The Five Star Movement and the League, the anti-establishment political groups that emerged as winners from the recent Italian election, are on the verge of forming a government. A policy paper leaked from their partnership negotiations and published by Huffington Post Italy outlines a set of radical economic projects, shaking up markets and driving down asset prices as investors seek to exit the country.
The Five Star/League government would, for instance, aim to increase spending by more than €200 billion, providing all unemployed citizens with a basic monthly income of €780, while cutting taxes and renegotiating the fundamental treaties that form the basis of the eurozone in order to allow member states to leave the single currency.
The two parties have disowned the document they reportedly signed on May 14 as an "outdated" draft and reiterated their commitment to keep Italy in the eurozone. However, markets have been shaken by suggestions of dramatic change and upheaval in the governance of one of the EU's founding members.
'Picture could change relatively quickly'
Italian stocks fell steeply on May 16, with top banks UniCredit SpA and Intesa Sanpaolo SpA down 3.76% and 2.71%, respectively, after the document had been leaked. The benchmark index FTSE MIB fell 1.99%. Meanwhile, the yield on benchmark 10-year Italian government bonds jumped 13 basis points to 2.080%, the strongest rise since January.
Bank stocks dropped more than the rest of the market as foreign capital plays a crucial role in the ongoing cleanup of the sector and because investors fear any suggestion of the country leaving the eurozone, according to Michael Roper, a credit analyst at investment house PGIM in London.
"In my recent meetings with banks, political risk has barely featured as a topic," he said in email. "If political fallout were to derail economic upswing or halt foreign capital flows into Italy, then this picture could change relatively quickly," he added, pointing "especially" to the market in bad loans. "If the market believes that 5*/Lega is determined to take Italy out of the euro, then the political noise becomes harder to ignore."
With help from the state, Italy's banks managed to sell €72 billion worth of nonperforming loans in 2017, mostly to overseas investors, according to estimates from Banca IFIS. The firm expects further sales and securitizations of NPLs with a face value of €57 billion in 2018.
"If investors demand a higher risk premium to compensate for the uncertain political backdrop, it might impact the ability of banks to dispose of NPLs in a timely fashion by widening the bid-ask spread," said Roper, referring to the difference between what buyers are willing to pay and what sellers demand.
Investors have long been convinced that any radical tendencies expressed in the election campaign by the Lega and Five Star will be tempered by institutional checks and balances, UBS analysts wrote in a note, adding that the document published May 15 changes that assumption. The analysts expect volatility as markets reprice Italian assets to take heightened political risks into account.
"As such, any incremental element questioning investors' assumption is likely to have a negative market impact," they wrote. "Italian equities in particular may prove vulnerable."
Yet for the time being, the UBS analysts are maintaining their general view that Italian stocks are set for long-term gains based on improving macroeconomics, which are unlikely to be offset by escalation in government-driven risks. But they also noted that Italian stocks have grown significantly in recent months thanks to the better-performing banking and energy sectors, making it more likely that investors would quit while still ahead as uncertainty grows.
"This leaves the Italian index significantly exposed to risk of potential profit-taking if investor sentiment around Italian political risk were to deteriorate," they added.
'Italexit' back on
A former government official also warned that the leaked document could signal a strong change in Italy's political direction, with potentially widespread impact on financial markets.
"While both parties have moderated their tones over the past few months, the issue of Italexit and the relationship with Europe comes back in the document in a way very much in line with their original programs," wrote academic and ex-Italian treasury official Lorenzo Codogno.
The document said the EU's fiscal discipline covenants are "untenable and unsustainable from an economic and social point of view" and "must be radically changed."
It added: "[It] is necessary to introduce specific technical, economic and legal procedures that allow the member states to withdraw from the union."
The document also suggested that the new Italian government will ask the European Central Bank to write off €250 billion worth of Italian bonds, roughly equivalent to Italy's contribution to the eurozone's quantitative easing program. British economist Shaun Richards said the ECB is unlikely to seriously consider this request because the Lisbon Treaty prevents it from providing credit facilities directly to member states.
Characterizing several of the details regarding the proposed policies as "unconstitutional," Codogno said financial market participants would be following Italy with greater concern and wariness after the revelations.
"This leak will be an eye-opening experience for those who had a very complacent attitude towards a Five Star/League government," he said. "Although the two parties may eventually water down the proposals, the document reveals the true extent of their oddity, inexperience and off-track nature. The attitude of financial markets will not be the same from today onward."