In October, two rating agencies struck down Italy’s credit ratings: Fitch lowered the republic’s long-term debt rating to AA–; Standard & Poor’s now has it at a lowly A+.
Cue bond traders selling billions of BTPs? No – the market hardly blinked. Fitch’s move, which was widely expected, was based on its concerns that the government would not be able to reduce debt levels in the coming years commensurate with maintaining a double-A rating.
Prime minister Romano Prodi’s government is making some attempt to raise revenues, but the rating agencies are most concerned about levels of spending. Ever since 2005, when Italy’s debt-to-GDP ratio increased for the first time in 10 years, the republic’s politicians have been on borrowed time. A failure to address the structural deficit aggressively enough in the latest budget proposals provided Fitch and S&P with ample ammunition to strike.
Contrast this with the judgment over at Moody’s Investors Service, where there appear to be few signs of anxiety. Italy remains unchanged at Aa2, with the agency seemingly not expecting the deficit or debt ratios to deteriorate in the next few years.
But plenty of economists believe that the current concerns only scratch the surface of the problem; that Italy is in deep, long-term trouble because of a catastrophic fall in productivity, a rapid rise in unit labour costs relative to the EU average and the failure of its politicians and ultimately its people to react to the environment of a single currency.
Many of Italy’s problems are of its own making, but Germany and France also have a lot to answer for. Italy didn’t meet the criteria for Economic and Monetary Union, which was hardly surprising because they were devised in Maastricht to keep the country out. At least the country’s politicians – in a Herculean effort – had got inflation and budget deficits under control.
Continuing discipline was supposed to be provided by the Stability and Growth Pact, but that soon proved to be barely worth the paper it was written on. German and French politicians fudged the pact when they realized they too would be caught out by its strictures.
Monetary union removes a powerful but dangerous tool from the hands of politicians: devaluation. Without it, when an economy’s competitiveness falls behind its main trading partners there is only one tool left – real wage reductions. And very few countries can handle such a painful method of external adjustment.
They’ve managed it in Germany, where unit labour costs have grown just 0.2% compared with 20% in Italy during the eight years since EMU. Productivity in Italy has actually fallen by nearly 1% in the same period – remarkable, but for all the wrong reasons.
Poor Italian productivity has many causes, not least over-regulation and a stuffy service sector. Only now is the financial sector becoming fully liberalized – the cold wind of international competition could be the catalyst Italy needs to address its longer-term issues before it is too late.
So far, the bond market is failing to punish or even recognize the degree of divergence in euroland. But if another rating agency, most likely Fitch, cuts Italy to single-A then, under Basle II regulations, the cost of holding Italian debt will rise because its risk weighting will leap from zero to 20%. This would cause a sudden rise in spreads on Italian bonds and hit their owners – the largest constituent of which remains Italian banks.
The bad news doesn’t end there. Italy’s debt pile is only manageable because of low interest rates. What would happen if the European Central Bank started to hike rates? Export growth might stagnate further and unemployment levels rise. Italy’s already euro-disaffected populace might grow to hate the currency even more and call on their politicians to withdraw. Other euro states might get fed up with their problem child, and quietly encourage Italy to leave.
That, of course, it some way down the line. But with last month’s news, one cannot help feeling that a crucial tipping point has been reached.
