The clock is ticking for Italy

Christopher Dembik

Head of Macro Analysis, Saxo Bank Group
Christopher Dembik joined Saxo Bank Group in 2014 and has been the Head of Macro Analysis since 2016. He focuses on delivering analysis of monetary policies and macroeconomic developments globally as defined by fundamentals, market sentiment and technical analysis.

How is the Italian economy performing?

The Italian economy is decelerating. Our leading macro indicator, credit impulse, is running at -2% of GDP, which is the lowest level reached since 2013.

Despite the European Central Bank's 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, automatically limiting the possibility of expansionary fiscal policy.

Explanation: Credit impulse leads the real economy by nine 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 loan data published by the Bank of Italy on a monthly basis.  

What is even more worrying is that monetary conditions are actually quickly deteriorating for Italy as a result of the (global) higher cost of capital and lower liquidity. Thus, political and institutional crises 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 a slowdown of the business cycle and a higher cost of credit in 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 Great Financial Crisis but Italy still lacks fundamental competitiveness. Structural reforms, especially those implemented by former PM Matteo Renzi, have not yet proved beneficial.

The country's 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 is mainly the result of higher trade 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 is the case with many other PIIGS – has mostly benefited from low euro exchange rate in recent years. This increased trade, but the country has not really regained competitiveness in the long run. 

Does Italy have the financial leverage to increase spending? The short answer is (obviously) no.

We have entered a new era of irresponsible spending. A plurality of Europe's populist parties , whether from the 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 the rapprochement between the League and the Five Star Movement, for instance).

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 two-year bonds. Based on a conservative scenario (a €75 billion increase in public expenditures, lower PMI, stable inflation, and decreasing GDP growth), debt-to-GDP could reach almost 135% in 2022, whereas the last International Monetary Fund forecast based on continued growth and responsible fiscal policy expects this metric to lower to roughly 107% over the same period of time. 

Could Italy really leave the euro area? No, but private investors are starting to freak out and this is bad.

In less than a month, the fear that Italy will leaves the Eurozone has substantially increased. Based on a survey of 1000 investors, Sentix break-up probability jumped to 8.2% for institutional investors – admittedly still far below the levels reached in 2012.

However, the fear of an Italian exit is much higher among private investors, having jumped from 4.8% in April to 14.2% in May. 

What’s next for Italy?

Italy could hold early elections on September 9 according to the most up-to-date information. Meanwhile, a caretaker government should be installed, but there is no certainty that this will calm down markets. If there is no official response from the EU or the ECB by then, the next key market event is the upcoming ECB meeting on June 14. 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 say that the Italian situation will change the short-term trajectory of monetary policy in the euro area. 

On the political level, the League is strongly supporting 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 Five Star Movement could then decide to form a coalition that has the potential to win a majority vote.

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 positions 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 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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