How is the Italian economy performing?
The Italian economy is decelerating. Our leading macro indicator, credit impulse, is running at minus 2% of GDP, which is the lowest level reached since 2013. Despite the ECB accommodative monetary policy, Italy has not managed to get back on track. GDP growth is expected to get close to 1% in the coming years, limiting automatically the possibility of expansionary fiscal policy.
Explanation: Credit Impulse leads the real economy by 9 to 12 months. It represents the flow of new credit issued by the private sector as percentage of GDP. Italy’s credit impulse is based on household and non-financial corporations loans published by Bank of Italy on a monthly basis.
What is even more worrying is that monetary conditions are actually deteriorating at a fast path for Italy as a result of global higher cost of capital and lower liquidity. Thus, political and institutional crisis are happening at the worst time ever. Our simple model of monetary condition index for Italy (below) is based on a set of variables reflecting interest rates, money growth, exchange rate and unconventional measures. Since November 2015, monetary conditions have tightened considerably indicating that a slowdown of the business cycle and higher cost of credit for a heavily indebted country.
Contrary to what has been written here and there, the Italian economy remains fragile. Cheap credit has fueled the economy since the GFC but, fundamentally, Italy still lacks of competitiveness. Structural reforms, especially those implemented by M. Renzi, have not yet proved beneficial. The lack of competitiveness is well-demonstrated when studying the trade balance with country members of the EMU and those outside of the EMU. As we can see below, the strengthening of Italy’s trade balance results mostly from higher trader with countries outside the euro area whereas changes are much more limited with countries inside the euro area. If Italy would have regained competitiveness, we could logically expect to see Italy performing much better inside the Eurozone. Actually, Italy, as many other PIIGS, has mostly benefited from low euro exchange rate over the past years which increased trade but the country has not really regained competitiveness in the long run.
Does Italy have financial leverage to increase spending? Short answer is (obviously) no.
We have entered a new era of irresponsible spending. A large part of populist parties in Europe, whether from extreme-left or far-right, have more in common than they have differences. What often brings them together is higher public spending, anti-capitalism, Euroscepticism, anti-immigration policy, strong corporatism and sometimes also regionalism. These elements explain well the rapprochement between the League and the 5 Star Movement. The question is not whether markets are willing to finance a bigger deficit in Italy but at what price. We note that while the country is preparing to blow out its deficit, bond traders care enough to almost demand positive yield to own Italian 2-year bonds. Based on a conservative scenario (75 billion euro increase in public expenditures, lower PMI, stable inflation and decreasing GDP growth), debt to GDP could reach almost 135% of GDP in 2022 whereas the last IMF forecast based on continued growth and responsible fiscal policy expects debt to GDP to lower to roughly 107% over the same period of time.
Can the risk that Italy leaves the euro area become true? No, but private investors are starting to freak out and this is bad.
In less than a month, the fear that Italy leaves the Eurozone has substantially increased. Based on a survey of 1000 investors, Sentix break-up probability jumped to 8.2% for institutional investors, still way below levels reached in 2012. However, the fear of an Italian exit is much higher among private investors. It has jumped from 4.8% in April to 14.2% in May.
What’s next for Italy?
Italy could hold early elections on September 9th according to most up-to-date information. Meanwhile, a care-taker government should take place, but there is no certainty it will calm down markets. If there is no official response to the Italian situation from the EU or the ECB by then, the next key market event is the upcoming ECB meeting on June 14th. On this occasion, the ECB should, at least, confirm its commitment to contain speculation against government bonds (and maybe take concrete action if market conditions deteriorate rapidly). Though it is obviously complicated to assess, it is certainly too early to consider that what is currently happening in Italy will change the short-term trajectory of monetary policy in the euro area.
On the political level, the League is strongly supporting the holding of early elections since the party could win more votes and more seats. Polls show that it has gained support since winning 17% of the vote in March 4 elections, now reaching as high as 24%. The League and the 5 Star Movement could decide to form a coalition that has the potential to win the vote of majority as mentioned yesterday our resident Italian Fixed Income Star Althea Spinozzi.
How high is the risk of contagion to other countries? In the short-term, quite elevated…but the PIIGS are in much better growth and fiscal position than in 2012.
It is hardly a recent revelation that markets are quite upset by political risk, leading to higher risk premium and potentially contagion to the financial sector and other “weak” countries. Actually, contagion has already started to spread to Spain and beyond. However, we remain optimistic in the medium term. The current economic and financial situation of the PIIGS has nothing to do with that of 2012, at the time of the European sovereign crisis. Credit impulse is fading in the PIIGS, as in most European countries, as a result of negative China credit impulse and rising protectionism but their growth and fiscal position is much stronger than five years ago, as we can see in the graph below.
This does not mean that they are immune to a lasting panic but that if the crisis is short-lived and mainly reflects a temporary increase in risk aversion (as was the case for the French presidential election in 2017), there is a good chance that the contagion will remain very limited.
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