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Sunday, January 17, 2010

The Italian Lion Sleeps Tonight, And Yet Awhile..........

“If we look at public-sector debt and interest payments, Greece isn’t doing particularly worse than Italy,” Peter Westaway,Chief Economist Europe at Nomura International
To everyone's relief, Italy's economy returned to growth in the third quarter of 2009, following five consecutive quarters of contraction. But that doesn't make the future look or feel any more secure than the recent past, and while an immediate return to a sharp recession isn't likely, it still isn't clear whether the Q3 performance was repeated over the last three months of last year, or whether output remained more or less flat. This does seem to be a more or less a touch and go call, and while the final result will hardly be a shocker one way or the other, my feeling is that we are looking at growth in the region of -0%. That is to say, slight contraction is marginally more likely than slight expansion. So Italy's economy is more or less dormant, but it's debt to GDP ratio is not, and is moving steadily upwards (see the last section of this post), so the lion sleeps tonight, and goes on sleeping, but what will happen tomorrow when she, or rather the financial markets, finally wake up, and discover seems evident, at least to me and Peter Westaway, that in the longer run Italy's sovereign debt problem is every bit a large as the Greek one, although given that most of the debt is in fact held by Italians, the threat to the good functioning of the eurosystem may well be proportionately less.

A "Weak" Recovery

If the most recent past is still clouded in uncertainty, what is a little less in doubt is the sort of rebound we might expect from the Italian economy, since any bounceback will surely be extremely muted to say the least. The Italian economy has been loosing steam for decades now, and only grew by something less than 0.5% per annum over the last - boom - decade. With the working age population declining and ageing, the outlook for the next decade is hardly improved.

My best-guess estimate is that the Italian economy contracted by something like 4.8% in 2009 (just a little less than the 5% German contraction), following a 1% drop in output in 2008. Consenus opinion is mildly optimistic for the year to come, but expectations are modest with the Bank of Italy arguing that what is still the euro region’s third-biggest economy will experience a “weak recovery” this year and a 0.7 percent expansion in 2011. Of course, as with forecasting the weather, the further into the future you move, the greater the level of uncertainty which is attached to any growth estimate, and in current global conditions this is even more the case. The Italian central bank forecast compares with a November projection from the Organization for Economic Cooperation and Development of 1.1 percent growth this year and 1.5 percent in 2011, while the IMF projects 0.25% growth for 2010 and 0.75% for 2011, and the EU Commission currently project 0.7% for this year and 1.4% for 2011.

Certainly all parties project that internal consumption will remain weak, and what growth they are expecting should be driven by external demand, which, of course, is itself subject to considerable uncertainty as government stimulus after government stimulus is steadily withdrawn. Almost all EU economies are now looking to live from surplus demand in other countries, and like the British working classes in the nineteenth century they can't all surely hope to live from "taking-in each others washing".

More than talking about growth, what we are really talking about is getting back to where we were, since if we look at the level of Italian GDP, it is clear that there has been a sharp drop in output since the start of 2008, and at current rates of growth it will be many years before we get back up to 2007 levels.

Mario Draghi, Governor of the Bank of Italy suggested at the end of last year that it would take four years for the Italian economy to return to its 2007 size. If the recovery is slower than anticipated these four years could easily turn into five or six with fairly serious implications for the Italian sovereign debt dynamic. Indeed, there already appear to be more downside risks emerging than the above forecasts contemplated and I'm inclined to agree with that doyen of Italian economy bank analysts - Unicredit's Marco Valli - when he argues for a likely upper limit to growth this year at around 0.5%, with plenty of scope for it to come in even lower.

Touch and Go In Q4

" We doubt that the pace of growth seen in the third quarter will be maintained in the fourth one: given the weak momentum with which industrial production closed the third quarter (-5.3% monthly in September after +5.8% in August), a substantial deceleration in industrial activity and GDP is likely in the final quarter. However, given that manufacturing surveys keep pointing north, car registrations remain firm and there are increasing signs that services activity is starting to re-gain some traction, we have penciled in flat GDP for the fourth quarter"
Unicredit's Italy Economist, Marco Valli, 23 November 2009

In line with most analyst expectation expectations, the Italian economy expanded by 0.6% between the second and third quarters of 2009, an improvement which was largely driven by a 4.3% quarter on quarter (qoq) rise in industrial output. GDP also benefited from a rebound in exports (+2.5% qoq) and machinery/equipment investment (+4.2%), some growth in private consumption (+0.4%, on strong car registrations) and a moderately positive contribution from inventories (+0.1pp). The evident weakness was construction investment, which continued to fall sharply (-2.1%).

Industrial production has been steadily losing momentum in the fourth quarter, and was up only 0.2% in November, on the back of a revised 0.7% increase in October. These rises follow a sharp 4.9% drop in September which means, assuming the upward December output rise is close to that indicated in the last PMI, industrial production in the last three months will be more or less flat in the final quarter when compared with the third, and could even be slightly down.

On the other hand, Italian consumer activity - normally the weak spot in Italian GDP - does seem to have recovered rather during the quarter. Consumer confidence has imporved considerably of late.

And while retail sales have long since stopped their upward trend ...

the retail PMI showed growth in both November and December following 32 consecutive months of decline.

Also services activity has been stronger, with the services PMI registering growth during the fourth the quarter for the first time in many months.

In fact private consumption has been looking up in the last two quarters, and this trend may continue.

However, at some point there will be a deceleration in momentum, since consumption will undoubtedly be negatively affected by the expiration of the car scrapping premium. As Marco Valli puts it: "the extent of the correction in durable goods spending crucially depends on whether the government decides to quit the premium outright (which we regard as unlikely) or opts for a gradual phasing out of the incentive scheme (more likely)". It is worth bearing in mind, however, that even if the current premium scheme were to be fully confirmed for the whole of 2010, the effect on car registrations would be much more restrained than in 2009, due to the fact that most of the earlier pent-up demand has already been met.

Is Italy Export Dependent?

Even if this seems strange to many people, the Italian economy is, in fact, highly export-driven. In this sense Italy is heavily reliant upon the recovery of German demand, and it just thios demand which now seems to be faltering. In Q1 2009, German imports fell 5.4% over the previous quarter, after dropping in Q4 2008, driving Italy's economy further and further down.

Exports amounted to some 28.8% of Italian GDP in 2008. In the third quarter of last year Italian exports grew by 2.5% on the quarter following a 2.5% drop in the previous one, while imports were only up 1.5% following a 2.5% drop in the second quarter. Thus the trade factor was positive for GDP growth. This situation seems set to change in the last quarter. Seasonally adjusted October exports were down, while imports fell less than exports, and if this trend is continued in November and December net trade will in fact be a drag on GDP. To my insufficiently well trained eyes it looks very much like the German car stimulus gave a big boost to Italian industry in August, and that this effect is now waning, even if the domestic Italian stimulus counterbalances to some extent.

Fixed Capital Investment Stimulated By Tax Incentives

Capital spending decisions look little better. Spending on machinery and equipment was up 4.2% quarter over quarter in Q3, but was still down 16.1% on the year, and the relatively strong recent performance is partly due to a tax incentive provided by the Italian government.

Again, Marco Valli points out that investment decisions are likely to remain conservative next year, since levels of corporate indebtedness are still high in an environment where profitability is notably weak. Moreover, extremely depressed capacity utilization rates will unavoidably put a ceiling on business investment. However, Valli suggests that firms will undoubtedly continue to take advantage of the tax bonus on machinery investment to replace old machinery during the first half of the year. When the bonus finally expires in July 2010, it is likely there will be a sizeable capex correction. As a result Unicredit expect machinery investment to drop 0.9% in 2010 following a likely -16% in 2009.

Official Figures Underestimate Unemployment

In November 2009 the Italian unemployment rate reached 8.3% in Novemember, as compared to 7.0% a year earlier. The European Commission expects the annual unemployment rate to rise to 7.8%in 2009 and 8.7% in 2010. The OECD's November 2009 economic outlook also expects Italian joblessness to peak in 2011 at 8.7%.

But the EU harmonised method of calculating unemployemnt rather underestimates the situation in the Italian case, and Italy’s real unemployment rate is significantly higher (around 10.7% according to Bloomberg calculations) once you add-in those workers paid by a fund known as cassa integrazione, or CIG. The CIG pays laid off employees about 80 percent of their salaries for up to two years.

Again Bloomberg calculate that use made by Italian companies’ of the CIG fund quadrupled to almost 1.5 billion euros in 2009 from 365 million euros in 2008. The official cost of the CIG in 2009 will be published in the annual report of INPS (the Rome-based agency that handles the welfare payments) later this year. Under Italian law, businesses suffering from a downturn can lay off permanent employees for as long as two years and take them back when conditions improve. In fact CIG aid can be extended to five years if the government decides that circumstances are “exceptional.”

Difficult Years Ahead If Italy Wants To Consolidate Its Fiscal Position

The overnment's response to the present crisis has been - at least formally - rather moderate due to the need to avoid a substantial deterioration in public finances, given the very high level of already existing government debt in a context of increased global risk aversion. Evidently the Italian government didn't want to draw attention to itself in the way the Greek one has. As a result measures taken to support low-income groups and key industrial sectors have been largely financed by reallocating existing funds, and this is even largely true of the additional stimulus package of 4.5 billion euros, in an effort to "intensify actions against the crisis," according to Minister of the Interior Claudio Scajola in a statement at the time.

However, even given this evident restraint, the EU Commission sill forecast that the government deficit probably widened to 5.3% of GDP in 2009 (from 2.7% in 2008) and remain at around that level in both 2010 and 2011. In comparison to other EU country deficits this is not big beer, but it does need to be situated within the context of the long history of public indebtedness in Italy.

Primary expenditure looks likely to have risen by more than 4.5% in 2009, significantly faster than planned in the stability programme update submitted to the EU Commission in February 2009. In particular, public sector wage growth is continuing to outpace inflation. In addition, government financed consumption via social transfers grew considerably in 2009 due to a combination of pensions being indexed to the previous-year's inflation, one-off transfers to poor households and the extended coverage of the wage supplementation fund. Capital spending also rose by an estimated 13%, as a result of recovery measures that bring forward some previously agreed investment plans. The only significant item expected to decrease is interest expenditure, which is benefitting from historically low short-term interest rates.

While the strength of the 2009 downturn understandably derailed the three-year budgetary consolidation plan adopted in summer 2008, a marked slowdown in expenditure dynamics is likely in 2010 and 2011, as the government attempts a return to the planned consolidation path. Capital expenditure is set to decrease in both years, while modest increases are projected for current primary expenditure. Interest expenditure is also expected to rise, due to monetary policy decisions at the ECB and the expanding size of the debt itself.

The EU Commission estimate that the gross government debt-to-GDP ratio climbed by almost 9 percentage points in 2009, to around 114.5%, and forecast that it will continue rising to around 118% in 2011. The 2009 increase is overwhelmingly due to the sharp fall in nominal GDP. Looking forward, the EU Commission emphasise that ongoing interaction between high debt-service requirements and Italy's low potential GDP growth rate underlines the importance of raising the primary balance so as to put the very high debt ratio on a declining path once again.

In this context, one of the concerns about Italy's government debt trajectory is the extent of recourse to one-off and make-and-mend measures to keep the state finances afloat. One good example of such a measure are the tax amnesties, a technique which Italian Finance Minister Guilgio Tremonti has had considerable experience with, since in both 2001 and 2003, as part of an earlier Berlusconi government, he enacted similar measures that brought some 20 billion euros back to Italy, with a further 15 billion euros being declared by Italian clients of Lugano banks, though it remained in Switzerland. But the yield the first time round has been dwarfed by the rich harvest this time. Mr. Tremonti recently announced that Italians had declared 95 billion euros in assets under the plan, with some 98% of the money being brought into Italy from offshore sources. The harvest should have added something like 5 billion euros to 2009 Italian tax revenue, and although the plan formally expired on December 15, a further ammnesty period is not ruled out.

In fact the Italian Finance Minister has often come under attack from those who want to see the government taking more decisive action against the economic crisis, but his insistence on fiscal prudence appears to have been justified, given the difficulties currently facing Greece. For once an Italian government can be congratulated for its prudence, and the risk premium on Italian government bond yields was just overcompared with benchmark German bunds is running somewhere around 80 basis points as compared with Greece, where the spread is now over 250 basis points.

Resources are also being acquired from the Trattamento di fine rapporto (TFR), a fund containing contributions paid by employers for employees' severance pay when they retire, leave their jobs or are made redundant. Although there is little doubt that the government will eventually reimburse the money, it is likely that it will have to resort to increased taxation or cuts in expenditure to do so.

So the issue is, that far from using the crisis as a justification for implementing the much needed deep-seated reform, it has instead and once more been used as an excuse for postponing it. I leave you with the words of The Italian economist Francesco Davieri, writing last June in the economics portal VOX EU:
If Italy’s government does not push reform more aggressively – issues like pension reform, the schooling and university system, and the labour market – the most likely scenario is that the Italian economy will return to its usual...[lacklustre]....annual growth after the crisis. This is why postponing reforms in today’s Italy is like consuming a luxury good when you are close to starvation. Today’s Italy just can’t afford it, if it wants to resume faster long-run growth.

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