With the European debt crisis intensifying since last Julys rescue package for Greece, Italys sovereign spreads and credit default swaps have come under scrutiny from financial markets, because of its high level of public debt and below-average economic performance. In November 2011 the yield on Italys 10-year bond surged to more than 7%: a level widely seen as unsustainable.
Under pressure from EU peers and financial markets, former Prime Minister Silvio Berlusconi had already taken measures to balance the budget and spur growth. After he lost his parliamentary majority and resigned, Mario Monti, a former EU competition commissioner, stepped in as the new Prime Minister on 16 November 2011. He immediately tried to regain investors´ confidence by pushing through a necessary - if relatively modest - additional austerity package, building on the much larger packages already in place. The measures included the closing of loopholes in the tax legislation, a wage freeze for civil servants, linking the retirement age to life expectancy including raising the female pension age in the private sector - and a VAT rise of one percentage point.
The aim is to cut the public debt level of over 120% of GDP to 117% of GDP in 2013 through fiscal consolidation designed to reduce the budget deficit from 3.9% of GDP in 2011 to 1.7% in 2012 and 0.3% in 2013. To put the 120% public debt level in context, it should be mentioned that gross foreign debt is also 120% of GDP. But net foreign debt to GDP stands at 40%, which means that the private sector holds [net] foreign claims of around 80% of GDP. As a result, Italy has no foreign debt issue.
Economic growth will contract in 2012
While the governments aim to reduce the budget deficit will be met, there is little prospect of a return to sustainable economic growth in the short term. According to the Italian National Institute of Statistics [ISTAT], in Q4 of 2011 real GDP decreased by 0.4% year-on-year and 0.7% on the previous quarter. Household consumption declined 1.2% year-on-year, while gross fixed capital formation decreased 3.1%. Only exports recorded positive performance: rising 3%. In 2011 the economy grew 0.5% but the downward trend seen in the last quarter is expected to continue. According to a preliminary ISTAT estimate in Q1 of 2011 GDP decreased 1.3% year-on-year and 0.8% on the previous quarter. It is expected that the economy will contract 1.5% in 2012, as austerity measures suppress domestic demand, while demand from many Eurozone neighbours also deteriorates. A modest 0.1% rebound is expected in 2013. However, this forecast is based on a supposition of no further Eurozone contraction, no unpleasant surprises from the impact of fiscal consolidation and bond yield developments and no additional fiscal consolidation.
Between 2002 and 2011, Italys economic growth rate has remained consistently below the Eurozone average. The economy shrank by a stronger than average 7% during the post Lehman crisis, with the subsequent recovery also below average.
Underlying this low growth are structural rigidities in the labour market and the product and service markets, an overall weak business environment hampered by red tape and corruption, and inefficiencies in the public service sector.
Private consumption will shrink in 2012 and 2013
After a short period of improvement in February and March 2012, consumer confidence again fell sharply in April: to 89.0 from 96.3, according to ISTAT. Household consumption is forecast to continue the downward trend seen in Q4 of 2011, decreasing by 1.7% in 2012 and 0.6% in 2013. Consumer spending is hampered by the negative effects on disposable income of rising unemployment and austerity measures. With lower consumer spending, IHS Global Insight expects retail sales to continue to fall: down 3.9% year-on-year in 2012 after last years 3.7% decrease.
Consumer price inflation increased 0.5% in April 2012 compared to the previous month, and 3.3% year-on-year, driven mainly by the higher cost of energy and clothing. Consensus Economics expects inflation to increase slightly in 2012 - to 3% after 2.8% in 2011 - due to the recent VAT increase, and to decrease to 2.5% in 2013, due to weaker demand.
Youth unemployment is an issue
Although it has increased by more than 1.5% since mid-2011 - to 9.8% - unemployment is still below the Eurozone average of over 10%, and significantly lower than the jobless rate of other Southern European countries. However, Italian youth unemployment [i.e. of those aged 15-24] stands at 28%: much higher than the Eurozone average of 21%. Those younger people who have found employment are comparatively worse off, as 90% of new job contracts are temporary and offer much lower wages than those of older workers with life-long tenures. This de facto dual labour market owes much to article 18 of the workers statute, under which Italian firms with more than 15 workers are obliged to reinstate workers that the courts judge to have been dismissed without just cause. However a revision of article 18 is now part of the Italian governments labour market reforms.
According to ISTAT, in March 2012 industrial production increased 0.5% from the previous month, after a 0.7% decrease in February. However, year-on-year it decreased 6.8% in February and 5.8% in March. Industrial production is expected to decrease 4.5% year-on-year in 2012.
The importance of net exports to 2012s economic performance
According to IHS Global Insight, export growth will slow from 6.3% in 2011 to 0.8% this year and 1.5% in 2013. In view of the subdued outlook for the other contributors to economic growth such as domestic demand - net exports will assume added importance in 2012 with sustained demand from trading partners outside the Eurozone crucial to their positive development. According to IHS Global Insight, net exports will show a surplus of EUR 11.3 billion in 2012 and EUR 12.5 billion in 2013, after EUR 4.3 billion in 2011 and deficits in the years before.
A generally sound banking sector
The Italian banking system is generally sound, in the sense that there has been no excessive lending to other countries in economic troubles and/or to highly leveraged Italian firms and households. The ratios of household and businesses debt to GDP were 50% and 110% respectively in Q2 of 2011. Italian banks will increase their capital ratios to meet Basel III regulations. This will give a much-needed boost to confidence, which has been eroded by increased holding of Italian government debt: up by 31%, at Euro 267 billion in February 2012 compared to three months earlier. Inter-bank funding has become difficult for Italian banks as the debt crisis has pushed up the costs of borrowing. Therefore they have drawn around EUR 270 billion under the European Central Bankss EUR 1 trillion Long-Term Refinancing Operation [LTRO] facility.
The financial markets still fear a potential vicious circle of deteriorating government debt and banks credit quality. Meanwhile, loans to the private sector are decreasing, due to the economic slowdown and tighter credit conditions.
Italys spread with the German bond yield peaked at over 5% in late 2011. While it began to decrease in early 2012, it has bottomed out and has recently taken an upward trajectory, although it hasnt reached the danger zone [see chart below]. Italy will remain exposed to financial markets sentiment and, if efforts to reduce the high public debt weaken and economic growth prospects deteriorate further, another sharp increase in Italian bond yields cannot be excluded.
The future reform process: many uncertainties remain
For the time being, Prime Minister Monti has the backing of the main parties to implement his fiscal consolidation/ reform agenda. The next general elections will be in April 2013 and so, for the time being, Italy is expected to enjoy relative political stability. However, there is still a risk that reforms will be watered down by vested interests and social resistance, and so it is likely that the government will pursue a rather cautious approach. And the risk remains of further dilution or even an end to reform efforts if political uncertainty returns after next years elections. Whatever happens, the structural reforms that have been introduced will need some time to start to contribute to economic growth. Therefore, Italys economic growth will most probably remain low in the coming years.
Italian industries performance outlook
For Italian companies, the short and limited economic recovery of 2010 and the first half of 2011 -following the steep GDP deterioration of almost 5.5% in 2009 has not been enough to rebuild cash and capital reserves to face the double-dip crisis. The traditionally geared financial structure of Italian businesses has also contributed to this Situation. We noted that many Italian businesses´ days sales outstanding [DSO] and days payable outstanding [DPO] did not improve in 2010 and 2011, and this signals that funding of working capital remains an issue. Liquidity problems are exacerbated by the fact that payment behaviour is still bad and Italian companies, compared to Western European peers, show a higher average gearing - especially short-term gearing.
However, the Italian economy still has some structural strengths, such as broad diversification, with some unchallenged market champions in the food, textile, metals, and engineering/machines sectors, strong local business districts and traditionally close relationships between banks and companies.
Corporate insolvencies expected to increase 10% in 2012
Since 2008, corporate insolvencies have increased at double-digit levels, and we expect business failures to increase by another 10% in 2012: to around 13,000 cases [see chart below]. Geographically, central and southern Italy are worst affected, as payment behaviour there is on average worse than in the north of the country. The south is also affected by the fiscal pressure exerted by the new government, which is increasingly eroding soft financing and cash recycling opportunities: the privileged funding source for companies in the region.
2013 will see another 5% insolvency increase, due to the expected weak economic rebound. In general, the main contributors to the tense insolvency situation are the current weak economic performance, austerity measures, tighter bank lending, the public sectors poor payment behaviour, increased energy prices, and decreasing demand in some major export destinations.
Expected default frequency for Italian companies
In the first half of 2011, the median Expected Default Frequency [EDF] for listed Italian companies continued its moderating trend, albeit at a slower rate than in 2010. However, since July 2011 the Eurozone debt crisis has led to a massive deterioration in Italian EDF: the December 2011 EDF for Italy [205 basis points] was 112 basis points higher than in June 2011 and even higher than in the wake of the 2008/2009 global credit crisis. Nevertheless, in line with the general trend in early 2012, Italys EDF improved, with the March 2012 figure 30 basis points lower than last December.
The Expected Default Frequency is based on listed companies in the markets referred to, and the likelihood of default across all sectors within the next year. In this context, default is defined as a failure to make a scheduled payment, or the initiation of bankruptcy proceedings. Probability of default is calculated from three factors: market value of a companys assets, its volatility and its current capital structure. As a guide, the probability of one firm in a hundred defaulting on payment is shown as 1%.
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