ITALIAN DRAMA NO GREEK TRAGEDY

Italy is not Greece. In recent weeks, markets have overestimated contagion risks to Italy. Burlesquoni gone, the Commedia del Arte has, thankfully, come to an end.

“It is like celebrating the end of the war,” said Eduardo, a hotel receptionist. Asked if Italy was ready for sacrifices under a Monti government, he replied: “We deserve them. We elected Berlusconi not once or twice but three times. We have to get out of this mess.” (FT)

I spent nearly 3 weeks in Italy last September and what I saw from Firenze to Milan, to Verona and up to the Swiss border was nothing suggestive of a bankrupt country. Italy’s North is vibrant and industrious and much less inclined to welfare than the Southern part. The unemployment rate in the North is about 4.5% compared with 8.3% for Italy. Importantly, some 50% of the population lives in the North and that proportion is increasing as more Italians move towards the more prosperous regions.

Italians have grown very frustrated by the inefficient and ridicule Berlusconi government and even business people who initially supported him were openly calling for his departure in early September.

The highly respected Mario Monti will be leading a caretaker coalition government that will implement the reforms Italy needs to get back on a solid footing. Monti has been made a senator for life: he is thus prohibited from forming his own political party, a scenario that derailed another technocrat government in the mid- 1990s. Goldman Sachs recently wrote:

 

To be sure, the road remains uphill for Italy. The new Italian government will have to pass important and politically controversial economic reforms in the coming months under close scrutiny by the ‘troika’ and markets. Debt roll-over needs also run high (around EUR25bn in December and around EUR114bn in 1Q2012), and some help from either the EFSF or IMF backstop credit lines may be needed along the way.

But a strong and reputable government leadership should reduce policy implementation risks (thanks to what we have previously called an ‘initial contracting’ with political parties on the policy programme), allow greater discretion on the sequencing of the individual measures (in recent pronouncements, Monti has emphasised growth-enhancing measures, while Amato has declared himself in favour of a wealth tax) and hopefully mitigate social tensions.

In terms of the bond market, we would expect a reduction of spreads following the appointment of a technocrat government, and a more gradual (and volatile) decline in yields after the successful introduction of new measures over the coming months.

The austerity  measures voted by the Italian government amount to a cumulative €59.8bn, or 3.4% of GDP, consistent with the balance budget target for 2013. Measures adopted are comprehensive and rightly balanced between the need to cut spending and increase revenues and the need to restructure to provide a stronger growth platform. The UK Telegraph (my emphasis):

On the expenditure side, measures include cuts in central government expenditure, implementation of the public spending review, reform of the tax system and welfare by way of an Enabling Act. Consolidation targets of the Enabling Act are ensured by law through a safeguard clause which provides for automatic cuts in tax expenditures if forthcoming measures do not provide the expected savings (leading to €4bn cumulative savings in 2012, €16bn in 2013 and €20bn in 2014). Measures include a wage freeze in the public sector until 2014. Moreover, reductions in social security spending are achieved by means of a payment delay in severance pay for seniority pensions.

• Sustainability of Italy’s pension system is improved by strengthening eligibility requirements. (…)

• On the revenue side, there is an increase in the ordinary VAT tax rate from 20pc to 21pc. Taxation on financial assets is set to 20pc (with the exception of public debt instruments which remain taxed at 12.5pc). The increase in taxation on oil products, which has been introduced on a temporary basis, is now permanent. Further measures have been introduced to fight tax evasion, including limiting cash transactions to amounts below €2,500 and harsher penalties in case of payment of professional services without proper invoicing. In addition, higher revenues are expected from lottery and excise taxes. A special tax on the energy sector is introduced to lighten the burden of cuts to local governments in the first year and then contribute to the overall correction later on. A three percentage point tax surcharge is introduced for incomes above €300,000.

Significant reforms are introduced to enhance potential growth. The structure of central and local government and administration is considerably simplified and its costs reduced. A constitutional amendment is foreseen for the elimination of one layer of government, i.e. Provinces. Competition in local public services is strengthened by limiting the direct ownership of public utilities by local authorities and incentivising privatisation of publicly-owned companies. Other measures relate to the reduction of red tape for firms and the allowance of more flexible labour contracts, strengthening the company level bargaining. A mandate is given to the Government to reorganise the structure of judicial offices with the aim of cutting expenditure as well as increasing efficiency.

• Finally, the Government has already started the Constitutional process of introducing a balanced budget rule.

 

image_thumb4

 

Italy is not in a true PIIGS country. From Credit Suisse (my emphasis):

Italy has a budget deficit of only 4.1% of GDP and actually runs a primary budget surplus of 0.6% of GDP based on IMF data (the only European country to do so apart from Switzerland and Norway).

Total leverage in Italy (government and private) is below the Euro norm. This is because very high levels of government debt (121% of GDP) are offset by low private sector leverage (total private sector leverage is 125% of GDP, about half the level of Spain and Portugal – because unlike most of the periphery there was no housing or private sector credit boom in the last decade). Total non-financial leverage in the economy is 246% of GDP (compared to 260% in the Euro-area overall and 280% in the UK).

Net foreign liabilities are just 21% of GDP (this compares to a peripheral European norm of close to 100% of GDP). This is absolutely critical because it means that into a worse-case scenario, namely a disorderly break up of the Euro, Italy would not need to default. A 50% currency devaluation would still leave net foreign liabilities circa 40% of GDP, a manageable level in our view.

• Italian bank borrowing from the ECB is just 5% of GDP (for Greece it is 45% of GDP), while the loan to deposit ratio at around 100% is lower than elsewhere.

• The loss of competitiveness in Italy and low growth is an issue. But with a current account deficit of 3.9% of GDP, the loss of competitiveness appears to be smaller than Greece and Portugal (where the current account deficit is 9.6% and 8.9% of GDP).

• Italy’s sovereign debt has an average maturity of 7.2 years and about half of this is owned by domestic investors (both higher than elsewhere). This means that each 1% rise in bond yield after 1 year only adds 0.4% of GDP to funding costs, according to the Italian Minister of Finance.

Gavyn Davies agrees:

It is true that 2012 happens to be a bumper year for Italian debt redemptions, which means that the sovereign will have to roll over as much as €350bn of debt, potentially at much higher interest rates than previously assumed. Even so, the impact of crisis interest rates is likely to increase the annual debt burden by less than 1 per cent of GDP next year, compared to what would happen with “normal” interest rates.(…)

In effect, Italy is being asked to repeat what it achieved from 1995 onwards, when it managed several successive years with primary budget surpluses above 3 per cent of GDP. But that was at a time when the economy was growing at a decent clip, quite unlike what will happen next year. If such a large fiscal consolidation can be achieved in the teeth of a recession, it will be very impressive, to say the least.

In all, there is no need for the Italian economy to substantially deleverage, quite unlike the other PIIGS countries or even the US, for that matter. As the FT reports:

According to a 2009 Bank of Italy report, the net worth of Italian households is pushing €9,000bn. That is more than €350,000 per household, or four times total government debt. Mr Monti could also decide to sell holdings of listed companies and hurry through privatisations.

There is also considerable real estate available. Altogether, a Cheuvreux report reckons these assets are worth another €110bn, or 7 per cent of gross domestic product. The irony, therefore, is not only that the eurozone easily has the funds to save Italy, but so does Italy itself. The trick becomes one of reallocation.

Ambrose Evans-Pritchard, International Business Editor at the UK Telegraph adds

The Italian state is a Christmas tree of valuable assets, owning 4pc of the oil company ENI, 31pc of the utility ENEL, 33pc of the aerospace group Finmeccanica, 100pc of Poste Italiane.

Company sales could generate €45bn quite easily and Mr Monti is already a convinced privatiser. Whether he can convince the centre-left in parliament to back such sales is an open question.

State assets total €1.8 trillion, roughly the same as public debt of €1.9 trillion. There is vast private wealth, by some estimates near €8.6 trillion, making the Italians much richer per capita than Germans or Americans.

Also, Italy is not highly vulnerable to the spiraling effects of rising interest rates. The
sensitivity of Italy’s debt servicing costs to rising yields is quite gradual, given the relatively high average maturity of its debt – about seven years. Morgan Stanley calculates that on average, a 100bp rise in yields only raises debt servicing costs by 14bp in the first year.

Italy’s primary problem is very low growth but that’s been the case for two decades: GDP per capita is below 2000 levels and real GDP growth has been only 0.2% a year since then. Italy needs to restore competitiveness through wage deflation and structural labor and pension reforms.

The country has lost 40pc in labour competitiveness against Germany over the last 15 years, leaving it locked inside EMU with an overvalued currency.

Italy has been losing global export share relentlessly as China chips away at its mid-tier manufacturing.

The Economist explains:

The deeper causes of weak productivity are a two-tier jobs market, which protects the jobs of older workers in dying industries but traps youngsters in temporary work; the industry-wide wage bargains that mean businesses cannot match wages to productivity; the closed-shop professions and trades that are a barrier to innovation and efficiency; and so on.

Italy still has some world-class firms and brands, and an exporting prowess that could be built on. Yet it does not have enough firms of sufficient scale. The ubiquity of micro family businesses is related to Italy’s rigid regulations, as are its tax-collecting problems. Small firms fall below the regulatory thresholds and are less often attached to the formal economy. If Italy is to carry its outsize public debts, it urgently needs to promote an environment where big businesses can flourish.

And the WSJ today runs a lengthy article which goes to the heart of Italy’s lack of growth and poor productivity.

Many factors have contributed to the country’s stagnation—from its rickety education system to its low rates of employment among women, youths and older workers. But a central reason, say economists, is that its private sector consists mostly of small mom-and-pop businesses that seem unable to grow.

Unions, meanwhile, are opposed to government proposals to loosen Italy’s labor laws. They have vowed to paralyze the country with strikes if the government attempts to pass such measures.

Behind the country’s stunted businesses lie the habits and fears of a long line of family entrepreneurs who cling to control of their companies late into life. Hemmed in by a thicket of regulation and legal restrictions, many of these families have learned to survive by doing business within networks of trusted customers and suppliers, rather than taking risks by dealing with outsiders.

image

The Monti-led coalition certainly has his work cut out but the plan is sensible. As long as politicians and union leaders realize that action is required, now.

A daunting task, to say the least.

“We believe Italy is beyond the point of no return and will be forced into a managed debt restructuring as early as 2012,” Roubini Global Economic commented in a doom-laden report headed “Italy: Too Little, Too Late.”

Mr. Doom has often been a coincident indicator with superficial analysis to back his sensational “views”.

Not to say that investors should relax about Europe. Spain and Portugal remain problematic and France looks shakier by the day.

But, gloom and doom might have reached a climax. Italian equities trade at a 13% discount to Spanish stocks, compared to an average premium of 30%. This is the highest discount in 20 years.

image

 

Leave a Reply

Your email address will not be published. Required fields are marked *