Italy: Banking sector weakness hampers economic recovery
- Economic growth turned positive in 2015, but is expected to remain subdued
- The weak banking is unable to support the recovery and poses risks to financial stability
- Some major reforms achieved over the past years still have to prove their effectiveness
- Moreover, lots of work remains to be done, but progress is likely to slow
Strengths (+) and weaknesses (-)
(+) Low household debt and high savings
Italian households are substantially less indebted than their peers and their net financial assets are largest of all eurozone countries. We note that junior bonds of (mostly) regional banks make up for a rather large share of total financial assets, which renders households vulnerable to ailing banks.
(+) Access to European financial support measures
The ECB’s promise to do “whatever it takes” (2012), the existence of the Outright Monetary Transactions framework and quantitative easing by the ECB help to 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 political instability and the apparent inability to improve Italy’s growth potential, have resulted in negative debt dynamics (high yields and low growth) and a very persistent public debt problem.
(-) Relatively weak institutions
Productivity growth and competitiveness are constrained by regulatory rigidities, a lengthy judicial system, rigid product markets, an inefficient labour market, a relatively low level of education, a high tax burden, inefficient public spending, a sizeable unofficial economy, and corruption.
1. Economy slowly recovers
In 2015, economic growth turned positive (0.6%) after three years of contraction. However, Italy keeps on lagging the recovery of most other crisis countries (figure 1). In February 2016, unemployment stood at 11.7%, down from its all-time high of 13.1% in November 2014. Looking forward, economic growth is expected to remain subdued in 2016 (around ¾%-1%), while unemployment will decrease slightly towards 11%, remaining well above pre-crisis rates (6.1% in 2007).
2. Weak banking sector fells prey to financial market stress
Early 2016, financial market stress related to Italy’s banking sector intensified. At its recent low (7 April), the FTSE All share banks index was valued 40% less than at the start of the year. The index recovered some since (figure 2), but still trades at only a bit more than half of book value. The stress results from a combination of (i) extremely weak asset quality; (ii) low profitability, due to the low interest rate environment, large loan loss provisions, and high (cost) inefficiencies at the countries multiple small banks; (iii) the new resolution mechanism for ailing banks. Since 1 January 2016, (junior) bond holders need to absorb losses before public money can be injected. In February 2016, total impaired loans (NPLs) stood at EUR 196bn (13.7% of total loan book and 11.9% of GDP); slightly below their record high in January. Total non-performing assets (impaired loans plus loans unlikely to be paid and loans past-due by more than ninety days) amount to about a striking EUR 350bn. The bad debt ratio of households stood at 8.7% and that of non-financial corporations at 17.6%. According to Moody’s, market value of NPLs is only around 20%, while average coverage ratios are 56%. This implies a gap between book and market of EUR 47bn, or 2.9% of GDP. According to Moody’s, (important) banks would still comply with eurozone supervisory rules regarding capital ratios if they incur such losses. That said, in this scenario non-performing assets other than bad debt, amounting to EUR 150bn, are not taken into consideration, while it is unlikely that these can be completely recovered. The stock of non-performing loans will expectedly remain very large in 2016. Together with weak profitability this will restrain credit growth and the economic recovery going forward. Moreover, risks to financial stability remain present.
3. Renzi’s attempted overhaul of Italy’s economy
In the past year, reform progress has continued. Most important progress is related to the banking sector and the central government. Also the backlog of pending legislation still to be implemented has been significantly reduced. But, reform progress is slowing, while more action is needed to lift the economy out of the doldrums and raise growth potential (Kalf and Wijffelaars, 2016 [Dutch]). Most important banking sector reforms: (i) The introduction of a government guarantee scheme to help Italian banks to sell NPLs. (ii) The government has arranged the set-up of the privately funded fondo Atlante, to deal with the possible lack of buyers for the weakest NPLs, but also to ensure funding for the recapitalisation of Italy’s weakest banks. Supposedly the fund can initially count on EUR 4 to 6bn. (iii) Changes to the insolvency law to induce banks to wright off bad loans faster and to create demand for NPLs. (iv) Reform of the small Popolari banks to stimulate consolidation of the sector, to improve efficiency. So far only two banks merged, but this first merger might set a precedent. While the intentions are right, it is too soon to tell whether these measures will help the banking sector to revive (Wijffelaars, 2016). Constitutional overhaul: On 11 April2016, Parliament gave its final approval to curb the powers of the Senate. As it concerns a constitutional reform, the bill also needs to pass a referendum in October. We believe the reform will pass, which is a large step forward in our view. The overhaul likely increases political stability and improves governability of the country.
4. Public debt remains high
In 2015, the public debt-to-GDP ratio marginally increased to 133%, despite lower interest payments on outstanding debt owing to the current low interest rate environment. The debt ratio is expected to broadly stabilise in 2016. In the current low interest rate environment, markets are unlikely to question the sustainability of Italian public debt. Neither the significant Grexit risks over 2015H1, nor the large falls in domestic banking shares early 2016, led to insurmountable increases in Italy’s sovereign bond yields (figure 2). Yet, stagnating growth, lack of inflationary pressure and a return of financial market stress pose risks to the debt-to-GDP outlook and the sustainability of public debt. The long-term debt structure does lower vulnerability to heightened stress, though.
Italy is the third-largest economy in the eurozone, but economic growth has been less than 0.5% on average in the past decade. 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 SMEs (over 70% of total value added), and more specifically microenterprises (33%). The IMF estimates current potential growth at around 0.3%. Accordingly, it will be very difficult for the country to grow its way out of debt, which has reached uncomfortably high levels. Large primary surpluses in the past two decades have been insufficient to compensate for large debt dynamics. Looking forward, it is important to note that ageing does not automatically worsen public finances, due to a contribution-based pension system and a retirement age linked to life expectancy. That said, problems might arise, due to expectedly increasing old-age poverty. In contrast to public balance sheets, banks were better prepared for the crisis, due to the built up of strong capital buffers. Combined with a strong depositors base and relatively low dependence on wholesale funding this prevented a banking sector crisis like that seen in other crisis-hit countries. Nevertheless, the long lasting recession has seriously impaired asset quality. Consequently, banks needed to significantly increase provisioning during the crisis years. Together with the fact that Italy hosts many small and local banks this has been partly the reason for weak profitability and functioning of the Italian banking sector in recent years. At the same time, banks have excessively increased the stock of government bonds on their balance sheets (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.