Country Report Italy
Italy’s recession has come to an end, but the crisis continues. Though, household financial wealth has remained high and the political situation seems to have improved a bit; yet words still have to be turned into action. Besides, weak institutions and large public debt remain a major issue.
Strengths (+) and weaknesses (-)
(+) Low household debt and high savings
Households are substantially less indebted than their peers, while financial assets are larger than the eurozone average. The amount of net financial assets ranks third of all eurozone countries. Furthermore, financial assets tend to be of the less risky type such as deposits and bonds.
(+) Access to European financial support measures
The ECBs promise to do “whatever it takes” (2012) 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
Large primary deficits between the mid-sixties and early nineties, in combination with weak politics and the inability to take decisive action to deal with Italy’s deep seated economic challenges, have resulted in negative debt dynamics (high yields and low growth) and a very persistent debt problem.
(-) 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 labour market, relatively low education, a high tax burden, inefficient public spending, a sizeable unofficial economy, and corruption.
1. Recession came to an end, but the crisis did not
Italy’s longest post-war recession finally came to an end in the last quarter of 2013 (figure 1). After nine consecutive months of decline, GDP volume rose with 0.1%. That said, in 2013 GDP volume shrank by 1.9% (compared to a fall of 2.4% in 2012), 45% of businesses with more than 20 employees reported a profit loss and house prices dropped for the sixth consecutive year (with 6% compared to 6.4% in 2012, figure 2). In the final quarter of 2013 however, house prices stabilised. Finally, the unemployment rate reached a record-high of 13% in February 2014. Going forward, the recovery is believed to slowly continue, but in 2014 and 2015 economic growth is expected to stay below 1% and the unemployment to stick at around 13%. As such, payment difficulties of the private sector will likely keep increasing.
2. Banks strengthen balance sheets as debtor risks increase
Even though figures differ substantially among different sources, they all show that the non-performing loan ratio has trended further upwards in the past months. According to World Bank data, the non-performing loan ratio stood at 15.1% end 2013, compared to 13.7% end 2012. The stock of non-performing loans accounts for about 10% of GDP. Moreover, the Bank of Italy reported a bad debt ratio of 9.1% end 2013, up from 7.8% in June 2013. More specifically, in January 2014, the bad debt ratio of non-financial corporations reached 13.4%, up from 9.7% a year before. While the proportion of financially vulnerable households is very small (3%), non-financial corporations are highly leveraged and around 30% can be classified as vulnerable. Especially to an increase in interest rates in line with that observed in the period 2011-2012 and even more to a scenario in which corporate income were to decrease in line with the fall observed in the period 2011-2012 at the same time. To be better able to cope with the risks of defaulting debtors, Italian banks continue to strengthen their capital base (the average core tier 1 ratio is 10.4%, ranging from 8.1% to 13.8%) and provisioning, while coverage ratios (measured by the ratio of loan loss provisions to non-performing loans) have held stable lately. In addition, the funding gap has narrowed to historically low levels and according to the IMF, banks' operating profits should be sufficient to cover potentially large loan losses on exposure to non-financial corporations this year.
3. A new reform minded and ambitious Prime Minister
In February, PM Enrico Letta was asked to resign by his own Partito Democratico (PD). Matteo Renzi, the new party leader of the PD since December, took his place. As a reaction to Renzi taking over and the recently presented budget 2014, but also as a result of recent capital outflows from Emerging Markets and maybe the improved economic outlook, the 10-year government bond yield fell further; at the 22th of April it reached a record-low (3.09). Renzi is widely hailed for being very reform minded and young and currently has the highest approval rating of all Italian politicians (57%, 28 of March). We agree that his proposals in essence have the potential to improve Italy’s long-term growth perspective and debt sustainability. However, we stress that several details are still lacking and that the reform progress is very likely to be slowed by a fragmented coalition; although it seems Renzi will enjoy some material support from Berlusconi (his Forza Italia moved into the opposition in February). Anyhow, so far, agreement has been reached on some measures that could boost short-term economic growth, but not yet on necessary reforms. Moreover, Italy’s budget for 2014 leads to a further rise in the already extremely large debt-to-GDP ratio (133% in 2013). As an aside, there seems to be some progress in Renzi’s effort to reform the electoral law and to constrain the power of the Senate, which have the potential to substantially improve the functioning of Italian politics. Though, it will take at least the rest of the year for them to be possibly introduced and it is still probable that the current set up will be diluted before implemented.
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 in combination with rising wages; partly due to the very large share of total value added produced by SMEs (over 70%), and more specifically microenterprises (33%). 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. 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 could be a problem for Italy, as it implies that the labour force is bound to shrink. As opposed to public balance sheets, Italy’s financial sector now benefits from the strong discipline in the past decades. Prior to the crisis Italian banks have built up strong capital buffers owing to conservative banking regulation. Furthermore, the depositors base is strong and dependence on wholesale funding relatively low. Accordingly, the banking sector has been able to cope relatively well with the consequences of the harsh recession. At the same time, banks have excessively increased the stock of government bonds on their balance sheets (about 10% of total assets). And while the reduction of debt in hand of non-residents (34%) 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. As an aside, also firms would suffer as higher sovereign yields rapidly feed through in firm lending rates.
 Please note that a continuation of these lower yields cannot be taken for granted as it also depends on liquidity in global financial markets.