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Perhaps It’s Time to Start Worrying About Italy Again

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Perhaps It’s Time to Start Worrying About Italy Again

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The causes for concern surrounding Italy are growing, even as the ECB keeps a tight lid on its bond yields, pushing its debt servicing costs lower as its debt explodes higher.

The Euro Area’s weakest link, Italy, is once again in the familiar grip of a political crisis. The trigger this time was a decision by former Prime Minister Matteo Renzi to orchestrate the resignations of two ministers from his fledgling IItalia Viva party. Renzi accuses the current premier Giuseppe Conte of amassing too much power during the coronavirus crisis. He also challenges Conte’s reluctance to draw upon European Recovery and Resilience funds and the European Supervisory Mechanism, which Conte fears could come with all sorts of nasty strings attached.

What happens next will depend on whether Conte can shore up support in parliament among independent lawmakers. He still has the backing of the Democratic Party and the 5-Star Movement, which have criticised Renzi’s move as irresponsible. On Monday, Conte made his case in the lower house and will have to do the same in the Senate on Tuesday. Each appearance must be followed by a voice vote, which is tantamount to a vote of confidence. On Monday, Conte won the vote after Italia Viva’s members chose to abstain but he’s likely to face a stiffer challenge in the Senate.

In the best case scenario, this crisis — like so many political crises in Italy — will fizzle out. Conte may well survive to lead what would be his third government by amassing enough support in both houses. But his already flimsy government will be further weakened. If he fails to form a new government, he will probably submit his resignation to Italian President Sergio Mattarella, who could call for the formation of a technical government.

An early election is the least likely outcome, given the logistic nightmare of holding a political campaign and election during the pandemic. The coalition partners are also fearful that a resurgent right could end up winning. 

Much Ado About Nothing? Not Quite

For the moment the financial markets are pretty sanguine about this latest episode of Italian high drama. The yields on Italian bonds are still close to an all-time low, at 0.63%. The main reason for this is that the ECB is buying even more Italian bonds than ever before. Through its public sector purchase program (PSPP) and pandemic emergency purchase program (PEPP) it purchased €165 billion of Italian bonds in the first eleven months of 2020, bringing its total holdings to €529 billion. 

Italian banks have also expanded their holdings of Italian sovereign debt, which now account for 11% of their total assets, a new record. This has stoked fears that the dreaded “doom loop” — the dangerous relationship of mutual independence between Euro Area sovereigns and their banks — is stronger than ever.

But even as the ECB and Italian lenders keep a tight lid on Italy’s bond yields, pushing the country’s debt servicing costs lower while its debt explodes higher, there are still major causes for concern. 

The pandemic has disproportionately affected Southern eurozone countries that were already weighed down with huge debt loads. Italy has the third highest incidence of coronavirus (COVID-19) deaths in the European Economic Area, after Belgium and Slovenia. The pandemic has also laid waste to its economy. The ECB forecasts that Italy’s GDP will have declined by 9.0% in 2020. Plunging output and soaring spending are expected to push its debt as a percentage of GDP up to 158%, from 135% in 2019.

“Credit risks are highest in Italy, Cyprus, Spain and Portugal given their high economic exposure to the crisis, together with their more limited fiscal space,” Moody’s warns in its 2021 outlook for the region. “High debt levels, together with stop-start growth, intensify the risk and potential impact of another shock, particularly if investor confidence in sovereigns that need to refinance very large amounts of debt weakens.”

Loss of Tourism

The virus crisis has devastated Europe’s tourism industry, a vital source of income for southern eurozone economies. In Italy it accounted for 13% of GDP and was one of the few areas of the economy that had been growing in recent years.  In 2019, for instance, it grew by 2.8% while Italy’s industrial output shrank by 2.4%. But in 2020 it collapsed. In October, for instance, foreign visitors spent just €1.193 billion in the country, down 70.4% with respect to the same month in 2019, according to a new report by the Bank of Italy. 

“The sudden, drastic contraction in tourism flows in Italy will have a significant impact on national GDP and serious consequences for businesses in the sector and their suppliers,” the report said

Last Thursday, the Bank of Italy said that the COVID-19 pandemic had led to “the biggest contraction in non-financial private incomes in 20 years in the first half of 2020.” Per-capita primary incomes dropped by 8.8% in the first half of 2020 with respect to the same period in 2019. That dwarfs the income drops registered during the credit crunch (-5.2%) and the sovereign debt crisis (-3.4%).

Back in July, the central bank published the findings of a survey of Italian households on the impact of the lockdown. Given the timing of the survey, shortly after a three-month nationwide lockdown, most of the findings were pretty bleak:

  • More than half of the respondents said they had suffered a contraction of household income following the measures adopted to contain the epidemic.
  • Fifteen percent of households had lost more than half their income.
  • Some 40% of families were struggling to keep up with their mortgage payments.
  • More than half of the survey’s respondents said that even when the epidemic is over, they expect to spend less on travel, holidays, restaurants, cinema and theaters than they did before the crisis.

The Euro Zone’s Ultimate Loser

This is all happening in a country whose economy has not grown since it adopted the euro at the turn of this century. In that time its debt-to-GDP ratio has exploded from just over 100% to almost 160%. A study published in early 2019 by the Centre for European Policy think tank, titled 20 Years of the Euro: Winners and Losers: An Empirical Study, found that out of eight Euro Area economies examined (Germany, France, Italy, Spain, the Netherlands, Belgium, Portugal and Greece) only two — Germany and the Netherlands — actually benefited from the introduction of the euro. Italy lost out most:

Without the euro, Italian GDP would have been higher by €530 billion, which corresponds to € 8,756 per capita. In France, too, the euro has led to significant losses of prosperity of € 374 billion overall, which corresponds to € 5,570 per capita.

As Bill Mitchell points out in a recent blog post, the situation will have almost certainly worsened over the three years after the cut-off point of the dataset used (2017). 

One of the main reasons Italy’s economy is in such dire straits is its strict adherence to the EMU’s macroeconomic rule book — in particular the rules on fiscal austerity and structural reforms — as Dutch economist Servaas Storm painstakingly details in his article “Italy: How to Ruin a Country in Three Decades”, which was featured on Naked Capitalism in April 2019:

Italy kept closer to the rules than France and Germany and paid heavily for this: The permanent fiscal consolidation, the persistent wage restraint and the overvalued exchange rate killed Italian aggregate demand—and the demand shortage asphyxiated the growth of output, productivity, jobs and incomes. Italy’s stasis is an object lesson for all Eurozone economies, but—paraphrasing G.B. Shaw—as a warning, not as an example.

There are, of course, many other homegrown reasons for the country’s economic stagnation. Corruption is rife, as is organized crime. Together with establishment inertia, a widespread predilection among the country’s business financial elite for property speculation and good old-fashioned nepotism, they ensure that much of the money that comes into the country is badly invested.

The Banks are Still a Problem

Then, of course, there are the banks. Monte dei Paschi di Siena (MPS), Italy’s fourth largest lender and the world’s oldest, was bailed out in 2017. Now, the government is hastily looking for a buyer so that MPS can be reprivatised before a European Commission deadline expires. The problem is that the bank is still chockablock full of non-performing loans (NPL). Its NPL ratio is currently around 12%. It also has a €2.5 billion capital shortfall. Craziest of all, according to MPS’ own strategic plan it is still “evaluating” the impact of the single most important new piece of banking regulation out there, the calendar provisioning rules.

This new legislation, together with new rules on default, forces banks to class a borrower as in default after an even partial payment delay of more than 90 days. Banks must also write down impaired loans in full over a set number of years. Such rules are already in place for lenders that use an advanced internal model to assess client risks. Banks using standard models had to begin complying from 2021. 

The idea behind the legislation is to force banks to begin moving impaired loans off their balance sheets before they become a major problem. But the timing of the legislation could not have been worse, coming in the midst of the deepest economic crisis in decades. Millions of businesses have had to take on huge amounts of new debt just to stay alive. As lockdowns continue to paralyse entire sectors of the economy, many will struggle to pay it back.

Most European countries have put debt moratoriums in place but once they end there is likely to be a sharp spike in defaults. The impact is likely to be particularly bad in countries such as Italy where debt recovery is notoriously slow and NPLs have been allowed to fester on banks’ balance sheets. Italian business lobbies have warned the EU that the new legislation could trigger a “huge surge” in borrowers being classified as in default. The fact that MPS is still evaluating the impact of the legislation two weeks after its implementation would certainly suggest that it is not remotely ready for it.  

The only Italian lender that is big enough to absorb MPS and apparently crazy enough to actually want to is Unicredit. But in return it will try to extract as high a price as possible, including — according to Reuters — getting the government to take on €14 billion of its own impaired loans as well as some of MPS’ high-risk loans. To make the deal even more palatable, the government is considering shielding any future owner of MPS from around €10 billion in legal claims.

Time is of the utmost essence: after warning its capital reserves would breach minimum thresholds in the first quarter, MPS must tell the ECB by the end of January how it plans to address the shortfall. MPS’ apparent delayed reaction to the EU’s most important new banking regulation does not exactly inspire confidence that its decades of mismanagement are behind it. Perhaps it’s no surprise that some very important Unicredit shareholders are mobilising forces to try to block the deal.

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