14 June 2016
The impending Brexit vote on European Union (EU) membership on 23 June 2016 will be a defining moment for Britain and Europe, and could have significant ramifications for global equity markets. Greg Goodsell, Global Equity Strategist at 4D Infrastructure, examines whether Brexit may be a catalyst for further EU exits, with Italy a possible candidate.
The EU and the eurozone: its origins, limitations and frustrations
The EU is an economic/political union which traces its origins back to the 1950s. It comprises 28 member states operating as a single market, with a broadly standardised system of laws. As a consequence, passport controls have been abolished in some countries (the Schengen area).
The monetary union (the ‘eurozone’ or ‘euro area’) was established in 1999 and came into full force in 2002. It comprises 19 (of the 28) member states that use the euro as their legal tender and have the European Central Bank (ECB) as their central bank. Therein lays a key structural flaw of the eurozone: it is a monetary union only. Member states retain fiscal powers although Brussels (EU’s HQ) looks to impose, with some success, fiscal discipline across all states.
There has been a huge amount of material written on Brexit, most of which focusses on the future pros and cons of remaining in the EU. However, as the EU has now been in operation for some time, we believe voters will be more inclined to look in the mirror before they pick-up a telescope. That is to say, they will first ask what has the EU delivered for their country, and for them as individuals before they look ahead towards potential future rewards. While Britain ponders an answer, we examine this question for two of the three biggest eurozone members – Germany and Italy - to identify who else may re-think their EU membership.
Germany v Italy and eurozone economics: the good, the bad and the ugly
From an economic growth and employment perspective, EU membership for Italy has been very underwhelming relative to Germany. As is shown in Charts 1 and 2 below, GDP growth in Germany has far outstripped Italy since 2002 (the start of the eurozone). Italy has been in recession for five of the past eight years, while unemployment is currently nearly twice what it is in Germany.
Looking further into the comparatives, the divergence in economic fortunes becomes even starker. Germany’s relative economic strength has allowed it to consistently run current account surpluses (Chart 3) relative to Italy’s decade of deficit, while GDP per capita, a broad measure of individual wealth, has also diverged sharply between the two countries (Chart 4).
The public accounts of each nation tell a similar story. Whereas Germany has moved to a budget surplus (Chart 5) and has a stable, manageable public debt load, Italy remains mired in budget deficits with public debt at 130%+ of GDP and climbing (Chart 6). Are we starting to sense some unhappy EU punters in Italy?
For our final point of comparison, we turn to financial markets. As shown in Chart 7, the difference in the two countries’ Net International Investment Positions  (NIIP) could not be more dramatic. Germany has a NIIP of +50% of GDP and growing, which means it is a substantial net creditor (lender) to the world. Conversely Italy’s NIIP is ~-25% of GDP, which means it is a significant net global borrower.
All of the metrics above are reflected in each country’s Credit Default Swap  (CDS) spread shown in Chart 8. Italy’s have been very wide (500bp in December 2011) and currently reside at ~120bp, or almost seven times those of Germany. Similar to a credit rating, these spreads reflect the relative credit standing and borrowing costs of each nation.
Has the EU really been that bad for Italy…and what was that structural flaw mentioned earlier?
Of course it is far too simplistic to attribute the differing economic fortunes of Italy and Germany to EU membership alone. Many of Italy’s issues predate the eurozone while other contributors to that divergence are the differing history and culture of each nation.
However, a number of important observations can be made from our analysis:
To Brexit or not to Brexit is the question facing UK voters on June 23. It will be a defining moment for Britain and the European Union, potentially a major macro event and have significant longer-term ramifications for global equities.
Looking to who may be next, based on their relative EU experiences Italy has clearly been a poor cousin relative to Germany. While this divergence in fortunes cannot be attributed to EU membership alone, it is still likely to be a very relevant and prevalent factor in deliberations in Italy should the Brexit vote conclude in the affirmative, thereby raising the inevitable question as to who is next.
 NIIP: is a country’s stock of external (foreign) assets minus its stock of external liabilities. It provides an indication of whether a country is a net creditor (lender) to the world (ie. where the NIIP is positive relative to GDP) or a net debtor (borrower) indicated by a negative NIIP. A positive NIIP is a sign of external financial strength.
 The credit default swap (CDS) spread is a measure of credit risk. A CDS is a financial swap agreement where the seller of the CDS insures the buyer against a reference loan defaulting, and charges a fee or spread for doing that.
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