Italy’s debt problem still a huge risk


Jeremy Weltman
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The elections will deliver a new government, but the old challenges remain.


Italy was one of Europe’s strong performers in Euromoney’s country risk survey last year, with its risk score gaining 1.1 points – to reach a total of 56.0 out of 100 – in response to the economy reviving and a calming of political risk.

With its 10-year sovereign yield now settling at 2.06%, the narrowing of spreads to equivalent Bunds reflects confidence in the financial markets that Italy is not on the precipice of another crisis, and will see a coalition government eventually formed, even if the elections on March 4 deliver a hung parliament.

Among the big players, the populist and euro-sceptic Five Star Movement (M5S) is leading in the opinion polls on 27% to 28%, ahead of the centre-left Democratic Party (PD) on 22% to 23%. Forza Italia, led by the irrepressible media mogul and former prime minister Silvio Berlusconi is third on 15% to 16%, with the secessionist Northern League fourth on 13% to 14%.

However, the new electoral law makes it difficult for a single party to gain a majority, and M5S has ruled out forming a coalition.

If that remains the case, the prospect of a strongly euro-sceptic party taking power and staging a referendum to take Italy out of Europe is an extreme tail-risk with a very low probability.

M5S in any event now has a more pragmatic leader than Beppe Grillo.

Luigi di Maio might even agree to a coalition with the PD led once more by former prime minister Matteo Renzi.

“Di Maio does not plan to leave the eurozone, so there is no fundamental risk with this possibility,” says European sovereign risk expert and Euromoney survey contributor Norbert Gaillard.

A left-leaning coalition would probably lead to less fiscal austerity, ie a more redistributive policy as in Portugal, without upsetting the markets as the economy strengthens.

Gaillard is less pessimistic than six months ago, “but the political climate is really noisy and will remain so”, he says.

The possibility of an upset should not be overlooked, with endless bickering, and no agreement to form a government, possibly resulting in fresh elections.

Plus, either a left- or right-leaning government might prove unstable, as highlighted by the low survey score for government stability, which along with corruption accentuates Italy’s political risks in comparison with more stable polities in Europe.

In either case, relations with Europe could worsen as new measures are sought to find a more effective and equitable solution to the debt problems the next government will inherit.

And it is not just M5S calling for an urgent restructuring of Italy’s debts; there are others across the spectrum sympathetic to a quick-fix to ease the fiscal burden and the interest payments associated with a gross debt burden now totalling more than €2.3 trillion, or 134% of GDP, weighing on the entire eurozone.

Economic uncertainty

Denied the advantages of competitive devaluation, or fiscal stimulus, Italy’s economic record within the eurozone is a never-ending tale of disappointment in comparison with the period before it joined.

An unemployment rate of 10.8% at the end of last year was the fourth highest in Europe. It is a huge cost to the Treasury, and a source of regional social tensions, especially since almost a third of the workforce under the age of 25 cannot find employment.

Ranking 51st in Euromoney’s global risk rankings, 10 places below Spain, Italy has fallen sharply since the sovereign debt crisis in 2010, highlighting its underlying political problems and banking-sector risks.

Of the five economic factors in the survey, only currency stability ranks highly, with GDP growth, unemployment, government finances and bank stability still marked down heavily despite minor improvements.

GDP growth of 0.4% quarter on quarter (1.7% year on year) in the fourth quarter of 2017 is certainly welcome, underpinned by global trade and domestic demand.

However, Italy’s debt mountain is unsustainable, and is vulnerable to the economy slowing again, as the European Central Bank gradually tightens monetary policy and global trade slows.

The European Commission’s latest forecasts point to GDP growth sliding to 1.2% in 2019 from 1.5% in 2018, with manufacturing exports at risk from a stronger euro.

Worse, the EU’s plans to differentiate the risk of sovereign bonds of different countries held by banks is encouraging a sell-off.

“These bad loans are sold downstream to specialist investors, which means that while debt problems may be easing for the largest Italian banks, the economic cost of non-performing loans will continue to weigh on Italian companies and households,” warns European expert and survey contributor Constantin Gurdgiev, a professor at the Middlebury Institute of International Studies.

“The depth of the problem is highlighted by the fact that large, systemically important banks like Intesa Sanpaolo are looking at a four- to five-year horizon for dealing with bad loans, stretching the legacy of the global financial crisis out as far as 2022-2023.”

The smaller banks are lagging, too, and with one-off write downs and asset sales lowering loss provisions for bad debt, the financial system is vulnerable – a position that is at odds with the Italian central bank’s comforting proclamation the risks are diminishing.

Gurdgiev quotes data from the NYU Stern School of Business V-Lab showing a 10% fall in equities, assuming 7% capital threshold, would trigger a €19.3 billion capital shortfall in Assicurazioni Generali, the largest financial institution, and €14.6 billion in UniCredit.

Plus, the top-10 institutions would have a capital shortfall of €76 billion, compared with €23 billion in Spain.

More work is required to clean up the mess, and build on the progress achieved in 2017. The questions are whether the authorities will do it effectively, and in time, before another macroeconomic shock occurs.