Italian debt sustainability: the impossible dream

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There is no magic formula that would cut Italian debt without triggering a civil uprising or worse: further boost popular support for sovereign default. A combination of measures – privatization, tax reform and cleaning up the corrupt state leviathan – is needed. But few are holding their breath.

It’s déjà vu at the Italian Treasury, which – despite perceptions to the contrary – worked surprisingly hard to cut its debt-to-GDP ratio from 120% to close to 100% before the advent of the global crisis. “It must be like Sisyphus rolling that boulder uphill yet again,” says Vanessa Rossi, a consultant and economics adviser to Oxford Analytica. Now the country must start again, but, she adds: “It’s just a long, slow grind – a corrosive process for the body politic and the country.” In fact, there is an economically simple, if politically unfeasible, solution to Italy’s unsustainable debt position at 127% of GDP: privatization, with Italy, according to some estimates, having the highest level of state ownership in the eurozone. Italy could, therefore, embark on lucrative divestments of  government stakes in companies, such as ENI, the multinational oil and gas company, of which the Italian government owns a third, the national post service, Finmeccanica, a high-tech industrial group, and Enel, the electric utility company. Yet politicians, many of whom are notoriously close to the state-backed businesses, have refrained from the privatization push, in part, thanks to the famous financial and personal ties among the corporate and political class in Italy. To gain traction, therefore, privatization should be pursued in conjunction with “an aggressive full house-cleaning reform of the bloated and crony bureaucracy at every level of government, which impairs growth, productivity and competition,” argues, rather ambitiously, Steven Solmonson, of Connecticut-based hedge fund Spectrum Asset Management. Exactly how much money could be raised via privatizations is debatable, especially in an environment of depressed asset prices. It is unlikely this would resolve Italy’s problems on its own. Worst still, the popular will to service current debts is low. “Argentinean default has considerable appeal amongst voters,” says Rossi. “Many in Italy – as in Greece – see Argentina as successful, so we must beware.” In truth, the only realistic course is a softening – rather than a repeal – of former technocrat PM Mario Monti’s policies, to mollify voters and prevent civil uprisings while pressing on with structural and tax reform. It is unlikely this will get Italy to a 90% debt-to-GDP ratio, but achieving a 100% to 110% ratio would probably be enough to satisfy Berlin, says Rossi. “Backed up by whatever look like the best privatization options, Monti-lite may just do the trick,” she says. A wealth tax, levelled on property or on all savings, could raise a lot of money quickly, though such a policy amounts to political suicide, a risk the botched Cyprus bailout lays bare. It would be simpler to improve tax collection within the existing framework, says Frank Jensen, chief investment officer at hedge fund Origo, by removing tax loopholes and evasion. Yet a tax-based solution, which would require an expansion of the middle-class tax base, is only made harder by austerity measures that undermine the very industries and institutions that would allow this to happen. What would make this more politically feasible in Italy would be tackling the tax issue at the European, not the national, level, says Solmonson, with the implementation of a eurozone-wide income tax regime, though prospects for such are low. At its heart then, the cornerstone of the centrist strategy is to encourage growth by increasing competitiveness, another slow and painful process. The easiest route is via wage compression, says Darren Williams, European economist at AllianceBernstein. However, in the short-term, this would have the opposite impact on debt sustainability by reducing the spending power of Italians and potentially forcing many to take on new debts. Over time, theoretically, Italy’s enhanced appeal to employers would create jobs and drive economic growth, ultimately reducing the debt burden. The question is whether Italians could wait for the rewards. “It is like an elastic band – you can only pull it so far but at some point it will snap,” says Williams. “You can make the Italian economy more competitive but in the meantime you are increasing the likelihood of social unrest and a backlash.” As well as reforming banking, regulation and privatization, the government should also reduce its role in the pension system, taking its waste, inefficiency and cronyism with it, to boost the country’s trend growth rate. “Various government departments seem very lapse in paying their bills; drug companies often talk about payment terms that can last up to a year,” says Andrea Williams, manager of the Royal London European Equity Income Fund. “These long payment terms do not help the economy to function.” However, tackling the state leviathan will only pay dividends in the long term, and even then the relationship between structural reform and growth is unclear, says Williams. Even in the case of the German “economic miracle”, it is unclear whether the credit belongs to Gerhard Schröder’s structural reforms, or whether it was simply a result of aggressively cutting wages. Reducing the debt-GDP ratio will be a balancing act between progress on these reforms, without pushing Italians to reject the process and force a default. Yet it is worth stressing that some question whether Italy should be required to pursue this path at all. “Italy has been running a [primary budget] deficit around the current level for many years,” says Origo’s Jensen.

This debt has been sustainable because around 80% of it is domestically financed, via the country’s huge pool of domestic savings, with the country's net financial assets worth some €2.8 trillion by end-2011, excluding pensions. Ultimately, this financing cushion has contributed to reform inertia, but the debt-clock is ticking as the population ages.

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