Under Mario Monti's government, Italy has been a "good student". Which, according to research published today by Morgan Stanley, means that the country has been pursuing an ambitious agenda of fiscal consolidation and with mixed success structural reforms.
Under Mario Monti’s government, Italy has been a “good student”.
Which, according to research published today by Morgan Stanley, means that the country has been pursuing an ambitious agenda of fiscal consolidation and with mixed success structural reforms.
Despite this positive attitude, the crucial risk for the country and its economy remains the sheer size of government refinancing, which makes Italy very sensitive to changes in market sentiment, driven by both domestic events and progress / setback in the journey towards deeper European integration, the economist Daniele Antonucci warned in the paper.
“Put differently, barring any unforeseen European policy response that goes way beyond our expectations, Italy can choose between pursuing its own (and Europe’s) fiscal and reform agenda with higher interest rates, or with lower interest rates,” Morgan Stanley said.
Even if commentators seem to see the extra conditionality that will likely be imposed and the quarterly deadlines that will have to be met as an insurmountable obstacle for Italy’s politicians to apply to the EFSF / ESM, analysts at the bank disagree, and think that, while not the preferred option for Italy, market pressure is more important.
With sovereign bonds no longer perceived as risk-free in the eurozone, most countries have already lost their ability to use fiscal policy in a countercyclical fashion – the smaller peripherals can’t even borrow in the market.
“So the key trade-off is not fiscal consolidation and reform vs. no fiscal consolidation and reform, and not even acceptable funding costs vs. unacceptable funding costs.
It’s fiscal consolidation and reform plus acceptable funding costs vs. no fiscal consolidation and reform plus unacceptable funding costs,” they added.
In this scenario, Morgan Stanley gives an answer to the five key risks of Italy’s economy.
1. Can growth come back at all?
Yes, but not before mid-2013. But while we are comfortable with or below-consensus forecast, we are more optimistic than most on Italy’s potential to reform. The financial crisis and its economic fallout might have damaged the supply-side of the economy, thus further hitting Italy’s sub-par potential growth. It might now have dropped to 0.5%. Thus, extrapolating into the future the pre-crisis growth rate of potential GDP might be too far-fetched.
2. Are the public finances being fixed?
Yes, and the primary budget surplus is increasing. Italy’s fiscal policy has historically been quite effective at maintaining large primary surpluses for several years in a row. We expect a gradual return to such situation, thus providing a meaningful offset to high interest spending. Continuing to fight the ‘shadow economy’, implementing extra measures to increase efficiency and reduce waste in the public sector, and further monetising government assets are areas where there’s significant scope to reap benefits, and the pension reform might deliver short-term savings and contribute to long-term sustainability. A key concern in the near term has to do with the rollover of government debt in large size, which makes Italy vulnerable to sudden changes in market sentiment.
3. Is political uncertainty a worry?
An unresolved political situation might turn into a further channel of contagion. Thus, political risk may return.
With austerity taking a toll on an already weak economic fabric, discontent might well rise. The risk is that the uncertainty in the run-up to the election, which has to happen by April 2013, might result in less willingness or ability to maintain a sound reform path.
Changes in attitudes towards the monetary union represent a further risk. Polls indicate that Italy is the country with the highest percentage of people thinking that a return to their national currency would be preferable. Italians might think that they lost out from the monetary union, but they are also keen to see budget sovereignty migrating at the European level. The psychology of contagion is such that when a eurozone sovereign is ‘dealt with’, then investors naturally focus on the next weak link. Thus, market pressures on Italy might intensify once Spain applies for financial support to the European rescue funds.
4. What will be the negative impact on regional economies?
Credit quality relative to Italy should decline modestly and by extension its ability to support and control its regions, is the key driver of their credit quality relative to alternative credit options. Regional financial conditions and credit quality remain closely tied to the nation as a whole, despite recent moves to fiscal federalism. However, ‘federal’ austerity programmes and weak national growth do hurt regional programmes relative to Italy. In the near term, the negative impact on Italy’s regions appears modest.
5: What are the biggest issues for the Italian banking system?
Large NPLs and low coverage remain a significant issue for Italian banks. NPLs net of cash reserve and collateral still absorb 20-90% of the tangible equity of our universe of banks. Funding remains difficult – banks have limited market access and need to gradually rebalance their 108% loan to deposit ratio, which may result in lending reduction for longer.
Adjusting the values of NPLs could allow disposal / transfer, e.g., to a specially set up vehicle. This would free up resources for the banking sector to provide lending and support the economy. This may require up to €20-41bn equity to help out with the ensuing capital erosion, in our estimates, but could unlock future profitability and improve banks’ valuations. – Further substantial cost restructuring would also help profitability, as the Italian banking sector is still heavily over-branched.