The coming to power in Italy of a coalition between the 5SM and the League alarmed the financial markets in May. After the news leaked that the scenarios configured by the coalition also included a plan to exit the euro, a flurry of political twists and turns started which caused the weakening of the euro, the European stock markets and above all the bond markets of the so-called “peripheral” Europe. In short, the specter of an EU country leaving the Eurozone has returned to haunt investors.
First, it must be emphasized that the paranoia on this issue is fully justified. Indeed, whether it is Greece or Italy, the exit of any country from the Eurozone could set a lethal precedent. If experience shows that a country can indeed exit the Eurozone, the plausibility of such a scenario would need to be quantified for each country. At this point, a euro would never again have exactly the same value regardless of the country in which it is deposited. Any investor would be encouraged to keep their capital in euros in countries where it would be safest, avoiding the more fragile Member States. It would be the end of the fungibility of the euro and therefore of the euro itself. The stakes are therefore much greater.
Does Italy in 2018 present a plausible risk of exit from the Eurozone?
It is technically entirely possible for a sovereign country to revert to its own national currency. However, at least two conditions must be met to do this. The first is that the exit from the euro reflects the will of the country. Instead, all the opinion polls show that the majority of the Italian population today wants to keep the euro. It is true that nothing prevents a democratically elected government from making decisions contrary to the will of the people. But this perspective would be at least paradoxical from an executive that explicitly declares that it wants to reflect the will of the voters. Secondly, the operation must be done by surprise. Indeed, if the government were to announce its intention in advance, this would obviously lead to a flight of capital, which would cause the immediate failure of the process even before it began. The combination of these two factors means that for the Italian government to decide on "Italexit" would mean explicitly and deliberately betraying the mandate given to it by the voters. Implausible.
Does this mean that Italy will quickly fall into line?
And so will the financial markets be able to resume their good trajectory supported by the convergence of the cost of debt among the countries of the Eurozone, sanctioned in the summer of 2012 under the reassuring aegis of Mario Draghi?
Very unlikely, and for two reasons.
First of all, if it is true that Giuseppe Conte's government cannot announce a plan to exit the single currency, it is also true that it will want to be the architect of a drastic change in economic policy: the dogma of budget austerity will be contested. Financial markets are unlikely to welcome the deliberate slide into larger budget deficits. But this risk should not constitute an immediate threat, first of all because Italy has a certain margin of maneuver which it can use without jeopardizing the public finances (the Italian budget deficit today is lower than that of France and the of Italy's current account is positive). It can also be assumed that Matteo Salvini's obsession with the issue of migrants offers Brussels, or the Franco-German duo, a negotiating lever to be exploited to obtain an economic program acceptable to the markets in exchange for help on this front .
The second reason for concern is deeper and does not only concern Italy.
Structural reforms in European countries and institutional reforms at Union level are still lagging behind. This deficiency has not so far been made evident because the European Central Bank has always provided active support and the economic cycle is favourable. On the other hand, the backwardness of the reforms could become clear in a few months, when the economy slows down, even more so if the deceleration coincides with the progressive reduction of support from the ECB. In fact, in the absence of reforms capable of allowing the reduction of debt rates, the markets will no longer allow the more fragile peripheral countries the luxury of being able to resort to the budgetary weapon without this leading to a rise in interest rates. And the European Union will no longer have a European budget sufficient to fill the shortcomings of the most vulnerable states. In other words, the weakest countries will be the most penalized and thus the magnificent dynamics of convergence among the countries of the Eurozone – from which equity, bond and credit markets have benefited over the past six years – will be sharply called into question. In this regard, such a perspective alone justifies the sense of urgency that Emmanuel Macron tries to instill in the implementation of his reform program in France. In summary: neither monetary policies nor fiscal policies will have the flexibility they had in the past to be able to stabilize the next economic slowdown. This next phase of the economic cycle will require investors to abandon the reflexes acquired since 2012 and to radically rethink their market risk management.
°°° The author is Managing Director of Carmignac
