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Italy's big-spending euroskeptics may be reined in by constitution, markets

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Italy's big-spending euroskeptics may be reined in by constitution, markets

The bond market's truce with the new Italian government has proved short-lived. But, while yields are rising again, the populist-far right coalition's scope for implementing its plans, and blowing out the country's public debt, will be constrained by both financial markets and constitutional hurdles.

The yield on Italy's 10-year sovereign debt neared 3.1% June 8, barely below the highs of late May when investors first panicked at the thought of a government led by politicians who had suggested the country could leave the euro. The spread between Italian bonds and safe-haven German bunds, at 264 basis points, was near the widest since 2013.

The coalition between the populist Five Star Movement and the far-right League has toned down anti-euro rhetoric, but its other policies are almost equally unnerving to debt markets. Plans to introduce a basic income and roll back pension reforms at the same time as slashing the top rate of income tax to 20% would add between €109 billion and €126 billion to the fiscal deficit of a country whose gross public debt is already equivalent to 131% of output, according to research institute Osservatorio CPI.

The League has also floated the idea of issuing bonds backed by future tax receipts which would be accepted as legal tender — in effect a parallel currency to the euro.

But investors can take some comfort from the fact that Italy's constitution, designed with the intention of impeding any repeat of Mussolini's fascist takeover of power, will make it difficult if not impossible for the government of inexperienced Prime Minister Giuseppe Conte to implement its plans.

The 2019 budget bill must be sent to parliament by Sept. 20, with a draft budget submitted to the European Commission by mid-October, but President Sergio Mattarella retains a power of veto, and is able, under Article 81 of the constitution, to reject measures that endanger the stability of public finances, according to Nadia Gharbi of Pictet Wealth Management.

The president has already had one confrontation with Five Star and the League, forcing them to drop their original choice of finance minister, Paolo Savona, who had openly called for Italy to leave the euro.

Referendums

In the past, Five Star has said it wanted a referendum on membership of the single currency, which it blames for restricting the government's ability to spend. But, as membership of the euro or the EU is governed by international treaties, even holding such a referendum would require changing Article 75 of the constitution. This, in turn, under Article 138, would need a vote in favor by two thirds of members of both the upper and lower houses of parliament.

If the government made it that far, it would then have to go to the public with two referendums, one to approve the constitution and another to exit the single currency, Gharbi said.

While euroskepticism is growing across Europe, a poll by Euromedia published May 31 found 60% of Italians would vote to remain in the eurozone with just 24% preferring to leave. A similar poll by Piepoli found 72% supporting remain.

And if investors became seriously concerned that Italian bonds carried a risk of being redenominated in another currency, they would sell off. The country's finances would quickly become unsustainable, according to Frederik Ducrozet, an economist at Banque Pictet, who reckons that a yield as low as 3.5% on Italy's 10-year bonds might be impossible for the government to pay for any length of time.

"Static analysis shows limits when you're playing with two out of three variables (primary balance, nominal GDP, interest rate), including with respect to the multiplier effect of fiscal measures. Our best guess is around 3.5%," he said, when asked what yield would be too much for the government in Rome.

Ducrozet's calculations could be tested sooner rather than later. Yields on Italian 10-year bonds could hit 4% by the end of the year, "due to lingering worries about the political and economic outlook in the country," Capital Economics wrote in a recent research note.

S&P Global Ratings analyst Marko Mrsnik said the country's BBB credit rating, the second-lowest investment grade, could be endangered if the new government's policies sap growth or the current account turns negative.

All this is taking place as the European Central Bank ponders whether to end its bond buying program later this year, something which would tend to put upward pressure on yields at the best of times. Bank ABN Amro noted that if Italy loses access to the bond markets the EU’s emergency lender, the European Stability Mechanism, could offer financial support as it has done with the Greek and Cypriot economies to prevent contagion to the rest of the eurozone.

However, the ESM would only grant loans if the Italian government agrees to a strict curtailment of its spending program. In essence, the populists would face the same dilemma Greek Prime Minister Alexis Tsipras did in 2015. In that instance the radicals turned back from their manifesto pledges and took the medicine. Would this Italian government be willing to cross the Rubicon?