Earlier this week, the euro fell to a 10-month low for various reasons. A key driver was a refocus on the political and economic situation in Italy, where there is a very complicated dynamic taking place.
Italy currently has a coalition government that was formed in March after an election in which the center-right League and anti-establishment Five Star Movement were the victors. The resulting coalition nominated Paolo Savona, a euro-skeptic, as finance minister. But in an unusual move, President Sergio Mattarella, a euro-supporter, rejected Savona's nomination.
Most of the recent market volatility, e.g. the rout in Italian bonds this week, was driven by the fear of renewed talks for a euro referendum. However we note that survey data shows a majority of Italians are supportive of the European Union.
On the economic front, the critical issue is Italy's debt, which is about $2.3 trillion, far eclipsing the $300 billion that Greece owed when that country's debt prompted concerns about the potential for Eurozone collapse. Italy is Europe's third-largest economy and contributes 15 percent of its total GDP.
This has led to two critical questions:
- Does Italy want to remain in the EZ or not? If they leave, they can forego any fiscal austerity from the EU and also allow a new Italian Lira to fall such that the country could export more goods and boost GDP.
- How will the EU and European Central Bank handle Italy's debt and fragile political situation? They cannot forgive the debt but if they play too tough, that could further choke the Italian economy. The ECB may also have to keep interest rates low so that Italy's debt service level continues to be reduced.
Our View: Given the complex political and economic mixture, the financial market is highly focused on whether Italy will stay in or leave the EU. We believe that it will remain, as that is probably still in the best interests of both parties. Italy needs the EZ's low interest rate to pay off its debt while the EU wants to restore confidence within the EZ even if it has to deal with sub-par economic performance in the short-term.
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