Berlusconi win: explosive on paper, a damp squib for the markets

Date: 10/05/01

Silvio Berlusconi is favourite to win this Sunday's Italian election. Phyllis Reed, a former analyst with Barclays Capital, assesses what impact a victory for his centre-right coalition will have on Europe's financial markets

On first inspection, it looks as if Sunday's Italian general election could be a difficult one for financial markets.

If recent polls are anything to go by, the outcome could be closer than anticipated, particularly with a large proportion of the population still undecided on how they will vote.

Although his lead has narrowed into single digits in some polls, Silvio Berlusconi's centre-right coalition is still expected to win. A narrow victory for Berlusconi or the incumbent centre-left coalition led by Francesco Rutelli will clearly translate into an absence of a strong mandate for the winner - a result which is never favoured by financial markets.

In addition to these "conventional" election worries, markets will have to digest a variety of complications which look set to emerge should the election result in a Berlusconi win.

First, there are concerns about Berlusconi the businessman. Clearly, his massive holdings in Italy, particularly his controlling interest in the media, will present a conflict of interest should he become prime minister. It remains to be seen just how he proposes to resolve this.

When Berlusconi was last prime minister in 1994, his draft law to resolve his conflict of interest was not approved before his government collapsed, seven months after taking office.

He is also under investigation for alleged indiscretions associated with his business empire in Italy, and Spain has asked the European Parliament to lift his immunity to allow him to be investigated for suspected tax fraud at Tele 5.

But market experts expect these difficulties to have limited impact beyond any implications for the share price of the companies in which he is looking to divest his interest.

As Luca Jellinek, global bond strategist at ABN Amro in London, points out: "Obviously any actual legal problems on Berlusconi's part would be damaging, if they materialise, but the market has shown a great deal of news fatigue when it comes to Italian political 'scandals' in recent years."

Secondly, Berlusconi's plans to cut both personal and corporate tax rates have been deemed by many as running counter to the fiscal austerity embedded in the Maastricht Treaty. Recently, the EU has shown its hand by censuring Ireland for cutting taxes when growth and inflation were both running at such high levels. If anything, Italy looks more vulnerable to such criticism, with the government debt ratio still running at around 110% of GDP, well below the 60% required by the Treaty However, Guilio Tremonti (expected to be Berlusconi's treasury minister) appears to have softened his stance on taxation by suggesting that the bulk of the cuts will only be introduced if economic conditions permit.

Against this background, fiscal policy looks set to be more of a neutral factor for both bond and equity markets, with the positive effects of any tax cuts (particularly those on savings) having to be offset by the negative effects of the deterioration in public finances and the action likely to be taken by EU officials to make their displeasure known, should these cuts be introduced imprudently.

Lastly, and on the face of it, what appears to be of most concern for the markets is the risk that a win by Berlusconi's centre-right coalition will prompt official action by EU authorities.

Already the international press and various officials have highlighted concerns about Berlusconi's continued inclusion of Gianfranco Fini's National Alliance Party and Umberto Bossi's Northern League in his coalition, citing their xenophobic stance on immigration as a threat.

There appears to be a growing risk that EU officials will respond to a win by the centre-right in the same way they did after last year's election in Austria when Jorg Haider's Freedom Party was effectively frozen out. Already Belgium's foreign minister, Louis Michel, has made comments indicating that his response to a Berlusconi government would be exactly the same as it was with Austria.

In Italy's case, however, there is a growing feeling that a repeat performance from the EU may not be forthcoming. George Johnston, sovereign credit strategist at Barclays Capital, says: "A lot of people thought that the EU overreacted to developments in Austria which might make them more cautious this time around.

"In addition, the EU is likely to be more reticent about sanctioning a country like Italy given its prominent size in the Community."

Jellinek echoes that: "It isn't entirely clear whether a Berlusconi win would cause EU members to kick up a fuss about his coalition allies. Even if that were the case, markets already have the knowledge that, in the end, the Austrian story came to very little.

"As a result, markets would be unlikely to push Italian yield premiums to Bunds/ OATs [German and French goverment bonds] out by more than a handful of basis points, i.e. very little."

Strategists at Banca Commerciale Italiana go further, citing any underperformance in the Italian bonds versus their German counterparts as an opportunity to buy the market. In a recent research note put out by the bank, they state: "There are no reasons, in our opinion, to justify a long lasting deterioration of the creditworthiness of Italy vis-à-vis its EMU partners.

"Whatever coalition comes out of the election, the conduct of economic policy will not change dramatically."

In the Italian equity market, worries about the slightly esoteric effects of EU isolation on a Berlusconi win should be contrasted with what experts believe to be more business-friendly policies.

Hasan Tevik, European equity strategist at Credit Suisse First Boston, says: "Given the centre-right's perceived commitment to freer markets and changes to corporate rather than personal tax, a centre-right victory would be likely to result in near-term outperformance by the Italian market."

The potential effects of a Berlusconi win look explosive on paper (in some newspapers that is), but are expected to be a bit of a damp squib for financial markets.

Despite the threat of negative consequences of a win by the centre-right, we must remember the simple fact that we've been here before - in 1994, Berlusconi was prime minister in a government coalition which included Bossi's Northern League.

Berlusconi had major business holdings and was being investigated for corruption then. What happened? Italian financial markets survived to see another day - unlike Berlusconi's government.

Once again, the benefit of hindsight has proved to be a great calming influence for investors in Italy.

Major feature. Silvio Berlusconi is favourite to win the forthcoming Italian election. Author, a former analyst with Barclays Capital, assesses what impact a victory for his centre-right coalition will have on Europe's financial markets.