MacroWatcher: Italy To Bring Anxiety Back to Eurozone

For the first time in five years, the eurozone has had a relatively quiet summer. With German elections looming, it was unlikely there would be any significant developments in Europe, and positive economic data has added to the recent calm. But with summer ending, it’s possible that political turmoil in Italy could be the catalyst for eurozone anxiety.

The coalition government has been tenuously held in place by prime minister Enrico Letta over the last four months, but it is now in grave danger of splitting. Once again Silvio Berlusconi is at the heart of unrest. Political upheaval is a recurring theme in Italy and Berlusconi’s presence is preventing the establishment of reforms to help rejuvenate a contracting economy.

Despite being convicted of tax fraud, the 76-year-old still plays a role in government through his People of Liberty party. To-date the coalition has survived by Letta avoiding key decisions and agreeing to the demands of Berlusconi’s party on issues of government personnel and tax. Last week Letta agreed to cancel a property tax even though the European Commission, OECD and IMF advised that the tax remain in place to help tackle the country’s 2 trillion euro public debt. The government has not yet announced how the lost revenue from the property tax will be recouped. Such assuaging to Berlusconi led former prime minister Mario Monti to label the government “gutless and spineless”.

Letta has thus far done everything to maintain a stable government, aware that financial markets would not take kindly to disorder. Indeed, the mere preservation of the coalition following the property tax negotiations helped Italy auction off its target of 6 billion euro worth of bonds last week.

While Letta has seemingly bowed to Berlusconi on many issues, he is standing firm in his support of a law that should remove the former prime minister from parliament – and that may be the coalition’s undoing. Berlusconi’s tax conviction has been held up by Italy’s highest court of appeal and on September 9 a Senate committee meets to begin deciding his fate. A full Senate vote on the issue is expected in October.

Letta’s support for the process has predictably drawn ire from Berlusconi’s camp. On Thursday, People of Liberty member Daniela Santanche claimed that Berlusconi has made a video that could announce his decision to withdraw support for Letta, effectively bringing down the coalition government. Berlusconi also plans an appeal to Italy’s constitutional court against the tax fraud verdict and his party says the Senate should wait for that ruling before passing judgment on him. It is obviously a delaying tactic and if the constitutional court agrees to hear his case it could take years before a decision is made. Such an outcome would keep Berlusconi on the scene and dim the prospects of significant economic reform.

There is little evidence of a recovery in Italy. The economy has contracted for eight consecutive quarters with the manufacturing sector experiencing a striking decline as output has fallen more than 25% from its peak in 2007. The nation’s unemployment rate is 12%, but this would be higher if not for a government policy introduced in the 1970s which aids struggling factories by paying “unused” workers 80% of the salaries while their employer attempts to solve its problems.

Earlier this week there were headlines trumpeting a rise in eurozone manufacturing aided by a surge from Italy. Export sales drove output in August but the same manufacturing survey also showed that employment in the factory sector fell for the 25th month running, and at a slightly faster rate than in July. On Wednesday it was announced that Italy’s services sector contracted by more than economists’ consensus, highlighting weak domestic demand. Overall, the manufacturing and servicing reports illustrated that while the wider global economic recovery is gathering steam, Italy remains stagnant.

In the stock market Italian bank shares are strongly outperforming those of other European nations this year. Much of this performance is due to the relatively sound nature of Italian banks as their conservative philosophy saw most of the major institutions avoid excessive leveraging and emerge from the financial crisis intact. Yet continuing economic sluggishness will soon deteriorate balance sheets and limit profitability.

The spread, or extra yield investors require to hold Italian 10-year bonds instead of German counterparts has risen in recent weeks to about 2.5% after touching a year-to-date low of 2.27% on August 19. Current levels are still significantly lower than this year’s high of 3.61% reached in March and nowhere near the 5.75% record set in November 2011. That record was spurred by the tumult surrounding Berlusconi’s prime ministerial resignation and it looks like he’ll have a role to play in spreads widening again.

This post also appears on Ronan Keenan’s MacroWatcher blog.