Will Italy's Lost Decades End With A Bang?

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Includes: DBIT, EWI, HEWI
by: Shareholders Unite

Summary

Italy's economy isn't expected to return to its 2007 output level until the mid 2020s.

While Italy would benefit from an Italian Margaret Thatcher, there are few good options left to save its economy.

Not even leaving the euro, now openly discussed, is without problems.

Meanwhile, debt and banking problems persist and the risks abound.

It's arguably the most beautiful country on earth. Literally everything is breathtaking, its art, its landscapes, its architecture, its food, its people, its language. Yet this potentially great nation has been languishing for a couple of decades.

Check for instance the IMF report on Italy, this really sticks out like a sore (our emphasis):

Under current staff projections, the economy is not expected to return to its pre-crisis (2007) real output peak until the mid-2020s. Italy is, thus, likely to experience nearly two lost decades, while its euro zone partners are projected to grow cumulatively by 20-25 percent.

What's even more amazing is that Italy hasn't really experienced anything like the boom that was so prominent in countries like Spain and Ireland, or a massive public sector spending binge, like Greece.

What is plaguing the country:

  • A sclerotic economy and judiciary process
  • An uncompetitive exchange rate
  • A banking system paralyzed with bad debts

A sclerotic economy

Despite recent efforts (most notably the Jobs Act), Italy is in urgent need of structural reforms which could insert some much needed competition and dynamism into its economy.

Look how business investment has declined in Italy:

It's too easy to blame this all on the sclerotic nature of the Italian economy. In fact, it's more the cause than the effect, as the structural problems are deep seating and long-standing, preceding this decline in investment.

This is mostly a result of the eurozone slump that hit the periphery hard (as one can see in the figure, Spanish investment has been equally hit). On the other hand, there is little doubt that investment can be revived with a program of structural and banking reforms, at least to some extent.

But there is little doubt that Italy would benefit from a Margaret Thatcher to shake things up, even if it's very doubtful whether such a figure would be given much time in Italy's volatile politics.

Fiscal policy

There are several vicious cycles operating simultaneously:

  • Low growth leads to bad debt dynamics via the denominator effect.
  • Deteriorating debt leads to an emphasis on austerity, which tends to reduce growth further.
  • Low growth and deteriorating debt dynamics have undermined the solvency of the banking system.
  • In turn, the impaired solvency of the banking system reduces credit provision and hence it reduces growth further.
  • The impaired solvency of the banking system also makes bailouts more likely which further worsen public finances.

At least in 2012, the ECB with Draghi's "whatever it takes" (to save the euro) has stopped another vicious cycle short when Italian (and those of other peripheral eurozone countries) bond yields were spiraling out of control, deteriorating public finances further, which provided yet more reasons to sell bonds (and creating large losses for bank's bond portfolios in the process, making bailouts more likely, etc.).

Since then, Italian bond yields have come down a lot, and Italy has been able to ease the austerity and a modicum of growth has returned, here is the IMF:

The government tightened the fiscal stance considerably during the crisis to register a peak structural primary surplus of 4.1 percent of GDP in 2013, among the highest in the euro zone. Since then, fiscal policy has been eased, and is set to ease further in 2016, with the structural primary surplus projected to decline to 2.6 percent of GDP. Meanwhile, the overall deficit is projected to decline to 2.4 percent of GDP in 2016 (from 2.9 percent of GDP in 2012-13) with the sizable interest savings of more than 1 percent of GDP largely offset by the fiscal relaxation (Fund advice had been to use the interest windfall to reduce debt). Debt continued to increase to 132.7 percent of GDP at end-2015.

That public debt is really uncomfortably high for a country that doesn't enjoy the benefits of having its own currency, is plagued by structurally low growth and (NOW) low inflation and banking problems and has few levers to substantially revive growth.

Three threats are fairly pertinent:

  • A new economic shock. Italy hasn't been able to bring down its public debt during the economic revival, a new economic shock will ratchet it up once again.
  • Discord within the ECB as a result of rising inflation in countries like Germany leading to a significant tightening of monetary policy.
  • A banking crisis.
  • Political instability.

Bond yields are already creeping upwards:

Bad debts

Italian banks are plagued by bad debts, a whopping 18% of their loan portfolios are non-performing, one of the highest percentages in the EU.

As a result, Italian banks are amongst the least profitable in the EU and it makes the Italian banks highly risk averse, leading to a decline in credit provision (from the IMF):

Credit to households has been growing modestly, but credit to the corporate sector has continued to decline and is about 11 percent lower than five years ago, despite the decline in real lending rates to SMEs.

It is really crucial to clear up this legacy as it's a big impediment to growth in several ways. Low credit provision dampens investment, which in turn leads to a deterioration of the capital stock, both in quantity and in quality.

That, in turn worsens productivity growth, which makes it even more difficult to recoup lost competitiveness. It is odd that Italy suffers from such low productivity growth as it has the second largest manufacturing sector in the eurozone.

Leaving the euro?

Four parties are proposing this and they could have a majority after the next election. However, there are considerable complications.

Of Italy's outstanding debt, about half can be converted into lira should Italy reintroduce that currency. However, this fraction is declining because new debt has a collective action clause which makes this problematic.

And of the more than 1.8 trillion euro in public debt, 200 million or so shifts every year to the collective action clause which makes redenominating these into (supposedly devalued) lira next to impossible.

Then there is the Target 2 balance, a settling account between the central banks for cross-border capital flows. Italy's position is currently a negative 358B euro, meaning that it owes other eurozone central banks (mostly the Bundesbank) some 20% of GDP.

Opinions vary how serious this is, so it came as a bit of a shock that ECB President Mario Draghi (an Italian) argued that Italy will have to settle this account in full upon leaving the eurozone. In that case it's public debt is 154% of GDP, not 134%..

The increasing Target 2 deficit is a sign that Italy is plagued by capital outflows, not necessarily surprising, given the economic risks, and the capital outflow itself is depressing the economy.

Conclusion

We see risks on many fronts. Given the rise in eurozone inflation, the ECB isn't likely to extent its bond buying program beyond this year, when it's scheduled to end. The ECB already holds more than 10% of Italy's outstanding bonds, or 210B euro.

Italy hasn't been able to reduce its debt/GDP ratio the last couple of years, which have been fairly benign, economically. It has benefited from a decline of the euro, low oil prices, and ECB bond buying, resulting in low interest rates and an uptick in economic growth.

These tailwinds are not going to last and Italy is liable to have to pay substantially higher interest rate in a climate of global reflation and a considerable tightening of ECB monetary policy.

Just as one can have serious doubts about the sustainability of Greek finances, similar worries could soon resurface about Italian debt.

We know from earlier episodes that the bond market suffers from what's known in the literature as the 'multiple equilibriums problem.' Basically, without a backstop a sell-off in the bond market can easily trigger a vicious feedback loop, as higher rates impose losses on bank portfolios and worsen public finances.

The backstop now is the ECB's bond buying program, Italy enjoys much lower rates than Greece, for instance.

But when that program ends at the end of this year, the markets might call the ECB's bluff and this could very well trigger the need for a formal bailout program if bond yields rise making financing the deficit and refinancing debt more expensive.

With the ECB already holding in excess of a quarter trillion in Italian bonds (by December), Italy's near stagnant economy, shaky banks and Target2 deficit of a cool 359 billion euro and counting, we say good luck to that.

With the rise of right-wing populism growing almost everywhere in Europe, we can't see a bailout anywhere near the required scale being proposed besides by politicians with a death wish.

What will happen is Le Pen gets elected in France, or Greece can't agree with its creditors (or these can't agree amongst themselves) is anybody's guess.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.