Italy's three-pronged threat to the eurozone

by Michael Collins, Investment Commentator at Fidelity International

June 2016

Italy’s comedian-turned-political-kingpin Beppe Grillo went to Athens in July last year to cheer on Greek defiance to the EU in the plebiscite that escalated that country’s crisis. The main purpose behind Grillo’s visit to Athens, however, was to publicise his push for Italy to hold a popular vote on whether or not to keep the euro. His Five Star Movement, which is Italy’s second-biggest political party,[1] is against the euro.

Polling in Italy at the time showed that a vote to abandon the euro would, by 11 percentage points, have beaten those siding to keep the currency, whose backers include Prime Minister Matteo Renzi’s Democratic Party.[2] If anything, euroscepticism has grown since then, as the rise of the nationalistic and anti-euro Lega Nord headed by Matteo Salvini attests.[3]

Forces marshalling against the euro are among the damage that Italy’s sick economy is inflicting on a country that helped fuse European integration after World War II. As well as fragmenting and radicalising politics, Italy’s floundering economy is propelling government debt to unsustainable levels. A 25% collapse in industrial production in the past six years has saddled its banks with so much sour debt the sector is wobbling. The worry is that Italy’s poor economic outlook will foment more support for the anti-euro and anti-elite political movements, send government debt towards default levels and trigger a banking crisis. Since Italy is Europe’s third-largest (and the world’s eighth-largest) economy, it’s arguable that Italy is a bigger threat to European prosperity than Greece.

Not all the readings on Italy’s economy are dire, it must be said. Italy’s economy expanded for the first time in four years in 2015, even if that growth was only 0.8%. The European Central Bank’s asset buying is keeping Italian sovereign yields, and thus the country’s debt-servicing costs, under control. Bank bad debts may well have peaked. Renzi has implemented reforms since he came to power in 2014 in an intra-party coup within the ruling centre-left coalition. Pro-euro parties have enough power to make sure no plebiscite on the euro eventuates. Any vote on the euro in Italy would not be binding anyway. But that’s little consolation. Italy’s self-perpetuating mix of souring politics, a sick economy and unhealthy banks could prove lethal in a country of 61 million people that has unsteady political foundations and weak institutions.

Going backwards

De’Longhi heaters, Alfa Romeo, Ferrari and Fiat cars, Salvatore Ferragamo shoes, Benetton and Gucci fashion and Pirelli tyres are among Italian products that make the country the world’s eighth-biggest exporter of manufactured goods.[4] The rise of these stars in the 1960s and 1980s harks back to when Italy was one of Europe’s best-performing economies.

From the 1990s, Italy presents a grimmer story, especially since the euro was introduced in 1999. It’s not far-fetched to say that the euro has been worse for Italy than for Greece, even though the Greek economy has shrunk by 25% since 2010. At least Greece enjoyed some fruitful times after 1999 for its economy expanded by 42% over the next nine years. By comparison, in the eight years after the lira was replaced, Italy’s economy only expanded 14%. Italy’s economic output last year was only 4.8% bigger than in 1998. On a per-capita basis, GDP has shrunk 2% over the past 17 years.

The most damage, to no surprise, has been inflicted since 2008. Economic contractions in five of the past seven years (2008 and 2009 and from 2012 to 2014) have left Italy’s economy 8.3% smaller than its 2007 size. On a per capita basis, Italians were 12% poorer in 2015 than they were in 2007. Nowadays the jobless rate stands at 11.5%, though some say the true rate is double that. The already-eight-year-old recession and prior lax fiscal discipline have boosted government debt to 133% of GDP, the highest in the eurozone after Greece, and up from 100% in 2007. Rome’s financial management has been so poor that gross debt has been above 100% of GDP since 1992. Deflation of 0.3% at last count is boosting the real burden of debt. The government in 2015 posted a fiscal deficit of 2.6% of output and is having trouble reducing the shortfall to meet EU budget laws.

Poor productivity in a country with centralised wage setting, powerful trade unions and a euro at a higher level than the lira could explain much of Italy’s loss of competitiveness. So too do rigid labour laws, excessive bureaucracy, poor education standards, the emigration of its smartest people, unaffordable welfare, little domestic competition, a reliance on small and medium-sized business that prevents economies of scale and an easily evaded tax system. Under price-competitive measures of productivity, Italy’s competitiveness has declined by 5% since the euro was adopted compared with an improvement of 20% for Germany, though other gauges are less unflattering to Italy.[5]

The country lacks easy options to regain competitiveness and achieve sustainable economic growth, especially when the world economy is weak. The most obvious cure for Italy’s competitiveness would be to re-adopt a much lower lira, as Grillo and others suggest.

Dodgy banks

The global financial crisis of 2008 saw large banks nationalised or propped up in Belgium, Cyprus, Denmark, Greece, Iceland, Ireland, Latvia, the Netherlands, Portugal, Spain, Switzerland, the UK and the US. Italian taxpayers were spared, however, but only because Italy’s economy was too feeble in the 2000s to host a housing bubble. The problem is that Italian banks would have benefited from recapitalisations and debt write-offs that accompany rescues. For after seven years of stagnation, problem loans held by Italy’s inefficient banks stand at an estimated 360 billion euros (A$550 billion), equal to about one-fifth of bank loans and the same percentage of Italian GDP. The sour loans not only threaten financial stability but retard the lending that the Italian economy needs to thrive. The country’s estimated 400-plus banks face the so-called doom loop, whereby the fate of the government and banks are tied together, because Rome’s debt comprises 10.4% of bank assets compared with an average of 4.2% for the eurozone.[6] Negative interest rates are squashing the profit margins of banks that rely on attracting savings so as to have money to lend.

To counter renewed concerns about Italy’s banks, Rome in April created a privately funded backstop for banks that need to recapitalise or unload dud loans to meet regulatory requirements. Rome, due to the size of its debt and ECB rules against state aid for banks, was forced to seek private backing for the facility (or “bad bank”), which was named after the Greek mythological god Atlas, or Atlante in Italian. Rome cajoled this private support by promising to modernise bankruptcy laws that hamper a secondary market for bad loans. Foreclosure in Italy takes an average seven years compared with about three years in other EU countries, a delay that means bad loans are underpriced in the secondary market compared with their value on bank books – a gap that, theoretically, could make Italy’s banking system insolvent.

Atlante has taken over one bank so far and could well own another bank soon if northern-based Veneto Banca’s capital raising flops.[7] The solution, though, has drawbacks. The initial capital of about five billion euros is considered too puny. Feeble banks were forced to donate capital, placing them under further strain. By injecting capital, healthier banks have tied their fortunes to the fate of weak ones. The solution does nothing to fix the poor practices of Italy’s smaller banks whose lending is often driven by political, rather than commercial, considerations.

Atlante better protect Italy’s banks in coming years, however. Italian banks have long sold their riskier debt to their retail customers, who often thought they were putting their money into something more like a term deposit. It’s estimated that bank customers, wittingly or not, hold about half of Italian bank subordinated debt. The political risk is that under EU rules that were first applied during the Cyprus rescue of 2013 these individuals will be “bailed in”, which means they must forfeit their money before a bank can be saved by the state. This happened in 2015 when four small banks failed, resulting in uproar and at least one suicide. But if Rome manages to slip past EU state-aid rules during any rescues, as some suggest it would, the political storm will occur in other EU countries. The other boobytrap Renzi faces is modernising bankruptcy laws because the political impact is that it hastens the process by which banks punish defaulters. As Grillo and others might well point out, bail-ins are a politically lethal requirement tied to Italy’s membership of the euro.

Politics

Italy’s political system that arose after World War II was designed to prevent the rise of another autocrat like Benito Mussolini. Out of an abolished monarchy emerged the First Republic, which was designed to run under standard liberal democratic principles. But successive governments proved so corrupt, dysfunctional and incompetent that the electorate approved changes in referendums in 1993 that ushered in, a year later, the Second Republic. Its first prime minister was Silvio Berlusconi, who over three terms, along with others of the political class, proved no better at governing.

While not as unstable as the tally of 63 governments since World War II suggests, Italy’s political machinations, corruption and paralysis have sapped Italian confidence in their political system. They, consequently, largely welcome the rise and spread of the EU as an alternative source of governance. Italians thought the EU would help the country overcome the handicap of weak institutions and suppress corruption. That faith has waned, though the disgruntlement is more targeted at the euro rather than at the EU.

In 41-year-old Renzi, Italy has a leader who promises to enact political, social and economic change. His centrist coalition has already had some impact. In January, as part of his drive to deliver more stable government, Renzi convinced the Roman Senate, pending a referendum, to give up much of its power, including its ability to vote no confidence in the lower house. On the economic side, the “demolition man” as he is nicknamed (il Rottamatore in Italian), has addressed the bad-loan problem, encouraged banks to merge or buy each other, loosened labour laws, reduced taxes on lower-paid workers, offered business investment tax breaks, has moved to sell state assets and is reining in public spending. Of importance, he has boosted confidence and encourages foreign investment.

To keep up his popularity, Renzi talks tough to the EU against austerity and challenges Germany. But Europe’s immigration crisis is creating a political headache for Renzi. Dropping support for his party will make it harder to do well in the referendum expected in October on constitutional reforms. Of special concern is that Renzi has pledged to quit if voters thwart the proposed constitutional changes, a resignation that would plunge Italy into fresh crisis and possibly herald a snap national election.

Even if Renzi avoids that fate, however, Italy’s likely tragedy is Renzi’s reforms will do less for Italy in the short to medium term than a competitive boost from a lower lira would – the standard cure pre-1999. Italians know this. Some speculate that Renzi, if he survives the referendum, may well be campaigning with Grillo against the euro in national elections due in 2018.

Information on the Italian and other economies comes from the IMF World Economic Outlook Database, April 2016 edition. http://www.imf.org/external/pubs/ft/weo/2016/01/weodata/index.aspx. Information on Italy’s bankruptcy laws comes from the Financial Times. Other financial information comes from Bloomberg unless stated otherwise.

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