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La Sofferanza Italiana

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After the turmoil of Brexit and the US Presidential election, this week the spotlight for political upheaval falls firmly on Italy. Several market commentators expect this Sunday’s crucial referendum to decide the political fate of incumbent PM Matteo Renzi and even the future of Monte Paschi and other insolvent Italian banks. Potentially, this may eventually lead to Italy leaving the euro, although this must be regarded as a long shot. 

The global populist revolt that propelled Donald Trump to victory in the US election and the UK to vote for Brexit has undoubtedly emboldened the enemies of previously comfortable political elites across the western world. Sunday also sees the Austrian presidential election. Norbert Hofer, only slightly to the left of Genghis Khan, stands a good chance of being elected. If he runs, François Hollande is almost certain to lose power in France’s April election, setting up a battle between François Fillon and Marine Le Pen.

Unlike Brexit and the US elections, Italy’s national vote is on a package of reforms to the Constitutional law aimed at, amongst other things, reducing the power of Italy’s upper chamber of parliament, the Senate, whose current remit exactly duplicates that of the Chamber of Deputies. Much like Brexit, the referendum was brought on by the PM. He believes the extensive powers of the Senate effectively block and dilute attempts to reform the Italian economy. A ‘no’ vote to the proposals could prove to be his undoing as he has suggested he will step aside in that event. Opinion polls, if anyone still takes heed of them, were closed two weeks ago but heavily pointed towards a successful ‘no’ vote.

As with any referendum or widespread election, the vote will be regarded by the populace less as an opportunity to vote on reform within the Italian Senate than a chance to vent frustration at the incumbent government and the current economic position. The message sent from the Italian people and the resulting political instability are likely to embolden Eurosceptic parties such as Beppe Grillo’s Five Star movement. Indeed, Five Star has raised the possibility of commissioning a vote on Italy’s eurozone membership (i.e. discontinuation of monetary union rather than membership of the EU).

Should the vote turn into a judgement on the state of Italy in Europe, rather than the powers of the Italian Senate, it is important to consider how Italy has fared compared to its neighbours in recent times. As is well documented, Italian banks are seen as particularly unstable at present. Almost 20% of Italian banking balance sheets (loans) are ‘non-performing’ and borrowers aren’t able to pay interest due. These non-performing loans, or NPLs, despite being substantially provided for, still represent a net position of some €89bn – the highest in the G20. By contrast, less than 5% of French banks’ loans have run into trouble and British banks’ bad loans amount to less than 1.5% of their books. The worst of these debts have not yet been written off, as banks’ capital ratios are too low and fears of forced recapitalisation and a creditor haircut under the EU's new 'bail-in’ laws stalk share prices. Unfortunately, Italian households are keen investors in bank bonds and would be badly burnt if they had to face up to those losses.

As a share of GDP, Italian government debt stands at about 130%, the highest in Europe after Greece and still rising. About 4% of GDP is being spent on paying interest on public debt: double the OECD average and nearly four times what Germany pays. In the eight years since the global financial crisis, the US and the UK have seen GDP growth up by about 12% and 8% respectively. In stark contrast, Italy’s GDP is down by about 8%. "We have lost nine percentage points of GDP since the peak of the crisis, and a quarter of our industrial production," says Ignazio Visco, Banca d'Italia Governor. Official unemployment figures are at 11.4%, and the European Commission says a further 12% have dropped out of the data, three times the average EU for discouraged workers. Youth unemployment remains at around 40%. 

As is practically always the case, the way to get out of a debt problem like this is through economic growth. Deflationary conditions have prevented nominal GDP rising fast enough to outgrow burgeoning debt. Positive rates of inflation, rather than the stuttering deflation that currently envelops the country, would alleviate debt-deflation. Unlike in the aftermath of Brexit, Italy has not and will not enjoy a boost to competitiveness of 20 to 30% through a lower exchange rate that would lead to an increase in net exports and higher economic growth, with corresponding gains to employment.

In the short term, the ECB will likely use its €80bn monthly bond-buying program - which already holds nearly €1.2tn in European bonds - to counter rapid increases in bond yields after the vote, smoothing the market and supporting bond prices. The ECB is also scheduled to meet on 8 December, just days after the vote. Should there be a volatile response to the referendum, we would expect ECB President Mario Draghi to look to reassure markets. 

It is not difficult to appreciate why Italians are expected to vote ‘no’ as a stand against the current status quo and bring about a change of leadership that could potentially lead the country on a path to leaving the euro. For the third time this year, the irresistible force of the ballot box appears set to meet the apparently immovable object of the political elites.   




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