Since the beginning of this year there has been a considerable improvement in a measure that was previously widely used to judge the Italian economy. If we look at Italy’s ten-year government bond yield it reached a peak of 7.38% in late November 2011 and then another peak of 7.17% in early January but has now fallen substantially to 4.85%. The fall in her three year bond yield has been even more spectacular as it has plummeted from 7.72% to 2.72% and if you were holding these large profits were available in a short space of time. However for the Italian government this represents a considerable improvement as it is now much cheaper for it to issue debt and its financial position is accordingly improved.
Is there a “rub” as Shakespeare put it?
The “rub” is that a false market in Italian (and other countries) debt has been created by the European Central Bank with its two large monetary operations which offered cheap (initially at 1%) three-year liquidity. Some of the over 1 trillion Euros supplied was used in what is called the Sarkozy trade where it was invested in higher yielding government debt. If you look at the high for 3 year Italian debt yields of 7.72% and you can fund it at 1% then one can see why banks would find such a trade attractive. For those who want the full details I discussed it in the article linked too below.
So this policy has helped achieve two main objectives. It has courtesy of the largess of the Euro zone taxpayer supported and improved the Italian government bond market and hence her public finances and done so via providing easy profits for Italian (and other) banks. So we have themes which are rather familiar which is that you could argue that this is a bank support operation which happens to have helped Italy! And that we have a can which has been kicked three years into the future.
Italy’s Economy
In the past I have established the view that Italy has been a slow growth economy with high levels of public debt. The latest economic growth figures only reinforce that view. From Istat.
In the fourth quarter of 2011 the seasonally and calendar adjusted, chained volume measure of Gross Domestic Product (GDP) decreased by 0.7 per cent with respect to the third quarter and by 0.4 per cent in comparison with the fourth quarter of 2010.
On a quarter on quarter basis there was a possibly ominous note to this as imports fell by 2.5% and exports were stationary. Falling imports improves GDP all other things being equal so we had a flattering influence whilst there was no sign of what is called “export led growth”.
If we look back we see that in the last three quarters of 2011 Italian economic growth went -0.2%,-0.4%,-0.7%. If we look forwards we see most forecasts are now for a decline by 1 to 2% in 2012.
A “lost decade”?
We see that in the period 2002 to 2010 Italy’s GDP barely rose moving as it did from 1,218,219 million Euros to 1,221,158 million using the year 2000 as a base. But if we add in that her economy had a fourth quarter in 2011 that was weaker than the same quarter in 2010 and looks as if it will shrink again in 2012 then are you thinking what I am thinking? 2012 could be weaker than 2002 in absolute terms and Italy will have had her own “lost decade” and a European economy will have mimicked at least partially Japan’s experience in the 1990s.
The latest evidence
One industry that is often seen as a trigger for other parts of the economy is construction and if this is so then 2012 has not started well.
In January 2012 the seasonally adjusted index decreased by 7.8% compared with the previous month…… The calendar adjusted index of production in construction sector decreased by 10.9 compared with January 2012 (calendar working days were 21 versus 20 in January 2011).
So in spite of having an extra working day the unadjusted numbers were still lower. Okay, so lets try industrial production.
In January 2012 the industrial production seasonally adjusted index decreased by 2.5% compared with the previous month….. The calendar adjusted industrial production index decreased by 5.0% compared with January 2011 .
We are not getting much release from a gloomy picture here and if we try to look forwards we can use the composite Markit purchasing managers index. Here are their thoughts based on a mid-February survey.
Italy and Spain both registered further sharp falls in new business, and stronger rates of contraction than in January.
The actual reading for Italy was 44.7 on the overall composite indicator where 50 is the benchmark between growth and contraction.
So we can see serious challenges going forwards and it comes on top of what was in itself considered a difficult year,2011. If we look at the latest numbers for unemployment we see an unemployment rate which is was 9.2% in January and that the number of unemployed had risen by 14.1% or 286,000. Sometimes these days unemployment numbers are seen as a leading indicator rather than a lagging one.
High public debt
In another repetition of the Japanese “lost decade” experience low or as I have observed above possibly no or negative economic growth has been combined with a high public debt level. The latest figures from the Bank of Italy show it to be 1.936 trillion Euros and the rise is partly technical this month but is in something of an irony also partly due to her share of other Euro zone bailouts. We are back to my simile of an unstable lifeboat here.
At the end of 2011 Italy had a national debt to GDP ratio of 120.1% and with debt growing and output shrinking she faces real challenges in 2012. If Bloomberg news is correct she can little afford to cancel and repay derivatives contracts with Morgan Stanley which have apparently just added about 2.5 billion Euros to her national debt. Am I the only one thinking of Goldman Sachs and Greece here? Yet again sovereign nations are weaker and banks emerge with a pile of cash.
Fiscal deficit and austerity
In 2011 Italy ran a fiscal deficit of 62.3 billion Euros or 3.9% of her GDP. So by the standards of her peers she is in relatively good shape and is not far from the original Growth and Stability Pact target on this measure. And yet she plans some 30 billion Euros of austerity measures which are split 2/3rds expenditure cuts and 1/3rd tax rises.
Why?
In essence this was driven by the size of her debt and fears over her bond yields. The problem it creates is that Italy is trying to apply it in an economic contraction and we all now know what the result of such a strategy has been in Greece and indeed Portugal. The danger is that we see the same downwards spiral of austerity leading to further economic contraction leading to the perceived need for more austerity and repeat.
In such a scenario we would see Italy’s national debt to GDP ratio rise quickly and we would therefore see her trampling the same dangerous road that the Hellenic Republic is on.
Comment
Whilst there has been a perceived improvement in Italy’s position as measured by the yields on her government bonds much of this represents the creation of a false market by the actions of the European Central Bank. Also her technocratic Prime Minister Mario Monti has bathed in the praise of his peers but let us recall that at the same stage so did the Greek Prime Minister and the dangers are similar.
Italy does have strengths that Greece did not as she does have a private savings culture and she has the opportunity to reform her economy and to tax at least part of her black economy. The size of a black economy is by its very nature hard to quantify but most estimates in Italy are in the range 20 to 25% of GDP.
As you can see reform which led to at least some of the black economy being moved from the “dark side” would transform Italy’s economic outlook. The problem is that it is not looking very likely as Euro zone austerity has completely failed to make any real progress on this front in Greece. Accordingly the one real solution is for Italy to have her own debt haircut to reduce her national debt to GDP ratio back to 100% and to do it early rather than too late.
The problem is that so many other countries need the same medicine.
Crazy thinking at the IMF
Somehow or the other the IMF had to make Greece look better off in 2020 and 2030. Checking its spreadsheet last night I notice that in 2010 she apparently had a positive output gap and that her output was accordingly above maximum/trend…..?
