The Italian Conundrum
After Spain, it’s Italy’s turn in the Eurocrisis spotlight. The immediate cause for this spotlight is a two notch downgrade of the Italian sovereign by Moody’s, a rating agency from A3 to Baa2, just two notches above the dreaded junk status. Despite the downgrade, Italy is not Spain and the fact that the downgrade had a rather limited impact on the pricing of Italian bonds issued in its immediate aftermath reflects some of its fundamental strengths.
Nevertheless, expect this to generate a barrage of strongly worded public criticisms from European leaders, but the truth is that they only have themselves to blame. The single biggest factor weighing on the Italian economy at present is the uncertainty about whether or not the Eurocrisis will be resolved. And it is this, rather than Italy’s own domestic situation (which is also complicated), that is the most serious problem.
While the Spanish economy is already caught in a vicious downward spiral, the Italian economy is not, at least yet. However, unless the Eurozone acts quickly to stem the uncertainties surrounding the Eurocrisis, what has essentially been a liquidity problem for Italy thus far (having to rollover debt at gradually rising interest rates) may well turn into a self-fulfilling solvency problem leading inevitably to a need to restructure its debt. This may not happen through the first order impact of rising interest costs, but through the suffocating impact on the private sector, through rising capital flight and through falling GDP as we discuss below.
The Italian debt dynamics are not that bad
Italy now has a sovereign debt burden of more than Euro 2 trillion, the largest in the Eurozone. This is more than 120% of GDP, the second highest burden in the Eurozone after Greece. This does not look good, especially when combined with the fact that as the Eurocrisis goes on, Italian borrowing costs are increasing. The 10 year benchmark borrowing costs are more than 6%, 5 year more than 5% and 1 year close to 3%. However it is necessary to put this into context.
In 2012 Italy is expected to deliver the highest primary surplus, of more than 3% of GDP, (government balance excluding interest payments on debt) in the Eurozone, even higher than that of Germany. On the whole, its fiscal consolidation plan has been reasonably successful and barring unexpected developments, the public debt stock should start falling in the next 2-3 years. The latest data shows that its deficit is a third smaller than at this time last year. Italy ran large primary surpluses in the 90s and has recorded surpluses for much of the last two decades so has shown itself capable of sustaining the large primary surpluses (of 5% or so) needed to start bringing the debt stock down.
The structural reforms that have already been undertaken and those that are planned are also likely to increase the structural surplus by as much as 2%-3% of GDP. The OECD has projected that Italy will have a structural surplus of 0.8% of GDP. Last but not the least, the Italian government has more than Euro 550 billion of assets that could be sold, at least in theory, to generate cash. Even though the whole amount will never be mobilized, there is room for substantial revenues to be generated. We think that up to a fifth of this, close to Euro 100 billion can be monetized in the medium term. Our point is that the public debt situation is less bad than it looks from the headline numbers alone and most importantly there is a credible downward adjustment possible.
The average maturity of Italy’s outstanding debt stock is close to seven years so this means that it will take close to seven years for any increases in funding costs (assuming a uniform rise across all yields) to register fully which means that Italy can absorb increases in funding costs in the short term as they will only have a limited impact on its overall interest bill. Adding to this is the fact that at this point the interest rate that Italy is paying on its stock of outstanding debt is a bit over 4%, which is close to the lowest it has ever been historically.
Other redeeming features for Italy are that its private sector indebtedness at around 140% of GDP is lower than the Euro area average of close to 170% GDP. Even factoring government debt in would mean that Italy has less aggregate economy-wide indebtedness than most other Eurozone economies. A critical part of why Italy is in a much stronger position than a country such as Spain is that Italy did not experience any major credit-fuelled housing or consumption boom. Consequently its banking system is also in a much healthier shape though it is not as robust as once assumed. Mid-sized banks in particular face some serious challenges but these seem surmountable. Another critical strength, for Italy is that its current account deficit is manageable and is in fact better than that of France. So it means that it does not need to attract significant amounts of foreign capital to fund the deficit. Last but not the least, the financial sector has savings of more than Euro 8 trillion and the mortgage to GDP ratio in Italy is below 20%, one of the lowest in the Eurozone.
So what’s the problem?
Italian public debt dynamics may not be bad and its private and financial sector balance sheets may be healthier than in many countries but it does face a whole barrage of problems, some more serious than others. In downgrading it, Moody’s referred to two main risks 1) Rising funding costs 2) Rising unemployment and falling growth in the near term. It pointed out that Italy has very high refinancing needs of Euro 415 billion in 2012-2013 and that foreign investors are not coming back so Italy may face problems rolling this debt over. It also says that the 2% GDP fall expected in 2012 will make outlined fiscal targets harder to achieve. This reasoning does make sense, but we need to drill deeper to look at what the real challenges that Italy faces are.
The first is large political uncertainty. Mr Monti, the current technocratic prime minister, has recently announced that he will not stand for election and will exit the scene next year. There is no obvious competent candidate to replace him and the electoral scene in Italy is highly fragmented with uncertainty heightened by the rise of anti-Euro populist movements. What’s worse is that Mr Berlusconi, Italy’s discredited ex-Prime Minister has suddenly started expressing openness to standing for election again after first having announced that he was retiring from politics. He is bad news for Italy.
Mr Monti, who was brought in to ‘sort out problems’ has been moderately successful having passed a number of helpful reforms on the labour market, on spending and on mobilizing additional tax revenues including through a crack-down on wide-spread tax evasion. These reforms were necessary but are unpopular and his popularity has declined. This also means that the willingness of the political parties that are supporting his program in the parliament to continue this support is declining and will do so precipitously as they seek to distance themselves from his increasingly unpopular reforms as elections come closer.
A big part of the problem has been that while the pain of reforms and austerity is being felt now, neither the markets nor the European Union have rewarded Mr Monti or Italy for the efforts which are likely to bear fruit over the longer term. Particularly as Spain has got caught up in the crisis, more and more attention has focused on Italian problems putting pressure not just on sovereign spreads but also much more broadly on the rest of the economy.
This leads us to the second big problem that Italy faces – economic uncertainty. Ever since the idea of a Euro break up hit the main-stream, investors have been unable to ignore the admittedly small probability of a Eurozone break-up and an eventual Italian exit. The losses they would face from such an outcome would be so large (as an Italian lira is expected to depreciate significantly) that this currency risk is starting to affect their behaviour. A combination of factors that includes 1) this ‘exit risk’ and 2) low growth prospects in the near term as well as 3) the crack-down on tax evasion is driving capital flight from countries such as Spain and Italy. We have documented how this dynamic can become dangerously self-fulfilling as capital flight drives even more capital flight in our piece ‘The Eurozone Dumbbell Trap’.
While capital is fleeing Spain at an alarming rate of 50% of GDP, the problem is not yet that serious in Italy but the dynamics are dangerous and things could easily get worse. First it was foreign investors that were pulling out through 1) not rolling over investments in the Spanish and Italian sovereigns, or corporates or banks and 2) through actively reducing their exposures through asset and investment sales and 3) through not making the investments they would otherwise have made. As the risks of a Euro break up have risen, even domestic investors have shown a tendency to reduce their exposure to the domestic economies in Spain and Italy and given that there is free movement of capital in the EU, there would be little that could stem such capital flight if confidence takes a further hit. That would be nothing short of a complete disaster the probability of which happening is unfortunately not negligible anymore.
This brings us to the last big (near-term) problem that Italy faces – high and rising sovereign borrowing costs. In the first section we stated that the real problem with Italy’s high borrowing costs were second order – through their impact on the private sector. Rightly or wrongly, sovereign borrowing costs represent a notional floor on the cost of credit in the real economy. There are exceptions to this rule, but it’s a useful rule of thumb.
As private capital has fled Italy, it has increasingly been replaced by ECB funding – through the LTRO and other ECB facilities and it is this what is reflected in the rising Target 2 imbalances (that everybody has expressed an opinion on) at the ECB. Equity investments, fixed income investments & bank deposits are being replaced by central bank funds which, as Credit Suisse has pointed out, are qualitatively different. Despite the low cost of funds for the banks themselves, sovereign borrowing costs are still used as a proxy for economy-wide risk and the lending costs to the real economy – both companies and individuals has risen. The volume of credit has also declined driven both by tightening credit standards and a rising cost and a secular decline in demand which in turn is driven by expectations of a declining economy where investments made today may lose money tomorrow. This means that capital deployed in the real economy is leaving and is being replaced by money that is less effectively deployed in the real economy.
This dynamic worsens growth prospects in the economy and interacts with the generalized political and economic uncertainty that we spoke about earlier to generate a downward spiral of self-fulfilling expectations and behaviour that can be fatal to any economy, leave alone one that does not have a lender of last resort that can stop liquidity problems form turning into solvency problems.
That is why Italy, despite a fiscal picture that is better than what it looks like at first glance and despite real structural reforms that are being enacted, remains vulnerable. Action to support Italy must come from the Eurozone as there is little that Italy itself or Mr Monti can do to prevent a descent into a downward spiral.
Steps that reassure investors and citizens that the Eurozone will not break-up and steps to cap effective Italian sovereign interest rates as we suggested last year are both necessary and urgent. Italy’s fate lies in the hands of the Eurozone and the Eurozone’s future in turn depends on what transpires in Italy.