to put the parties’ fiscal plans in focus.
We sat down with Silvia Ardagna of Goldman Sachs Research to discuss the likely increase in government spending and tax cuts, the impact on debt sustainability and the coalition’s commitment to the Euro area.
What do you make of investor reactions to the agreement by Italy’s two leading parties, Lega and the Five Star Movement, to form a coalition government?
Silvia Ardagna: In the short term, the deal relieves some of the political uncertainty that had roiled markets in the last week. But in our view, a positive market reaction is misplaced. First, based on recent political events, it is not clear how long the coalition government will last.
Second, even though the coalition agreement does not envisage Italy exiting the Euro area, a more confrontational relationship between Italy and the European institutions and partners is likely to emerge, especially as regards fiscal and immigration policy. Such confrontation would likely see investors continue to question the new government’s commitment to respecting EU rules and thereby sustain uncertainty about Italy’s participation in the Euro area.
Third, if the coalition government carries out fiscal policies as indicated in the already agreed program, we think any increase in economic growth would be limited, and public debt would again be placed on a rising trend, which would increase investor concerns and potentially result in rating downgrades.
The coalition program proposed a fiscal plan that would cost around €110 billion, representing about 6.5 percent of the country’s 2017 GDP. Why do you see a limited impact on economic growth?
SA: A sizeable fiscal expansion in Italy, such as the one proposed by the coalition agreement, isn’t likely to increase real GDP growth significantly because of the country’s high debt levels. Rather, our analysis suggests that in the case of Italy, the impact of fiscal easing on real GDP growth is likely to be quite small versus the average country in our sample. In Italy, government spending increases and tax cuts are likely to have a much larger impact on Italian bond yields and interest rates, given high debt levels and institutional weaknesses.
Fiscal policy is a much more powerful tool to boost growth, even if only temporarily, in countries with low levels of public debt than in countries with high levels of public debt, such as Italy.
In order to prevent an erosion of confidence in Italian sovereign debt, what type of fiscal policy would be appropriate based on your analysis?
SA: Our analysis shows that a government which eases fiscal policy with caution, such as starting with small tax cuts rather than large spending increases, would be more likely to achieve the desirable combination of effects on growth, interest rates and public finances.
It would mitigate market concerns about the sustainability of public debt and reduce the likelihood of rating downgrades. And it would reduce tensions between Italy and the European institutions, reassuring markets that Italy will retain support from its partners and remain part of the Euro area.
By contrast, any Italian government committed to implementing a large fiscal expansion risks setting in motion negative market dynamics, including rating downgrades.
This would have profound implications for the Italian banking system and the liquidity support it receives from the European Central Bank. It would also call into question Italy’s participation in the euro area, likely leading to a more extensive repricing of Italian assets and possibly spillovers to other countries.
Goldman Sachs
