Four of the eurozone’s five largest economies are likely to have elections in 2017. Finance leaders that have a solid understanding of the political dynamics in Europe and the sustainability of the European experiment will better navigate risks and opportunities this year. While the upcoming elections are not expected to fundamentally change Europe’s future, a shakeup in Italy would be particularly concerning.
Italy has failed to enact any structural reforms, being a laggard behind the reform posterchild Spain. Meanwhile, although the percentage of Italian support for the euro remains in the high 50s, it is low compared to the eurozone average of 68 percent. Polls show that if elections were held today, the ruling Democratic Party would gain a narrow victory ahead of the euroskeptic M5S Party. However, it is not clear what electoral laws would apply to the contest. The reformed electoral system for the Lower House remains under review by the Constitutional Court until at least February. The ruling will make all the difference between further gridlock and a viable government.
Business executives and corporate treasurers should consider three factors when considering Italy in 2017:
- The December constitutional referendum was not a vote on the euro and thus cannot serve as a proxy for a future referendum.
- The market will punish Italy the moment it sniffs out even a whiff of a potential referendum to exit. This will bring forward the future pain of currency redenomination, influencing voters’ preferences.
- The benefits of the EU membership for Italy are considerable, especially since they allow the country to integrate its unproductive, poor and expensive southern regions.
The larger question is whether the rest of Italy’s eurozone peers will allow the country to remain mired in its unsustainable status quo. We think the answer is yes.
First, Italy is too big to fail given the size of its economy and sovereign debt market. Second, is the Italian status quo really that unsustainable? The OECD projections for Italy’s debt-to-GDP ratio are not ominous given its impressive budget discipline, which would ensure that its debt load would rise only marginally.
Monetary policy should also remain supportive in the coming year as labor market slack continues to keep inflationary risks at bay, allowing the European Central Bank (ECB) to maintain an easy bias. This should keep the euro currency relatively weak, a boon for equity prices and corporate profits in the region.
Bottom line: The ECB has essentially become Italy’s central bank. Despite solid global growth prospects, a firming recovery in Europe, continued euro weakness, and rising commodity prices, the ECB must remain accommodative to minimize political risks in Italy. This will further drive down the euro and support European economic activity and corporate profits in 2017.
The implication for corporate executives is that the eurozone will survive and long-term investments and business expectations will not be scuttled by the exit of an important economy. Currency risk associated with the potential dissolution of the eurozone will be minimal in 2017, although hedges might be appropriate given the potential for some depreciation.
Marko Papic is chief strategist for BCA Research.
For more insights on the rapid rise of geopolitical risk, download the 2017 AFP Risk Survey, supported by Marsh & McLennan Companies.