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Thursday, February 27, 2014

Could Mario Draghi Implementing QE At The ECB Possibly Help Matteo Renzi Raise the Italian Deficit?

What a convoluted title! Still, the lack of formal elegance might just be compensated for by its communicative efficacy. The aim of the above header is to link two names in people's minds, both of them Italian: Mario Draghi and Matteo Renzi. Naturally the idea is not original, the FT's Peter Spiegel  recently published an entire blog post ( Does Renzi owe his job to Draghi?) trying to establish some sort of  connection between the arrival in office of Italy's Matteo Renzi and the recent German Constitutional Court ruling - in the process casting the central bank President in the role of midwife. Indeed, according to the FT,  Italy itself is currently rife with rumours about what might actually lie behind Renzi's meteoric rise, and  again the role alloted to Mr Draghi seems to be  rather more than an incidental one.

But this post is not about rumour, nor is it about speculation - beyond, that is, speculation about what the ECB might do in its campaign to keep the Eurozone deflation menace at bay. Rather than conspiracies (real or imagined) it is about coincidences and the role they so often play in shaping events and outcomes. In this sense the fact that Mario Renzi took over the helm of government in Italy just a short time after the German Constitutional Court ruled on the ECB's Outright Monetary Transactions (OMT) programme has real potential.

What we could call Spiegel's hypothesis suggests the driving force for the "unholy alliance" which may or may not have been forged between Matteo Renzi and Mario Draghi would be found in the latter's interest in getting prime minister Letta out of  office before pressure from within Germany about maintaining open the offer of a legally questionable  OMT programme to an Italy which was enjoying cheaper bond yields but was manifestly not advancing with its reform programme became too strong to withstand.

"Do last week’s German constitutional court ruling lambasting – but failing to overturn – the ECB’s crisis-fighting bond-buying programme and Matteo Renzi’s ousting of Italy’s prime minister Enrico Letta have anything in common? In the view of many ECB critics, particularly in Berlin, the two are not only related, but one may have caused the other."

"The German government has always had a bit of a love/hate relationship with the bond market throughout the four-year-old eurozone crisis. On the one hand, it regarded sovereign bond holders as greedy opportunists looking for German taxpayers to bail out their bad bets. On the other hand, those same traders were a useful tool to keep pressure on wayward governments – particularly Italy – that were in dire need of economic reforms to spur growth."

"In the view of many German critics, there has been no serious effort by the Italian government – be it in the fading months of Mario Monti’s premiership or during Enrico Letta’s foreshortened tenure – to undertake major economic reforms since ECB boss Mario Draghi first announced he would do “whatever it takes” to save the euro in July 2012."

"The bond-buying progamme that the German constitutional court grumbled about last week – known as Outright Monetary Transactions – was the product of that speech 18 months ago and has kept the crisis at bay ever since, helping keep Italian borrowing costs near pre-crisis levels."

Leaving aside the problem of mechanism - how could Mr Draghi or anyone else have stirred up participants in the Italian Democratic Party's primary election - the potential synergy between the two developments (the Karlsruhe ruling and the new government in Italy) is more than evident.

The key part of the background here, as Wolfgang Munchau has already pointed out, is that the German court ruling effectively left OMT - which only ever had a virtual existence and was increasingly seen as an empty bluff since it was clear no one was going to accept the conditionality side - deader than that infamous dead duck. Karlsruhe's objection to the existing bond buying programme was that it went beyond the ECBs mandate since directly financing government debt is prohibited under Maastricht, and the objective of OMT was to help governments finance at an affordable price. Since break-up risk - which could have offered an alternative justification for OMT - is for the moment off the table, OMT lacks definitive legal justification and in practical terms the emperor visibly has no clothes. It is just a question of how long the markets need to wake up to the fact.

Under these circumstances, as one argument would have it, it is only a matter of time before market sentiment turns and peripheral spreads come back under pressure at which point OMT would be tried tested and severely found wanting. While I think this risk to peripheral spreads in the short run is probably overstated (since at this point market participants are so bullish they are effectively immune to flashing red light warning signals), letting Italy simply drift does involve a high level of potential risk, and certainly a higher level of risk than a prudent central banker might want to run. So that part of it I buy: Mario Draghi would be at least rooting for Renzi even if he wasn't doing anything to actively make his wish come true.

But then, enter the deflation threat. The ECB is - and not without justification (see the above chart showing the movement in 5 year index linked forwards prepared by Commerzbank's Michael Schubert) - concerned about the possibility that longer term inflation expectations could become anchored well below the 2% price stability level the maintenance of which the ECB does consider to be its mandate. Aggregated inflation across the 18 countries who constitute the monetary union has fallen and remained below 1% for an extended period of time now. In several EU countries prices have actually started falling, in others inflation has dropped to very low levels of 0.5% or below. Greek inflation is currently running at an annual rate of minus 1.4% and has been in negative territory for eleven months now (see chart above). Worse still, and again as Wolfgang Munchau points out, there is a real risk that the periphery economies drag the German inflation rate down along with them.
"Germany’s federal statistics office said last week that real wages – after inflation – fell in 2013. This was unexpected because other surveys suggested they had gone up. What seems to have happened is profit-related pay and other hard-to-measure components of wages came down last year. For the eurozone, German deflation is a nightmare. If the periphery wants to become more competitive, it needs lower inflation than Germany. But if Germany, too, is deflating, then either the competitive adjustment will not happen; or the whole of the eurozone goes into deflation; or, more likely, both."

"Insee, the French statistics office, announced that the annual rate of core inflation – without volatile items and tax measures – dropped sharply from 0.6 per cent in December to 0.1 per cent in January. Factory prices are another forward-looking indicator. According to data from Eurostat, the EU’s statistical office, they went down in the eurozone as a whole by a whopping 0.8 per cent annually in December." 
 As he says, deflation in Germany would become a true "worst case scenario" nightmare for Euro Area monetary policy. So, with the risk continuing to rise the bank will need to do something, and  some version of Japan-style bond purchases seems to be the most likely thing it will do. Lowering interest rates or more initiating more LTROs simply wouldn't have a big enough impact (which doesn't mean that both of these might not happen taken as part of a broader package. This time the  FT's David Oakley explains:

"At last, after resisting for so long, the European Central Bank looks closer to implementing its own version of quantitative easing to spark growth across the eurozone.................. Investors and strategists expect about 30 per cent of the bond buying will be in German Bunds in a €400bn programme. The ECB would then likely buy about 20 per cent in French Oats, 18 per cent in Italian BTPs, 12 per cent in Spanish Bonos, with the rest being bought in the other much smaller debt markets......"

"The German constitutional court has asked the European Court of Justice to make a ruling on outright monetary transactions, which Mr Draghi introduced as a backstop to the eurozone in the summer of 2012. Although outright monetary transactions would involve buying government bonds, it is not the same as QE as it would be introduced in the event of a run on one or more of the debt markets. The ECB could successfully argue that QE, which involves buying a range of bonds to lift inflation, was within its remit as it is designed to bring about price stability....."
So the initiation of some kind of bond purchases programme at the ECB is looking increasingly likely. If such a programme is implemented it will differ from OMT in the justification offered (to try to attain the bank's inflation objective), the fact that the bank will buy bonds from ALL countries according to their weight in Euro Area GDP, and by the fact that there will be no conditionality attached. Naturally, the fact that they will initiate such a programme doesn't necessarily mean it will work and achieve its objective. As we can see in Japan, the effectiveness of the policy is questionable, but then a central bank can hardly say, "deflation ahoy, but there's nothing we can do about it".

Whether or not it is possible to reflate economies which have entered some kind of enduring process of secular stagnation - as Larry Summers obviously thinks you can (or see here) -  remains an open question as far as I'm concerned. If part of the problem is demographic - as I explain here and here in the context of Abenomics - then it is hard to see how you can. Possible we need to start to learn to live with deflation and find ways of managing the impact on the financial sector. As the FT's David Pilling so cogently put it recently in the Japanese context: "monetary policy can't print babies", and one day or another as our workforces accelerate their decline it may be hard to sustain positive growth. Maybe there are some realities looming out there that we are just not ready or able to accept yet.

But, going back to Renzi, the initiation of sovereign bond purchasing type QE will surely mark the beginning of a Japanese turn in ECB policy. It may start with just 400 billion, but it could then grow and grow, especially if the structural weakness in domestic demand continues to exert a downward pressure on prices even despite the money printing. So just who might benefit from this? Well, you don't have to be excessively astute to see that Italy would be prime candidate. The country currently has a gross government debt to GDP ratio of around 135%, small when compared to Japan's level of nearly 245% but still it is large and rising, especially if Italy continues to push on its fiscal deficit limits. And they will need to do this since there are no signs that the country's economy - like its Japanese equivalent - can grow any faster than it did before the global crisis without ongoing fiscal stimulus. Pushing the debt upward much beyond the current level without being forced into some kind of debt restructuring would seem to be be virtually impossible, unless........... unless the ECB start to buy the bonds. So could Matteo Renzi, who doesn't seem especially worried by the size of Italy's public debt levels be just the man for the job?

The key to the new win-win strategy would lie in the Renzi's aim getting agreement to increase the country's fiscal deficit (rather than as previously lowering the bond spread) in exchange for structural reforms. Basically any ECB Italian bond purchasing would ease pressure on Renzi in the short term. Mario would "have Renzi's back" provided he complied with the reforms. And if he didn't, well then more than likely he would simply go the way of Enrico Letta.

And to those would argue that all of this goes beyond what the German public have come to expect from Euro Area policy, I would suggest that all of what is about to happen was already evident when Mario Draghi used the famous "whatever it takes" phrase. He meant what he said. As I argued in October 2012, in a post entitled "Taking a Man at his Word":
"The heart of the issue is that Mario Draghi has vowed to do enough, and enough seems to have no limits. So what could the ECB do if we really put our imagination to work on the issue? Well like Ray [Dalio] argues, they could print money, lots of it, even to the point of doing it helicopter style. Those people who think the ECB is already printing money (which they aren’t necessarily doing when they increase their balance sheet) ain’t seen nothing yet. That’s what the “it will be enough” promise means. None of this is in the mandate yet, naturally it isn’t, but it could be, and it would be much easier to put more in the mandate than it would be to keep going to the German Parliament to ask for more money. So it could, and most probably will, happen.When you’re crossing that rope bridge and it starts to creak and sway then you just have no alternative but to continue moving towards the other side. We have all seen far too many movies about what happens to the people who try to turn back."

Friday, August 10, 2012

Is The Italian Elephant About To Break Loose Again?

Market nervousness about Italy has been growing in recent weeks, with the Moody's credit downgrade of the country being only  one of the reasons. A bailout is clearly in the offing, with the only real questions being how and when. While the situation inside his country appears to be deteriorating, Mario Monti has been doing the rounds of European capitals in an attempt to drum up support. While in Helsinki he raised an eyebrow or two when he warned that without a serious plan to bring down interest rates disaffection with the euro in his country could easily grow to dangerous proportions. Crying wolf, or a piece of insider information? Probably a bit of both.

Italy is in a deepening recession which has now lasted for over a year. Monti himself  has ruled out the possibility that he could continue in office after next spring's general elections, while at the same time Silvio Berlusconi is constantly hinting that he would not be averse to accepting prime ministerial office again, should his country need him. All of which makes me ask myself just over a year after my "Is Italy, Not Spain, the Real Elephant in the Euro Room?" post, whether in fact the currently chained beast is not about to break its tethers and go for a crockery breaking rumble round the Euro living room.

What follows is a summary of a revised version of a presentation I gave in Cortona last autumn. I have put the presentation online here.

Low Growth And High Debt, A Highly Combustible Cocktail

Just as I highlighted in the case of Portugal in my recent post, Italy's problem is long term growth. This is not a passing phenomenon, but one which has been getting steadily worse over decades. Italy has lost growth at a pace of about one percent a year over the last four decades. If the pattern continues Italy GDP will drop over this decade and continue to do so for as far ahead as the eye can see.

To give us an idea of what this means, Italian GDP at the end of June was at the same level it first reached in the second quarter of 2003. If the current recession continues as forecast by the Italian government during this year, by December we will be below the GDP level of December 2000, which is another way of saying that it will be below the level first attained some 12 years earlier. If the recession is slightly deeper that the current government forecast, and continues throughout 2013 (certainly not an excluded scenario) we might even arrive at levels first seen in the late 1990s.  In the meantime the country's population will have risen from 57 million to 61 million, hence GDP per capita will have fallen substantially. This is not a situation either to be taken lightly, or one which it will be easy to turn around.

There are a variety of reasons for this sharp drop in growth momentum. Some of the reasons are undoubtedly, as I will argue demographic. Others are associated with the loss of international competitiveness experienced by the  Italian economy since entering the European monetary union.

Once clear indication of the extent to which the deteriorating growth outlook is associated with cometitiveness loss is to be seen in the correlation between worsening growth performance and the deteriorating current account balance.

Double Dip Recession

Italy first fell into recession at the end of 2007 – some months before the other Euro Area countries - and didn’t come out of it again till the start of 2010 , so the economy contracted for two full years. GDP fell by 1.2% in 2008, and by 5.5% in 2009.

After an 18 month recovery, the economy again fell into a second “double dip” recession around the middle of 2011, after a surge in borrowing costs forced the government to apply stringent austerity cuts in an attempt to recover investor confidence.

In the three months up to June GDP contracted for a fourth straight quarter, falling by 0.7 percent over the previous quarter. We don't have the detailed breakdown from the statistics office yet, but it seems clear the contraction was again led by sharp falls in consumption and investment as concerns about the fiscal outlook and the euro area crisis depressed confidence and tightened credit conditions.

It is quite possible that Italy will experience a deeper recession this year and next than most forecasters predict (IMF current 2012 -1.9%), reflecting headwinds from the sovereign debt crisis compounded by Italy’s large planned fiscal adjustment. The government will likely miss its deficit targets and even in the absence of any major shocks to yields, the country’s debt to GDP ratio is surely going to increase significantly over the next few years.

Part of the problem is that Italy's fiscal spending has assumed the importance it has in the country's economy due to the loss of international competitiveness. Reducing the government contribution to GDP in this context only makes the economy fold in on itself. More urgent competitiveness raising issues are needed, ones which will bring quicker results than the ongoing programme of long term structural reforms.

So Just What Do We Mean By International Competitiveness?

The issue of international competitiveness is the one which has perhaps caused most theoretical controversy during the current Euro Area crisis, with one side arguing vehemently that some sort of devaluation is essential, while the other argues equally vehemently that it isn't. In the follwoing slides I propose a slightly new definition of international competitiveness, which is to do with having an export sector which is appropriately large given the median population age of the country concerned.

You can enlarge the slides for easier reading by clicking on them, or alternately you can view them via my slideshare version.

Bottom line:
• Median population age is an important economic indicator
• Populations with high median ages tend to be export dependent
• Export dependency gives a better, more precise measure of international competitiveness.
• An export dependent country is internationally competitive when it has a large enough export sector to drive economic growth.

Italy and The Eurozone Debt Crisis

Total Italian debt is not excessive in comparison with some other countries in the Eurozone, but public debt is the second highest.

Despite having normally run positive primary balances

Italy has run general budget deficits since the 1980s

The problem here is the weight of the debt, the burden of interest payments

Italy Is Now Poised On A Knife Edge

Italian gross government debt to GDP is currently perched just under 123% of GDP. The key factors which will influence the future trajectory are GDP growth, inflation and interest rates. With GDP falling, inflation low and interest rates rising the outlook seems quite problematic. Hence The Problem Of Market Pressure, and concerns about interest rates. Italy is currently paying around 6% for 10 year debt issues, and the average maturity of Italy’s debt is 6.7 years, the lowest level since 2005.

The IMF currently predicts that Gross Government Debt To GDP will peak at 124% in 2013. Any significant slippage on this and debt restructuring becomes inevitable. Investors are worried with good reason. Market responses are not just simple speculation. ECB support is critical, but so are radical measures to increase the growth rate.

Too Big To Rescue?

As stated above, Italy shrank further into recession in the second quarter with a 2.5 per cent annual decline. The 0.7 per cent quarterly fall in gross domestic product, only slightly better than the first quarter’s 0.8 per cent decline, means the economy has now been contracting for over a year, and there is at least another year of the same or worse to come as spending cuts steadily bite and the Euro debt crisis rocks its way forward. The recession will weaken tax revenues and hit jobs and consumer spending, a vicious circle which makes it harder for Mario Monti, who is aiming to cut the budget deficit to 0.1 per cent of GDP in 2014, to meet his public finance goals.

Consumer Confidence and PMI indicators suggest that the Italian government’s GDP growth estimates (of a contraction of 1.2% for 2012 and an expansion of 0.5% for 2013) are way too optimistic . The consumer confidence reading was only just up in July from June's 14 year low, and for the first time since the launch of the PMI services survey in January 1998 firms generally expected output to be lower in a year’s time than current levels.

The employers group Confindustria now forecast a contraction in GDP of 2.4% in 2012. A further fall of 2.0% is not unlikely in 2013 as the European debt crisis worsens. Compared to the other forecasters I would be more negative on the outlook for both private consumption and investment activity. In addition, with a more negative outlook for the euro area economy – destination for 43% of Italian exports — these are unlikely to put in an unexpected stellar performance in 2013.

Unemployment Rising Sharply

Italy's unemployment rate hit a record 10.8 percent in June, up from 10.6 percent in May. There were 2.79 million people looking for work in June, according to seasonally adjusted figures -- a rise of 37.5 percent compared to a year earlier. Youth unemployment dropped from 35.3 percent in May to 34.3 percent. These are not yet anything like Spanish numbers, but they are not to be sneezed at either.

The number of people living in absolute poverty in Italy rose to 3.4 million in 2011, or 5.7 percent of the population, up from 5.2 percent in 2010.Those living in relative poverty for Italian standards were roughly stable at 8.2 million, or 13.6 percent. But among families with no workers and no pensioners, the relative poverty rate rose to 51 percent from 40 percent.

Fiscal Targets Look Increasingly Out Of Reach

The implementation of austerity measures in Italy is likely to have a substantial negative impact on the economy in the coming years. Given its lack of competitiveness, the economy lived off constant demand stimulus from the government. Without this the growth problem is likely to become worse.

There have now been five fiscal packages introduced by Italian governments since July 2011, with the objective of a  cumulative fiscal consolidation of some 5.2% of annual GDP (€85.8bn) between 2011 and 2014. With the majority of the measures concentrated in 2012, there will inevitably be a large negative impact on the economy throughout this year.

Given the deep recession the country will be in over the next couple of years and poor potential growth prospects over the medium- and longer-term, Italy’s public sector balance sheet problems are likely to mount. Although the 2011 fiscal deficit of 3.9% was not particularly high in comparison with many Euro Area countries the governments projection of a close-to-balanced budget in 2014 looks hugely optimistic. A more realistic expectation would be for the deficit to be under the EU 3% level at that stage, but the danger is this could well mean gross debt to GDP will be over 130%. Above the danger mark.

The ECB's role in the crisis both helps and doesn't help, depending on how you look at it. They have been very tardy in acting, and normally when they have done so it is been via half measures which have not got to the heart of the problem. The LTROs are a good example. Italian banks have borrowed more than 283 billion euros from the ECB via the 3 year LTROs and other liquidity operations, but this liquidity is by and large used to either purchase government bonds or buy up their own expiring debt. Buying government bonds is attractive since they pay yields which are far above the ECB lending rates. This difference - the so called "carry" -  helps bank profitability and enables them to recapitalise, but it also means that interest rates charged to small business clients rises as they need to compete with the government for funds. Despite the fact that such practices make the banks more "joined at the hip" than ever with their sovereigns, and that their exposure to losses should the Italian sovereign eventually have to restructure rises, they remain attractive because the risk weighting and hence "capital consumption" of public sector lending under the Basle rules remains absurdly low. This is where the real private sector “crowding out” comes.

Banks increased their holdings of the country’s bonds by about 78 billion euros in the first six months of 2011. This forms part of the “nationalisation” of Europe’s sovereign debt markets. Foreign investors cut their holdings of Italian government securities by 18 percent in March from a year earlier, according to the Bank of Italy. In the same month Italian banks boosted them by 39 percent.

Meanwhile, as we can see in the chart above, the rate of new lending to the private sector has been falling steadily, to both households and corporates. As I say part of the problem is that as the recession deepens the credit risk perception of Italian households and companies deteriorates,as the ECB pointed out in their latest monthly report.

The report immediately produced criticism from the Italian consumers’ association Codacons, who complained that the ECB itself had not found a solution to this situation. “If companies are insolvent it’s because banks are strangling them, denying them credit,” Codacons said. Coldiretti, the Italian agricultural association, also estimates that 60 per cent of companies in the sector risk being starved of credit as they face interest rates that are 30 per cent higher than the average of other sectors.

This problem is more complex than it seems. It is not so much a question of credit being strangled, but of demand being strangled as austerity bites. Companies who cannot sell profitably are a high credit risk. There is demand globally, but as I am saying Italy is insufficiently competitive to take advantage of it. Bottom line, the high cost of financing Italian government bonds is pushing up longer term interest rates, and discouraging investment, and this is an issue the ECB could address, by directly buying commercial paper, for example.

Easing In The Bailout

The possible Italian bailout is fast becoming a tricky political issue. The technocratic government of Mario Monti would like to get an MoU agreed before handing the country back to the politicians.

The request for bond buying would involve ECB secondary market purchases as well as primary market purchases by the EFSF. It would also involve a Memorandum of Understanding which would undoubtedly contain strict conditions and an implementation supervision mechanism. The ECB would surely also have a say in those conditions if bank bond purchases were to form part of the package.  Indeed, the ECB has only this week in its August bulletin made clear what it thinks is required. The Bank suggests countries with high unemployment need to “abolish wage indexation, relax job protection and cut minimum wages”. The bank is not impressed with the Italian labour reform, which is too little too late, and thinks direct wage cuts are now the only workable remedy.

Unsurprisingly, many Italian politicians are highly reticent about being seen to hand over their country’s future to an institution with such views, which if implemented would be massively unpopular in the country, so pressure is mounting for Monti not to ask for help. That having been said, the country really has no alternative if it wants to stay in the Euro.

Is Italy Facing A period of Growing Political Instability?

But this is just it, exactly how committed is the Italian political class to staying in the Euro? Certainly it is the one country on Europe's periphery where you can hear speeches from politicians with serious followings questioning whether there are not alternatives. Indeed Mario Monti warned on just this point during his recent Helsinki visit. "I can assure you that if the (bond yield) spread in Italy remains at these levels for some time then you are going to see a non euro-oriented, non fiscal-discipline-orientated government taking power in Italy," he said.

He was, of course, referring to the ambivalence of Silvio Berlusconi on the Euro issue, and the outright hostility to the common currency displayed by the rising (5) star of Italian politics, Beppe Grillio. “After me the populists”, as Monti once said.

A lot of these statements can be read as brinksmanship, but as BofA Merrill Lynch foreign exchange strategists David Woo and Athanasios Vamvakidis warned in a July 10 report, investors “may be underpricing the possibility of voluntary exit of one or more countries” from the currency bloc. And these countries may not be the ones most widely talk about, like Greece or Spain. It was Italy, the euro area’s third-largest economy, which they found would enjoy a higher chance of achieving an orderly exit than others and would stand to benefit from improvements in competitiveness, economic growth and balance sheets.

Woo and Vamvakidis employed a variant of game theory and found that while Germany could “bribe” Italy to remain in the bloc and avoid the fallout from an exit, its ability to do so is limited. That’s because Italy has more reasons than Greece to leave so any compensation could become too expensive for Germany and Italians may be even more reluctant than the Greeks to accept the conditions for staying.

Interestingly enough in this connection Nomura's Jens Nordvig and Nick Firoozye (whose excellent work on Euro break up dynamics unfortunately did not win them the Wolfson Prize) argue in their afterthought essay (Wolfson: What we learned about the future of Europe, Nine specific lessons from the Wolfson Economics Prize competition) that one of the things they learnt from doing the spadework was the following.
"We have constructed a data base of the relevant liabilities for each Eurozone country, and our calculations show large relevant external liabilities in Greece, Portugal, Ireland and Spain. This analysis highlights that currency depreciation following exit from the Eurozone would substantially increase the external debt burden of these countries...."

"Meanwhile, we note that estimated balance sheet effects following exit in the case of Italy and France, are substantially smaller than in other peripheral countries, mainly as a function of the prevalence of local law obligations (which can be redenominated) within external liabilities. It follows that policy makers and investors should pay close attention to the size of balance sheet effect (not only to standard competitiveness and the trade effects) when thinking about the macro impact of specific exit scenarios".
So, summing up briefly, while the Monti Government’s structural reforms are obviously a step in the right direction it is unlikely they will go either far enough or fast enough to significantly lift the country’s potential growth rate from its present lamentable level.  Further, as the April 2013 election approaches  the growing  popularity of new political movements like Beppe Grillo's Five Star one could easily  lead to the kind of political fragmentation already seen in Greece - Italy has hardly been a model example of the two party system -  making the traditional political forces which back the Monti Government even more reluctant to accelerate the adoption of far-reaching reform.

And going beyond April, the political arithmetic of a post Monti government looks complicated, making the kind of stability needed to advance what the population may well see as "harsh" reforms unlikely. In other words, as Monti says, when I go watch out for the populists!

This post first appeared on my Roubini Global Economonitor Blog "Don't Shoot The Messenger".

Wednesday, January 18, 2012

Monti, The Full Version

The version in question is an interview with the Financial Times. A summary was available here, but now they have gone live with the whole interview. If you can raise it on Google or something then it is well worth a read. For one thing it will offer you a trip down memory lane. Anyone remember this? “If you’ve got a bazooka, and people know you’ve got it, you may not have to take it out.” The reference is, of course, to former U.S. Treasury Secretary Henry Paulson, who famously used the remark in 2008 congressional testimony. But as Republican Senator Bob Corker pointed out in a subsequent hearing:
“I do want to remind you that the theory behind the bazooka was that if you have a bazooka in your pocket and the markets know that you have it, you will never have to use it. I would like to point out that you not only pulled it out of your pocket and used it, huge amounts of ammunition was pulled out of the taxpayer arsenal to solve that. I think you’ve done some very deft things and I compliment you on that, but the point is that things don’t always work out the way people, in their best efforts, think they’re going to work out.”
Well, the idea just surfaced again, this time from the lips of Mario Monti:
“I’m convinced, and the IMF is also convinced, that the more pledges are made [to the rescue fund], the higher the volume of pledges made, the smaller the probability that a single euro of cash will have to be disbursed.”
But, as former IMF Chief Economist Simon Johnson once explained, the latest version of the "bazooka" is unlikely to be any more successful than the previous one.
"Today’s proposed bazookas are about providing enough financial firepower so that troubled European governments do not necessarily have to fund themselves in panicked private markets. The reasoning is that if an official backstop is at hand, investors’ fears would abate and governments would be able to sell bonds at reasonable interest rates again. This idea is just as dubious as Paulson’s original notion. Markets are so thoroughly rattled that if a financial backstop is put in place, it would need to be used -- probably to the tune of trillions of euros of European debt purchases from sovereigns and banks in coming months. Whether or not it is used, a plausible bazooka would need to be huge."
Fortunately the ECB has deep pockets, and as I argue in this post, these will probably suffice to keep short term bond yields down to acceptable levels, and help the banks fund themselves and recapitalise. What the ECB's LTRO's won't do is get new credit moving (one significant part of the initiative involves banks in the troubled periphery economies not having to write down the asset side too much too quickly, so there will be little room for "creative destruction"). As fund managers Bridgewater put it recently:

"We believe that a) there are logical limitations to the amounts of debt that creditors will choose to lend to debtors, b) at this time numerous debtors have passed their limits, and c) the projected rates of adjustment that policy makers are using, which generally mean slightly slower rates of increase in indebtedness rather than debt reductions, cannot happen. In other words, despite attempts of policy makers to push this debt expansion further, they can’t. Significant funding gaps will remain....... understandably, central banks are now trying to fill the funding gaps with abundant liquidity. At the same time, banks must contract and consolidate as they can’t adequately recapitalize."
Leaving aside the tricky issue of the extent to which the latest Euro management initiative will work, Monti does have more interesting things to say. He is, for example, quite positive about Standard and Poor's:
“If I ever dictated anything, it must have been what S&P had to say about domestic Italian economic policy,” he chuckles, before quickly correcting himself: “I never said the three letters BBB,” a reference to Italy’s new S&P rating of triple B plus........“It’s very interesting when they go through the various factors, and concerning the political risk factor they say there is one negative: ‘The European policymaking and political institutions, with which Italy is closely integrated’,” he says. “And then they go on, saying, ‘Nevertheless, we have not changed our political risk score for Italy. We believe that the weakening policy environment at European level is to a certain degree offset by a strong domestic Italian capacity’. “I think I’m the only one in Europe not to have criticised the rating agencies,” Mr Monti boasts.”
As Peter Spiegel and Guy Dinmore not unreasonably conclude, the reason for this positive tone is clear: "Mr Monti’s 60 days in office have been enough to convince the agency that his government is on a path of reform that could return the country to growth and shrink its debt levels, but that European Union mismanagement of the eurozone debt crisis is dragging down struggling countries, including Italy with its €1,900bn ($2,400bn) debt mountain".

"Over the course of the 90-minute interview, Mr Monti is careful not to challenge his counterparts directly. Asked whether the S&P analysis is a condemnation of Ms Merkel, who is widely viewed as the driver of the current response to the eurozone crisis, he is diplomatic: “I don’t think we can really single out one country or one person,” he says. Later on, when asked how concerned he is that strikes by taxi drivers and pharmacists could derail his reforms at home, he insists that when he wakes up in the morning, he is more concerned with “European leadership” than domestic unrest. “European leadership – not the German chancellor,” he quickly clarifies."

Monday, December 26, 2011

Italy Braces Itself For The Full Monti

The Italian government, Mario Monti informed the country's parliament last Thursday, is now planning to concentrate its attentions on achieving economic growth. A timely decision this, since the statistics office announcement a day earlier that the country had once more fallen back  into recession, while not being a surprise nonetheless does constitute a cause for concern. Not that Italy is any stranger to recession, since the country has now had five of them since entering Europe's Monetary Union at the turn of the century. In fact the Italian economy has now contracted in eight of the last 15 quarters, and GDP is back in the good old days of 2003, stuck below the level it first attained in the first three months of 2004. And of course it is now going backwards in time again. Depending on the depth of the recession now being provoked it is touch-and-go whether the economy might not at some point even revisit levels last seen in the closing years of the 1990s. And remember, this is not deflation ridden Japan, this is real, not nominal GDP we are talking about here. So far Italy hasn't been experiencing deflation, or at least not yet it hasn't.

All in all, it would be hard to say that the Euro has worked well for the Italians. Maybe it was a great opportunity that the country was unable to take advantage of, but in any event all they are going to see from here on in is the downside part of it. The inability to adjust the value of a domestic currency they don't have to compensate for all that wantonly lost competitiveness means they are going to have to do things the hard way, subjecting themselves to a collective ingestion of codliver oil the like of which the country has not seen since the harsh days of the1920s.

Sinking Below Ground

The extent of the problem the country now has can be easily seen in the chart below, which shows annualised growth over a decade (as a moving average). What is absolutely shocking is that in the ten years  up to 2010 Italy had an average annual growth rate of just 0.28%. Assuming growth of about 0.5% in 2011 (which may now be generous), in the decade to 2011 this will drop to 0.15%, and if we pencil in a contraction of 1% in 2012 (perfectly realistic, in fact it will probably be worse) then the number turns negative. That is to say, on average the Italian economy will have shrunk every year for a decade.

Some may say that this result is in part a by-product of the global crisis, and they would be partly right. But look at the trend over the last three decades, far from seeing some stylised version of steady state growth hovering around a constant mean, the rate of expansion in Italian output has been heading relentlessly downwards, so logically it was always bound to cross the zero line at some point. That point now seems to be about to arrive in 2012, a year which may mark a before and after in modern Italian history.

Naturally, the reason why Italian growth has fallen so far is the big point at issue here. One of the reasons is obviously a competitiveness loss resulting from higher than Eurozone average inflation sustained over a long period, but another component is possibly the impact of population ageing, which has hit Italy more than any other European country except for Germany, and it is with Germany, of course, that Italy has the largest competitiveness loss. Demographically speaking Italy is Germany minus all that export competitiveness.

Looked at from another angle, like many other countries Italy probably grew rather over trend in the years between 2004  and 2007, and then dropped back sharply in 2008. But the Italian economy fell further than most of its peers, and subsequently really failed to recover. This is the clearest demonstration of the competitiveness problem, and it won't be easy to address.

It's The Competitiveness Silly!

As is well known Italy is weighted down by a massive burden of public debt (120% of GDP). Even before the recent surge in Italian bond yields servicing this debt consumed an onerous volume of government income. But this debt alone does not explain why Italy has such a poor track record. Japan, for example, has a debt burden of over 200% of GDP and still manages to eke out a better growth trajectory. The two countries are similar in that domestic demand is permanently weak (they both have elderly populations, with a median age of around 45) yet difference between the two countries is obvious, since Japan (like Germany) has a large and dynamic export sector which generates a trade and current account surplus, and this buoys investment and GDP growth. Italy, on the other hand, has a trade and current account deficit, and both of these have been worsening since the end of the last recession.

Naturally a negative trade balance weakens the GDP reading, given the impact of the net trade effect, but curiously the recent GDP slowdown has been associated with a drop in government spending (which is what previously had been sustaining Italian GDP in positive territory), a fall in domestic consumption, and a consequent fall in imports (which is why the trade balance has been improving somewhat of late). Indeed, the reduction in imports meant that the net trade effect was one of the few positive points in the latest GDP reading - even while the economy contracted by 0.2% net trade added 0.8 percentage points to what would otherwise have been a devastatingly bad number. So there is no need to call in inspector Clusot to find out what happened, it was clearly the sharp cut in government consumption that finally killed off the fragile Italian recovery, although naturally, given that government debt was - and has been for some years - on an unsustainable path, the spending tap had to be shut off at some point. What Italy now needs - like so many of the countries on the EU periphery -  is a sharp improvement in international competitiveness and a significant surge in investment into the export sector. The two of these naturally go together, since few will invest in activities which are unlikely to be competitive and profitable.

Italy does have a stronger export sector than some of its Southern European counterparts, and exports did surge as the global economy started to recover (see chart above), but they never managed to reach their pre crisis level, and now, at least according to the latest PMI surveys, they are weakening once more as the European and global economy slows.

Italy was far from having a consumer boom during the good years of the first decade of this century. In fact household consumption grew by less than 5% between 2000 and 2008, and in any event the pace was much slower than in the 1990s (see the shift in steepness of the slope in the chart below).

Retail sales have been falling since 2007.

And construction spending has been one steady slide down.

And yet, despite all the pressure on Italian banks there is (as of October) no sign yet of a sharp credit crunch affecting either firms or households, since private sector credit is still growing at an annual rate of around 4%, a stark difference from the picture in Greece, Spain, Ireland and Portugal where private sector credit is steadily contracting.

No Boom, No Bust

So to be clear, Italy did not have any sort of housing or credit driven boom during the first decade of the century, Italian households and companies are not massively in debt when compared with their Euro Area peers, and credit is not in especially short supply. Ageing population dynamics lead domestic consumption to be weak in Italy (following a pattern which is strikingly similar to that seen in Japan and Germany), yet Italy's export sector has been allowed to drift as competitiveness has been lost. Really the most telling chart I have is this one, which shows how as the current account surplus has widened (ie as competitiveness has been lost) long term growth has steadily declined.

With neither exports nor private consumption able to pull the economy the state has been under constant pressure to offer support via deficit spending, leading to the accumulation of an unsustainable quantity of government debt. This deficit spending is about to come to an end (permanently according to the latest EU agreement), and under these circumstances the economy is likely to remain in or near contraction for as long as it takes to recover competitiveness. The question is, how long is that going to be, and what will happen to the debt dynamics in the meantime.

To take the second question first, one of the reasons that many are confident Italy will make it on through with the debt challenge is the country's recent record in controlling the deficit. According to OECD data, while Italy ran a cyclically adjusted primary deficit every year between 1970 and 1991, it ran a cyclically adjusted primary surplus every year since 1992. That is to say, before allowing for interest payments Italy has not been running a deficit for many years now, and it is simply the burden of servicing the accumulated debt which is causing the country to spend more than it receives in revenue. As many of those who are in the "optimistic" camp on the question of the country's ultimate solvency eagerly point out, Italy’s cyclically adjusted primary balance as a proportion of GDP has remained in a better shape than those of the largest developed countries as well as those of European peripheral and core countries since the onset of the crisis. It is only the legacy of the past which acts like a dead weight pulling the country down, but what a legacy this is, and especially as yields on Italian debt have steadily risen.

Poised On A Knife-edge

But given everything it is clear that Italian debt, and with it the future of the Euro, now sits poised on a knife edge, as is illustrated in the chart below (which comes from Barclay's Capital). If you take a neutral scenario where Italy has a balanced budget and a sum total of zero nominal GDP growth (ie growth+inflation = 0) debt stays put at 120% of GDP out to infinity.

But then imagine the average finance cost of Italian debt rises, and stays high. In this case  the only way to compensate  is by running a larger primary surplus (ie more spending cuts, or revenue increases to compensate for the extra interest cost). The net effect of this would either be to generate deflation or a more sustained economic contraction, in which case debt to GDP would start to rise indefinitely. Think of it like this, either prices fall by one percent and GDP (via exports) rises by 0.5% (for example), in which case nominal GDP falls 0.5% a year (the Japan type case), or prices rise by 0.5%, exports lose more competitiveness, and so growth falls by 1%. I mean, this example is only illustrative, but it is meant to give some sort of feel for what "knife edge dynamics" really mean.

In fact, before the recent surge in the spread, average interest costs on Italian debt had been falling in recent years, but now they are evidently rising again. It is very important here to remember that  yields in bond auctions only affect new emissions of debt (and changes in the secondary market only really affect banks, and sovereigns through possible needs to recapitalise banks). So it is a question of years before the higher levels "lock in" - the average maturity on Italian debt, for example, is around 7.2 years, and indeed since governments finance at fixed and not floating rates (not at a certain % above 3 month Euribor, for example), debt costs are at much at risk from increases in ECB base rates as they are from the actual spread with German bonds. Any substantial increase in interest costs naturally makes selling debt more expensive. Fortunately for peripheral sovereigns, the likelihood of ECB rate rises in the foreseeable future is near to null.

No Way Back Home

But again, let's do another thought experiment. Imagine I am right, and  Italian debt is on a knife edge path, and suppose the average interest rate on the whole debt creeps up by 1 percentage point. With debt at 120% of GDP, then the primary surplus to cover the added interest costs and maintain a balanced budget would be 1.2% of GDP. But suppose, for the sake of argument, that increasing the primary surplus by 1.2% pushes Italian debt to gdp up to 125% (via a combination of either deflation or economic contraction), then the next year the primary surplus would need to be up by an additional 0.05%, helping force debt to GDP up even further and so on and so forth. This is why people call this the debt snowball. The point is, whichever way you turn, you seem to find the exit door locked.

Coming back to the details of the present situation, the Italian government has committed itself to a consolidation program worth €74bn over the next two years amounting to roughly 3.7% of GDP. This is designed to bring the budget into balance (or the deficit to zero) by the end of 2013. On quite conservative assumptions, just to tread water, and maintain the debt level where it will be in 2013 (which will be more than 120% of GDP due to the recession), Italy will need a primary surplus of 2.3% of GDP.

But then we need to think about the recently undertaken commitment to reduce the debt (the last EU summit). The exact numbers have yet to be agreed for the new pact, but it looks like a cyclical maximum of 0.5%, and (even more importantly) a commitment to reduce outstanding debt over 60% of GDP by 5% a year. This, in Italy's case will mean the country is going to need (from 2014 onwards) a primary balance of something like 5.5% of GDP (depending on the evolution of interest costs) over the rest of this decade. Which means the Italian economy is going to face an even more restrictive fiscal environment.

Now, those who argue the Italian crisis will have a happy outcome point to history, and argue that Italy was able to achieve a primary surplus of around 5% on average during the years 1995-1998, so why shouldn't the country be able to do this again? The main counter argument would be that that was then, and this is now. That is to say, these were the years of Italian "coupling" with monetary union, sizable privatisation programmes, falling (not rising) interest rates, and basically Italian trend growth had not fallen as far as it has now.

Moreover, the external environment in Europe will not exactly be conducive to boosting exports. Even core Euro Area countries are commited  to undertaking additional fiscal consolidation beyond what is currently envisaged in order to comply with the new debt rule. Taking 2014 as the starting point, debt to GDP for the Euro Area as whole might be something like 90%. Hence the 1/20th rule would imply that on aggregate the Euro Area will need to reduce its debt ratio by around 1.5 percentage points per year. If this agreement is complied with the adjustment will almost certainly imply a net fiscal drag on growth in the years following 2013. Of course, if it is not complied with then it will almost certainly be "bye bye Euro" (assuming the common currency still exists that far up the road).

It's All About Structural Reforms, Or Is It?

So basically, what the whole argument about whether or not Italy can make a final burst and reach the finishing line is all about structural reforms, and whether the country can get enough growth (quickly enough) to turn the "knife edge trap" around. Personally I am extremely doubtful that it can, which is why I placed so much emphasis on the growth performance in the first section. The turnaround needed here is massive. It is a 30 year decline we are talking about, and I doubt short of outright default and substantial devaluation we have historical examples of anyone doing this. The adjustment made in Germany between 1999 and 2005 was much smaller in comparison.

One of the proposals is to introduce labour market reforms to increase participation rates, but in fact the Italian labour force grew substantially between 2004 and 2008 (due to large scale immigration), with employment being up by over a million (or around 5%, see chart above), yet the increase in output was ridiculously small. On the other hand we know the Italian working age population is contracting (and the average age rising), while the elderly dependent population is increasing rapidly. Conventional economic models tend to be silent on this issue, but common sense should tell us that this is going to take its toll on growth - a factor the "structural reform answers all our problems people" don't seem to have given enough thought to.

The Monti government needed  just five weeks in office to push through an additional 30 billion-euro emergency budget package, but how long will he need to get GDP growth back up above 1% annually? And how much time does he have? Investors initially cut him some slack, but judging by the reaction to the final approval of the package by the Senate - the yield on Italy’s 10- year benchmark bond was pushed up by 12 basis points to 6.91%, dangerously close to the key 7% level (although still somewhat below the Euro era record hit on November 9, just before Monti took charge). 7% is  widely considered to be critical if sustained for any great length of time, partly due to the cost of debt servicing but also because of the level of dependence of Italian banks on the ECB that it would produce.

Till The Dowgrades Fall

So the "Full Monti" effect now seems to have  been priced in, while investors nervously wait to see what the real plan for Spain and Italy actually is.

The first quarter of 2012 looks to be critical for Italian debt, with about one third of the total Euro Area debt maturing being Italian. Indeed the battle starts this week with the Treasury having to sell an assortment of T-bills and 2 year and 10 year bonds. In addition the Italian government is now increasingly guaranteeing bonds issued by Italian banks to be used as collateral at the ECB  - with about 40 billion euros being issued last week according to some estimates. So effectively Italy is now more or less guaranteeing the banking system with the likely outcome that ratings agencies will be even harder on the sovereign rating.

Not that the outlook was exactly bright on that front anyway. Understandably, Italy was among the 15 Euro Area countries Standard & Poor’s placed on review for a possible downgrade on December 5. This follows an earlier downgrade to a single A by the agency in September. In addition, Spain and Italy were both warned by Fitch (which cut Italy's rating to A+ on October 8) on December 15 to brace for a further debt downgrade after concluding that a "comprehensive solution to the eurozone crisis is both technically and politically beyond reach". And to complete the set, Moody's, which cut the country to A2 on October 4, maintained a negative outlook, signifying that a further dowgrade in the coming months was highly probable  The bottom line is that Italy is both too big to fail and too big to be bailed out, which is why it is still hanging dangerously in limbo-land. Since, as I argue in this article, some sort of restructuring or other is well nigh inevitable in the Italian case, the sooner Europe's leaders work up a credible plan on how to achieve this, the better. Otherwise it will not only be Italy's citizens who are subjected to the Full Monti, Europe's leaders may also find themselves with their credibility stripped naked.

This post first appeared on my Roubini Global Economonitor Blog "Don't Shoot The Messenger".