05.06 Weekly Viewpoint : New Italian government

The final changes made to the list ministers set forth for the new Italian government seem to have eased investor fears of Italy possibly launching a stern challenge of the institutional architecture of the EU…….

However, there is lingering concern on a possible lack of fiscal discipline: on this front, we will have to wait for more accurate indications on which strategy will be chosen to implement the “government contract”.

US tariffs on steel and aluminium imports from the EU, Canada and Mexico have come into force. The share of import-export trade affected is very modest, but problems could mount over the next few months. It is wishful thinking to believe that tariffs can help cut the US trade deficit, which depends on macroeconomic factors.

In Italy, almost three months after the elections, and following a string of surprising turns of events, the formation of a government has been announced, supported by a Five Star Movement-Lega coalition majority, and led by Professor Giuseppe Conte. Compared to the list of ministers proposed last Sunday, important changes have been made in key positions, including the Economy & Finances and Foreign Affairs ministers.

The changes (after those made to the initial draft of the government contract) seem to significantly reduce the risk of Italy openly challenging the European Union’s institutional architecture (and of possible “coups de main” placing in question Italy’s Eurozone membership). This helps explain the positive reaction of the financial markets, after the phase of escalating tensions, which peaked on Tuesday.

However, the other reason for concern among investors is the potential lack of fiscal discipline, which is also tied to the first as it could, if taken to the extreme, cause a potentially disruptive fallout on Italy’s relations with the euro area.  This potential risk is still in place, and it may generate new tensions in the future. Yet, as was the case with the process of drawing up the list of ministers, the government parties are unlikely to turn a deaf ear to the warnings of the President of the Republic and of the financial markets (more than from the European authorities), which, if issued and reasserted, could even undermine the political consensus currently enjoyed by both movements.

However, market turbulences also originated from the fact that the “government contract” signed two weeks ago did not identify adequate sources of funding for the proposed measures; nor did it establish an order of priority for the measures. In our view, it is reasonable to expect that the “contract” will be implemented neither rapidly, nor in whole; furthermore, the fact that the funding measures explicitly declared in the document fall short of the requirements implied by the expansionary measures does not mean that they will be entirely deficit-funded (in other words, other funding sources could be identified over time). Therefore, it will be important to wait for more accurate indications on the government’s action strategy, with particular reference to the priority afforded to individual measures. Such indications could come already when the new government takes office, at the beginning of next week. In any case, a gradual strategy could be opted for, starting with a package of measures without a dramatic effect on public accounts. The first important test will be the Budget Law, to be unveiled by mid-October: at that stage, a decision will have to be made on whether or not to allow the safeguard clauses to kick in, and the government could be tempted to introduce an initial, strong dose of tax cuts (citizen’s income could be put in hold, as it requires job centres to be reformed beforehand, and a general reform of the pension system would take time, although some partial measures could be introduced immediately). Therefore, the unveiling of the 2019 Budget will mark crunch time, and tell us how credible the threat is of Italy openly breaching European fiscal rules. Relations with the system of domestic institutional counterweights, with the European authorities, the rating agencies, and international investors, could become tense again.

However, a “truce” between now and the autumn cannot be ruled out.

After a number of postponements, today the United States have enforced tariffs on steel and aluminium product imports from the EU, Canada and Mexico. The tariffs amount respectively to 25% for steel and 10% for aluminium, and have been explained with the need to protect national security. According to the European Commission, the US measures involve exports which in 2017 were worth a total of just 6.4 billion, by all means negligible when compared to the size of the European economy, and very modest also in terms of the share of overall import-export trade between the two regions (in 2017, 375 billion in exports to the US, and 257 billion in imports from the US). The EU is now likely to enforce, within two weeks, the retaliation tariffs already identified for imports from the United States, within the framework of WTO rules, as notified on 18 May. However, the dispute between the EU and the United States on the trade front could extent to a larger portion of overall import-export trade, as the US Department of Commerce has opened an inquiry into potential threats to national security stemming from auto imports.

Tariffs on steel and aluminium product imports undoubtedly represent a gift to US producers, which were able to apply higher prices to their domestic clients. In fact, the trend of US prices is diverging sharply from the global trend: aluminium prices are 150% higher than they were at the beginning of 2017, as opposed to an increase of only 35% in Europe. For what concerns steel, the increase has been 52% vs. 8-12% in Europe since the beginning of 2017. However, as these are intermediate goods, the benefit also implies a damaging fallout on the competitiveness of US businesses in other sectors. This may be another reason why focus has now shifted to the auto sector, which is a significant user of metals. 

For the time being, the protectionist initiatives taken by the United States are not enough to alter the still positive global economic picture, although a further extension of the measures could start to weigh on confidence. The question lies in what kind of concessions the United States expect from the EU: if they are aiming to achieve greater market openness, the final outcome would not be necessarily negative. On the other hand, if the aim is solely to support the profit margins of some US companies, as seems to be the case, the effects would be negative for both the United States and the European Union. Without necessarily producing an improvement in the overall trade balance, which depends principally on the course of macroeconomic policies.

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