Monday, May 21, 2018

Italy Update - How Italy Got Into Its Current Mess

With Italy's bonds taking a hit and the country facing political turmoil this piece presents an overall look at how things got this bad. For years the world has focused on the "Greek Tragedy" that is far from over. While the ongoing misery of Greece continues to play out our eyes have been diverted from economic problems that fester and brew in Italy. Many people have failed to notice the Euro-zone debt crisis has taken a heavy toll on Italy where consumption and investment are expected to remain weak. The country’s economy has shrunk by around 10% since 2007 and output has regressed to levels not seen in more than a decade. While overall unemployment is around 12%-13%, with youth unemployment hovers around 40%. To worsen the overall situation an increasingly large number of refugees from North Africa are landing on Italy's shores.  

Smaller enterprises that are the country’s backbone continue to suffer from low sales, declining profitability, and lack of financing. Italy's banking system reflects the problems hampering future growth. Italian banks carry on their books around 200-300 billion euros of bad or doubtful loans, which has exposed inadequate capital and reserves. While counterparts in the U.K. and the U.S. have been able to deal with such loans Italian banks have been unwilling or unable to confront the asset quality problem. This has affected their ability to lend. Large companies can use capital markets for financing, but this option is less available to crucial smaller companies. This lack of credit in combination with the general erosion of Italy’s industrial structure creates little hope of a recovery and paints a grim picture going forward.

Italy Is One Of Several Nations With A Heavy Debt Load
Italy is the third largest economy of the Euro-zone after Germany and France, unfortunately, it holds the largest public debt totaling over 2 trillion euros. While Italy talks about its commitment to fiscal reform it continues to run a budget deficit of 3%. With government debt standing at $2.4 trillion dollars around 140% of GDP other problems are sighted. We see a government slow to pay its suppliers and weak in its ability to collect taxes, each year there is an estimated $160 billion in taxes uncollected.

Still, while this debt is a major factor hampering growth Italy’s problems are deep-rooted and fundamentally the economy has grown little since the introduction of the euro in 1999. It is clear that Italy still suffers from the legacy of its powerful Italian Communist Party in the time following World War II. This left Italy with rigid, high labor costs and multiple barriers to hiring and firing workers. A long-running government regulation requires the state to pay laid-off workers up to 80% of their normal salary while their employer restructures. Productivity improvements are also slow.  Italy’s economy is increasingly unbalanced. High-end producers, such as those in luxury products, and also advanced manufacturing have benefited from demand from emerging markets while other sectors, such as standard automobiles, domestic appliances and low-priced fabrics and clothing have found it difficult to compete with rivals from those countries.

Domestic appliances or white goods exemplify Italy’s decline. In 2007, Italy, once a world leader in the sector, produced 24 million appliances. By 2012, that was down to 13 million, the output of washing machines, dishwashers, refrigerators, and cooking appliances were down, respectively, by 52%, 59%, 55% and 75%. Italian manufacturers have been forced to shift production to lower-cost countries, resulting in large job losses. Italy ranks 65th out of 189 countries for ease of doing business in recent World Bank studies. Several key sectors are an issue, infrastructure, is in need of renewal lagging that of leading economies, and energy costs are high. Italy spends less than 5% of GDP on education, compared with a 6.3% average across OECD countries. As a result, only one-in-five Italians aged 25-34 completes higher education versus 39% for the broad OECD. 

In addition to Italy's other problems. it is burdened with a large corrupt and bureaucratic public sector. Italy is ranked 69 out of 175 countries by Transparency International in perceived levels of public corruption, comparable to Romania, Greece, and Bulgaria. Tax and other revenues are around 46% of GDP. According to the World Bank, the effective Italian corporate tax burden is around 65%. The European average tax on corporations is around 41%, with only France (64% and Spain (58%) in a comparable range. Switzerland and Croatia, both located close to Italy, have tax rates of 29% and 20%, respectively, which diverts investment from Italy. Even with high taxes, the quality of public services remains poor. Enforcement of a contract in Italy takes around three years, versus an OECD average of 18 months. Civil lawsuits take more than eight years to complete, compared to under three years in Germany.

Italy A European Debt Bomb Waiting To Explode
The truth is that in all reality Italy went bankrupt in summer 2011. Back then we saw interest rates on the national debt spike going out of control and Italy lost access to the financial markets. At that time the ECB and political authorities in Europe agreed to create around the country’s finances an artificial market to give the impression of stability and the appearance that Italy could work its way through its problems.

Italy, it appears is now forced to stay on this artificial support until the economic conditions improve and confidence is restored to where the country will have again access to real and normal credit markets. This most likely will never happen because not only is the country mired in debt but it is also a mess politically. The truth is not only the size of debt but the quality of the debt meaning the ability to repay it is an important issue. Because of the sheer dimensions of Italy as an economy and as a debtor, it dwarfs the problems posed by other countries that make up what has been referred to as the Euro-zone PIGS that have received so much attention in the past. All countries are not equal in size and the reason for their woes vary, however, propping up an economy is not a long term fix and the ECB loaning money to banks to have them purchase government-issued bonds is a scheme and instrument that allows international investors to over the years exit Italy in an orderly fashion.

All in all, it might be fair to say Italy is a European debt bomb waiting to explode. This is not sustainable and the country is held together only because of the direct intervention of the ECB which made over 102 billion euros of Italian bond purchases in 2011-2012 alone. This has continued since then and the sum has gotten much larger. Only through the LTRO have the finances of the Italian state been kept afloat. Way back in 2011 Nouriel Roubini warned that Italy needed to pursue an orderly restructuring of its debt to avert a default in coming years. Almost everyone agrees that Italy’s public debt is unsustainable and needs an orderly restructuring to avert a default, but as usual in the Euro-zone no action is happening. In many ways for Euro-skeptics Italy remains the Achilles heel of Europe, these skeptics are quick to point out that, once foreign investors withdraw, Italy will crumble under the weight of its debt.

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