Country in Focus: Italy

April 06, 2016 | Emerging Markets

Italy is the third largest economy in the eurozone. It is the second most visited country in Europe, and has become a pillar of modern design for everything from high-fashion clothing to luxury sports cars. With its famous culture, architecture, and palatial landscapes on one hand, and its state-of-the-art, high-end auto industry on the other, Italy often represents an intersection of old and new. This also applies to Italy’s politics and economy, as the country and its people are often torn between old habits and the prospect of renewal and reform.

Economic growth has been sluggish in the past decade as the country has been held back by its decrepit institutions, among other issues. A relatively high degree of corruption and cronyism within the economic and political systems and an incompetent bureaucracy have led to an inefficient allocation of resources. Productivity growth and competitiveness are also constrained by rigid labor laws, excessive red tape, high barriers to entry in several sectors, an inefficient judicial system, a high tax burden, and inefficient public spending. Overall, the country ranks quite poorly for a developed economy in well-followed international surveys such as the World Bank’s Ease of Doing Business survey. It ranked 45th in the world, and scored particularly poorly in categories such as “enforcing contracts” and “paying taxes.” Extremely weak productivity growth and a loss of competitiveness when combined with rising wages have hurt the Italian economy. As a member of the eurozone, Italy does not control its currency and cannot resort to easy devaluations to increase its competitiveness. The result of all these self-inflicted wounds is an economy that has struggled to maintain positive growth since the global financial crisis, and remains a whopping 9% below its 2008 peak in real terms.

However, there are signs that the people of Italy, and in particular its lawmakers, are finally opening up to the idea of breaking old habits and embracing new ways of thinking. Prime Minister Mateo Renzi has ushered in a new era of reform, including a recent overhaul of Italian labor law that should make it easier to hire and fire workers. The reforms put the country’s laws broadly in line with its European peers on this metric, and even in line with Germany, which has famously reaped the economic benefits of similar reforms undertaken in the mid-2000s. A look at the contrasting performance of the German and Italian labor markets since the German reforms and through the financial crisis illustrates how powerful the long-term rewards can be. Some recent Italian banking reforms also look promising in that they encourage consolidation among weaker players, but the real heavy lifting centers on fixing the foundation of the system so that future reforms are not nearly so difficult.

The institutional and political reforms that Renzi is currently attempting are potentially more meaningful than anything that has been undertaken so for. Essentially, the reforms would curb the powers of the Senate, reducing its ability to obstruct and block legislation. A complementary reform that changes the electoral system has already been adopted—it awards a majority premium to the winning party and makes it easier for governments to win majorities and govern with more stability. The overwhelming consensus in financial media is that this is an unequivocal positive. While we believe the near-term implications of this change are likely to be positive, given the reform credentials of the current government, the idea of giving more power to some future, less business-friendly government could be a negative. In that sense, the new Italian electoral system will essentially do the opposite of what Chile’s unique binomial system has done over the past 25 years or so (before recently being scrapped). That system essentially promoted a “tie” in the legislature, encouraging moderation and consensus. It is sometimes credited as a main reason why Chile has been able to avoid populist politics more successfully than its neighbors in a region full of unfortunate case studies of the pitfalls of populist policies and vote buying (see Argentina, Venezuela, and more recently Brazil). Nevertheless, if we continue to see a reformist government in Italy, then the further empowerment of that political force will likely yield a more favorable environment for a reasonable investment horizon, regardless of the long-term unintended consequences.

Italy still faces many challenges. Despite some much needed economic relief from lower oil prices and quantitative easing by the European Central Bank (ECB), its recovery is by no means robust. This matters in the medium-term because of Italy’s huge government debt pile. Italy’s debt, equivalent to north of 130% of GDP, has become something of a Catch-22. On one hand, the debt load has pulled forward future demand and has required pulling money out of the economy to service the debt. On the other hand, higher growth is required to make the debt sustainable. In other words, the debt is a drag on growth, but growth is needed to repay it. Italy has a debt problem as well as a growth problem, and both of these are currently feeding off of each other, further adding to Italy’s economic woes.

The structure of Italy’s government debt (low foreign ownership and a consistent primary budget surplus) compared to that of other Economic and Monetary Union countries makes it fairly resilient to shocks. The ECB’s quantitative easing is also helping the debt math by lowering present and future interest payments. Italy has a large share of floating-rate and inflation-linked bonds. This means lower yields and lower inflation translate more quickly into lower interest payments than would be the case for other countries with more fixed-rate-oriented debt structures.

In a more normal world, we would probably take a more negative view of Italian yields. However, we believe that the ECB stands ready to hold down rates, as it has made the conceptual leap to shed the stigma tied to monetary financing of government budgets and engage in the process, whether officials want to admit it or not. Overall, while we do not view anything the ECB is doing as a panacea in terms of growth, we do believe that it is providing some relief to the economies of Europe, with Italy being a primary beneficiary. One way to illustrate this is by looking at the convergence of borrowing rates for small- and medium-sized businesses between Italy and Germany since the summer of 2012 (when ECB President Mario Draghi gave his famous “whatever it takes” speech and laid to rest most concerns of systemic currency and financial crisis).

However, despite recent improvements, Italy is once again making headlines, this time setting off alarm bells over the rot taking place in its banking sector. Even with the fall in borrowing costs, credit growth in Italy has been very weak, and mostly negative in the case of business lending. At the core of Italy’s banking woes are a slow-growth economy and a pile of non-performing loans (NPLs) that, as a share of sector-wide assets, is among the highest in Europe. There are several reasons for this, some of which lead back to Italy’s weak institutions. The country’s banks have not been able to shed their NPLs to the extent that their Irish and Spanish peers have. In Italy, the issue is that the problem loans are more skewed toward small businesses than housing (housing was the issue in Ireland and Spain). These loans by nature tend to be more complicated. Furthermore, it is difficult to find buyers for Italian NPLs because of the slow and inefficient court system, where asset recovery is uncertain and delayed. These issues, combined with new EU regulations requiring bail-ins of bank equity and junior bonds holders, have made the problem difficult to remedy.

Adding fuel to the fire in recent months has been liquidity pressure on some banks. This has stemmed from deposit flight in the wake of a few smaller banks being restructured toward the end of last year via bail-in mechanisms. Given that large depositors can theoretically be on the hook in bail-ins, many average Italians decided not to take any chances and simply moved their money. We do believe that the ECB’s recent decision to extend the scope of its Target Long-Term Refinancing Operations (TLTRO) will be effective in reducing systemic liquidity risks, as it provides banks with long-term free money. However, we do not believe any moves implemented thus far will solve Italy’s growth problem. It is also unclear whether the ECB’s moves will give regulators cover to manage bank restructurings with a heavier hand, which could actually result in more bail-ins.

While systemic banking sector risk has probably been reduced in the wake of recent central bank action, it is difficult for us to get excited about investing in Italy. Economic growth is expected to remain very weak. Confidence indicators have rebounded with the fall in energy prices, but these may be at risk of rolling over, potentially weighing on demand. Moreover, political risks can never be ruled out in Italy, where politics are in constant flux. Renzi has staked his political future on passing a national referendum set to take place in October on the previously mentioned constitutional reforms to the Senate. While we believe a loss for Renzi is a low probability event, this or any other unforeseen political event—potentially linked to further banking issues or refugee strife—could again rattle Italian financial markets. Ultimately, despite our view that Italians are finally beginning to open up to new ideas regarding the country’s politics and institutions, potentially setting the country on a course to more effectively manage its future challenges, this is going to be a very slow and drawn-out process. Similarly, given Italy’s debt and demographic realities, we believe that any economic recovery is going to be equally slow and drawn-out, especially in the absence of more radical improvements to the business operating environment. We can envision a path for Italy to become a more exciting destination for investment opportunities in the future, but their adherence to that path is very uncertain at this time. For now, we may find some specific opportunities in the country from time-to-time, but overall Italy remains more attractive as a travel destination than as an investment destination.

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