Italy’s New Goverment and What It Means for the Eurozone, Sterling and Brexit Negotiations

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As of late last week, Italy has what is considered to be the first truly populist government of a major European nation since the Second World War. With the March general election failing to result in one party winning a strong enough majority to form a government, 40% is the minimum requirement, a coalition was agreed upon between Five Star, who led the polls with 32.22% of the vote, and third placed Lega (The League) with 17.69%.

The Five Star Movement, which is described as ‘Eurosceptic, anti-free trade and pro-Kremlin, dominated in the south of Italy where its populist vows to slash corporate tax and provide a minimum national monthly income of €780 rallied support. The party is also proposing a radical ‘direct democracy’ system that would see the electorate voting on many issues traditionally decided by parliament. Lega is characterised by its right-wing, anti-immigrant policies.

Why The Hold Up?

Since March, first wrangling between the two parties over coalition terms and then receiving presidential approval for a proposed joint cabinet had plunged Italy in a political crisis that spooked markets. As recently as last week President Sergio Mattarella’s refusal to accept the proposal of Paolo Savona, the 81-year old Eurosceptic economist as finance minister sparked a mass sell-off of Italian debt and finance equities.

On Friday a compromise was reached with Savona taking the role of minister for EU affairs and the finance and economy role going to Giovanni Tria, a professor of political economy at Tor Vergata University in Rome. Giuseppe Conte, a lawyer and university professor of little front-line political experience is the coalition’s prime minister and the leaders of Five Star, Luigi Di Maio, the The League, Matteo Salvini, both vice-premiers.

Quoted in the Financial Times, Roberto D’Alimonte, a professor of political science at Luiss University in Rome, commented on the patchwork new government sworn in on June 1st:

“This is a government like we have never seen in this country before and I can’t think of anything similar in other countries. It’s a new animal, a goat-stag. It’s half political and half technocratic”.

Why Is the Eurozone Concerned?

Concerns over how Italy’s new government might impact the Eurozone centre around Italy’s continued membership and public spending plans. The final composition of the cabinet has, for now, alleviated fears the country may move to withdraw from the euro. This was demonstrated by the single currency’s sharp rise against the dollar on May 30th after Savona’s proposed role as finance minister was rejected. There was also strengthening against pound sterling and other major currency peers. Savona is well-known for his anti-euro views and opinion that its management by Germany ‘damages the South’.

Technocrat Tria is a more conciliatory figure and his appointment means the danger of any short-term danger of Italy edging towards the Eurozone exit-door has dissipated.

The other major fear is how the economic policies the coalition partners campaigned on will impact Italy’s finances if pushed through. The League want a flat or two-tier tax system of 15% and 20%. The right-wingers also want to roll back pension reforms. Economist predicts these policies would cost the public purse a respective $50 billion and $8 billion. Five Star want to introduce a minimum income and ramp up public spending.

Italy has the third-largest debt level of any country in the world at 2.3 trillion euro. It is 1.3x annual GDP and Moody’s said on Friday it may downgrade the country’s debt. Higher costs to service existing debt, while adding to it, would make the country’s finances hugely vulnerable. This has sparked concerns Italy may become a second Greece if the technocrats in the new government can’t temper spending plans.

Potential Repercussions for Brexit and Sterling

It is thought the Eurosceptic flavour to Italy’s new government could lead to the EU making an example of Britain during ongoing Brexit negotiations – sending a warning out to Rome. Five Star’s support of Brexit and stated intention to put a stop to the EU’s ‘punishment’ of the UK in ‘respect for democracy’ may well backfire on Theresa May.

If Italian dissent pushes the EU into a harder line approach to Brexit, pound sterling would be expected to continue to suffer again over coming months. A partial recovery from the drop that followed the Brexit referendum result has recently faltered.

With the euro and pound sterling facing strong headwinds from the Italy fallout, the major beneficiary would be expected to be a recently resurgent dollar.

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