Country Report Italy
Italy has to deal with a severe crisis and large public debt stock. Non-performing loans in the banking sector are on the rise, while government bond yields are vulnerable to political instability. Given large debt dynamics, Italy should improve its potential growth rate to ensure debt sustainability.
Strenghts (+) and weaknesses (-)
(+) Low household debt and high savings
Households are less indebted than their peers, which makes them less vulnerable to economic and financial shocks. Accordingly, banking sector exposure to households is less of a risk for bank balance sheets.
(+) Access to European financial support measures
The ECBs promise to do “whatever it takes” and the existence of the Outright Monetary Transactions framework has helped lower government bond yields, despite the country’s large debt stock and the apparent inability to bring it down.
(-) Political instability and large public debt stock
Policy uncertainty combined with the inability to take decisive action to deal with Italy’s deep seated economic challenges hampers economic growth. Moreover, both could trigger sovereign yield shocks which, in Italy, rapidly feed through in higher firm lending rates.
(-) Weak institutions
Productivity growth and competitiveness are constrained by regulatory rigidities, high barriers to entry in a number of sectors, a lengthy judicial system, a rigid labor market, relatively low education, a high tax burden, inefficient public spending, a sizeable unofficial economy, and corruption.
1. Recession continues, hampering debt reduction
In 13Q2, Italy’s GDP shrank for the eight consecutive quarter (-0.3% q-o-q). Since its pre-crisis peak, output has dropped by 8.9%. The GDP contraction in 13Q2 was substantially less than in the previous two quarters, but we do not expect growth to turn positive before the end of the year. In fact, in our base-line scenario, the economy will only stagnate in 2014. In our view, exports will pull the economy out of recession next year but domestic demand will continue to act as a significant headwind to growth. Moreover, authorities should tilt austerity more towards public spending cuts and efficiency savings instead of tax hikes and introduce structural reforms to improve competitiveness and productivity growth. Otherwise, it is even likely GDP growth will remain below 1% in 2015 and beyond. Besides its negative impact on private sector balance sheets, weak growth also makes it very difficult for the Italian government to lower the debt-to-GDP ratio. Consequently, debt sustainability could be endangered.
2. Rising non-performing loans worsen bank balance sheets and credit conditions
While Italian households are not highly indebted, the number of highly leveraged and distressed firms has been on the rise since the start of the crisis. As a consequence, non-performing loans (NPLs) have tripled since 2007. At the end of 2012 the bad loan ratio equaled 7% and total NPL (which in Italy comprises bad debt and substandard, restructured and past due loans) stood at 14%. Given the still weak economic outlook, NPLs are expected to continue to rise next year, which is bound to weaken bank balance sheets further. Moreover, 30% of all firms are classified as vulnerable to a prolongation of the weak economic environment. As 50% of corporate debt on bank balance sheets is held by these firms, bank balance sheets might considerably suffer if the crisis would to continue next year. The good news is that according to IMF estimates, potential losses on corporate exposure in 2014-2015 can in the aggregate be covered by provisions and operating profits without eroding existing capital buffers. Nonetheless, the banking systems’ strength would decrease if the provisioning coverage appears to be too low (39% end of 2012). But additional provisioning would tighten credit conditions, which will further dampen growth.
Meanwhile, credit conditions might also tighten when the amount of ECB funds available falls (e.g. when current LTROs mature, end 2014-beginning 2015). At this moment, Italian banks appear to depend on the central bank’s funding. It is unclear, however, if this additional funding is necessary in order to provide loans, or if it is mainly used to make profit; by borrowing cheap and buying Italian government bonds with high returns. Especially if lack of affordable wholesale funding and deposits are the reason behind the large demand for ECB loans, non-financial corporations could see the cost of credit increase if the ECB support is reduced. The IMF estimates the funding gap to be 12% of total liabilities.
3. Bond yields have risen on the back of political turbulence
The formation of the broad coalition at the end of April 2013 resulted in a significant drop in bond yields. During the two months thereafter, they moved up substantially (10-year bond yields rose from 3.76 to 4.86) due to continued political turmoil. Yields did come down again, but they have been susceptible to political instability and turbulence during the entire period since the elections. The inability of the government to pursue policies that address Italy’s structural problems, ‘taper talks’ in the US and weak economic data have not helped either. On the back of the reduced risk of new elections in the short-term and the slightly less worse economic environment interest rates have started to fall since the beginning of October (to 4.13, 31st of October). The lower risk of an immediate coalition-break stems from surviving the confidence vote PM Enrico Letta had called for at the end of September; after Sylvio Berlusconi had ordered his PDL ministers to resign. In the end, even Berlusconi declared his support for the government as he saw no other option when confronted with a split within his own party. Next to calming the markets, this should reduce the negotiation power of Berlusconi, not to mention the credibility of future threats of pulling the plug on the coalition government. Thus, a possible Senate vote in favor of banning Berlusconi from public office (expected before the end of the year) no longer poses a severe threat to political stability.
We stress, though, that given the broad spectrum of ideals within the government, the continuation of the coalition neither implies political hurdles have vanished nor does it mean decisive policy action will be taken. Moreover, favorable election polls or renewed tensions between the coalition parties will still likely lead to a party ’heading for the exit’ in the course of next year. In the short to medium term, Italy’s deep-seated economic challenges are therefore not likely to be dealt with, which may possibly jeopardize debt sustainability and investors’ trust.
That said, the fact that negative spillover effects to the rest of the euro area can be substantial, makes it plausible the ECB and European leaders indeed want to do whatever it takes to prevent Italy from re-entering a debt crisis. This feeds investors’ confidence and thus supports debt sustainability. It is doubtful, however, that Europe is actually able to provide sufficient financial support to save Italy if necessary. A drop in investors’ confidence with soaring bond yields as a consequence therefore remains a significant downside risk to Italy’s public debt sustainability.
Italy is the third largest economy in the eurozone, but growth has been sluggish in the past decade (less than 0.5% on average). The main reason is that Italy has been losing competitiveness owing to extremely weak productivity growth. Italy’s growth potential seems to have stalled in 2013 and the IMF expects it to only rise to 0.5% in 2018. Therefore, it will be very difficult for the country to grow its way out of debt, which has reached uncomfortably high levels on the back of large primary deficits between the mid-sixties and the early nineties. Large primary surpluses during the last two decades have been insufficient to compensate for large debt dynamics. Note though that ageing does not automatically worsen public finances due to, amongst other things, a contribution-based pension system and a retirement age linked to life expectancy. Nevertheless, ageing is a problem for Italy, as it implies the labor force is bound to shrink which harms productivity growth.
When turning to the financial sector, it appears that prior to the crisis Italian banks have built up strong capital buffers owing to conservative banking regulation. Accordingly, the banking sector has been able to cope relatively well with the consequences of the harsh recession. The acceleration of corporate defaults in recent years do impair the banking sector’s strength, however. At the same time, banks have excessively increased the stock of government bonds on their balance sheets (9% of total assets). While the reduction of debt in hand of non-residents (35%) has lowered default incentives and rollover risks, it has also intensified the vicious feedback loop between the sovereign and domestic banks. This makes the latter, and therefore also short-term economic growth, extremely susceptible to deteriorating public finances.