The Daily Update - Italy

Media coverage of Brexit has somewhat eclipsed the Italian local elections results; these look to be yet another example of populist politics gaining ground in a push back against incumbent regimes and the European austerity mantra.  As we have said before, creating the euro currency union between creditors and debts without a European Treasury, unified fiscal policy and fully functioning redistribution mechanisms is problematic.  Under the current system, the adjustment process to reduce imbalances has taken the route of austerity which has hit the debtor nations hardest in terms of weak growth and deflationary pressures, exacerbated by the lack of debt write-offs. Greece, Portugal and Spain have already experienced a good deal of political upheaval and this week there were signs that Italy could be heading this way too.

Matteo Renzi, Italy’s Prime Minister, has been critical about Europe’s budget deficit rules stating “Europe has taken the wrong road, austerity alone is not enough.”  However, his words have clearly not been enough as far as the general public is concerned and the initial stages of the municipal elections have punished his party: in Rome the anti-austerity and anti-establishment Five Star Movement won 35.3 percent of the first round vote ahead of Renzi’s PD Party candidate, Roberto Giachetti, who secured 25 percent of the vote. While the local election process still has further to run, this is a setback.  Compounding this, Renzi has stated he will stand down if he loses the October referendum on constitutional reform and reducing the legislative power of the senate, an area he has targeted for reform.

Unquestionably, the Italian economy has been lacklustre: after three years of contraction, real GDP grew 0.8% in 2015 and is forecast to grow at only 1.1% in 2016.  In fact the IMF forecast that Italy would not return to its 2007 (pre-crisis) level of growth until the mid-2020s.  Italy is also battling deflation with HICP inflation at -0.3% yoy in May.  It faces challenges such as an ageing population and declining labour productivity and competitiveness; but these constraints to growth are compounded by its high debt levels and Europe’s austerity driven approach for countries in this position.  The EC forecasts the budget deficit of 2.4 percent in 2016 marginally down from 2.6 percent in 2015 and general government gross debt to GDP of 132.7 percent.

Italy also faces the challenge of needing to resolve the banking sector bad debt problem.  This has constrained credit growth and been a drag on growth.  Estimates put Italian non-performing loans (NPLs) at €360bn or ~18 percent of total loans and ~22% of GDP although ‘sofferenze’ or the severely delinquent bad loans are closer to €200bn.  Net of provisioning estimates put the figure closer to €85bn.

Some progress has been made in addressing the bad debt problem with the announcement of the formation of a multibillion-euro fund, Atlante, estimated at around €5bn in size, to help smaller lenders raise capital and offload bad loans.  That said the fund is financed in part by the larger banks.  In addition, there are proposed improvements to the bankruptcy law to speed up foreclosure.  Italy also reached an agreement with the EU earlier this year whereby Italian banks can securitise non-performing loans into special purpose vehicles to start to free up the banks’ balance sheets for new lending.  Banks can acquire a state guarantee but only for the senior tranches where the loans are to be investment grade.  Banks will have to recognise losses for the difference between the recognised value and the price bad debts are sold to the SPV with market pricing is expected to be lower than the recognised value.  Thus, this initiative will at best only see a portion of bad debts securitised.

A lot more reform and restructuring will be required before the Italian banking sector can be considered ‘healthy’ and the economy returns to a more robust growth trajectory.