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Roman castles in the sky

 Salomons Judgement

Mario Draghi may keep the interest rates low, but when clowns and fools are building castles in the sky, the situation is getting out of hand. And euro stress is back again.

Some people responded to my last column that not the corporate debts but Italy might well be the canary in the coal mine. It may seem that way, but the problems in this country are not the result of recent debt accumulation. Italy has a fiscal deficit of -2.3%, but a current account surplus of 2.6%. The primary surplus in the state budget, excluding repayments and interest on debts, has been in surplus for more than twenty years. Try to find that in other countries in the eurozone.

The grotesque government debts (132% of GDP) were largely incurred in the 1980s and never diminished due to a lack of economic growth. The euro is not the root cause of the problems in Italy. The problem is not so much the country’s debts as it is the lack of growth. With just 0.5% growth since 1999, GDP grew even less than in Japan, but managed to beat Greece. If growth is below the interest rate on debt there is no easy way out. Productivity growth and demographics trends are among the worst of the G20. However, the difference in growth between the north and the south of the country is huge.

The attempt of Lega and M5S to form a government together is therefore quite remarkable. Lega had favoured a segregation of the south for a long time, as the people were said to live off the money that was made by hard-working northerners. The Five-star Movement, on the other hand, got a lot of voters from the south. Apparently, my enemy’s enemy is my friend. 

Based on former experiences, the financial markets were not particularly shocked by the Italian election results at first. They didn’t say ‘basta!’ until the plans of the new government were gradually becoming clear. The populists are heading for a clash with Europe on the euro, and they want to spend tens of billions extra without it being clear how and if these will be compensated by additional income.

Mario Draghi can keep the interest rates low through a bond buying program. If interest rates rise due to more growth, that’s fine, but not if that happens by building castles in the sky. Not only were the interest rates on Italian government bonds rising, but the redenomination risk for a member state leaving the eurozone is also back. A possible downgrading of the creditworthiness of Italy in the coming weeks would only make it worse.

Except from a lack of growth and need for structural reform, the financial sector remains vulnerable. Somewhat tongue in cheek it has been said that Italy has more bank branches than pizzerias. Reforming the financial sector is easier at low interest rates and the process is really set in motion, but it’s far from complete. The balance sheets of Italian banks and insurers are loaded with national government bonds. The financial sector is the biggest creditor of the state. Now that the odds of a default are rising, investors are again paying attention to that. When in doubt about solvency, savings and pensions are indeed at risk.

On economically rational grounds, the Italian President Sergio Mattarella prevented the appointment of a eurosceptic finance minister. It remains questionable whether the Italians would have thanked him for that if in the case of new elections. The Italian voter has given the populists a clear mandate and would probably do so again. Do not hold your breath.

Populism is here to stay. Investors must take the stress this involves into account. Just when Europe is talking about issuing bonds that is covered by all its member states, the timing could not be worse ...

The author

Roelof Salomons

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