When Erik Nielsen writes about Italy, it is always worth (and it pays well) to listen carefully.

Hence, let me quote his most recent “Sunday Wrap”, this time dedicated to Italy.

The European project is 60 years old this weekend, the sun is shining and massive celebrations by political leaders and ordinary folks have been taking place across Europe.

Newspapers and other outlets are also celebrating, but mostly by questioning the future of European cooperation, as they dedicate a disproportionate amount of concern to Italy.

Last Sunday, I argued that the global economy is recovering strongly, including in the Eurozone (further evidence of that with Friday’s PMIs) and that the political risk in Europe has shifted from downside risk (of a Le Pen victory in France) to upside risk (of a strongly pro-EU French presidency along with a German government coalition more closely aligned with the rest of the eurozone.) And the overwhelming feedback was along the lines of “yes, broadly agreed, but what about Italy – you didn’t mention Italy. Italy will surely ruin the party”.

So let me dedicated today’s note to Italy.

I’m not going to argue that everything is fine, but I’ll argue that the Italian reality is quite different from the (too simplified) perception expressed in much of the investment community and in the Anglo-Saxon media.

Let me start by noting that putting Italy in the proper perspective feels a bit like a discussion we have had before. Not to pick on anyone in particular, but Dan McCrum’s piece in this weekend edition of the FT (“Analysis: Italian angst refuses to go away”) is a good example of the received wisdom:

It starts with a story of someone walking into a New York equity hedge fund in July 2011 only to find that these guys were not focused on equities, but all about shortening Italian sovereign debt. And it proceeds to argue – via a good line-up of fund managers and other experts – that Italy is again about to cause big trouble in Europe.

Well, that line of argument didn’t work out very well in late 2011 – and it’s no more likely to work out well this time.

As I argued in a note in October 2011, it made no sense that Italian 10-year yields were north of 5 ½% when e.g. 10-year Gilts traded with yields at 2.35%. I suggested that they should probably trade at broadly similar yields. I called my note: “Italy versus the UK: What am I missing?”

That note caused quite a debate at the time. Most thought I got the economics all wrong, but FT Alphaville mostly agreed with the macro part, although they suggested that the yield difference could be justified by the unpredictable and messy Italian politics. (The FT’s piece from October 10, 2011, is here, in case you are interested: https://www.ft.com/content/7f3d0d04-ef79-11e0-941e-00144feab49a)

The point on politics seemed a fair comment in late 2011, but I am less sure today. While Italian politics still seem messy, Berlusconi left and a number of government have since implemented a fair amount of reforms, while keeping the fiscal side in check. And we have a powerful display of Eurozone progress since then, ranging from the introduction of the OMT at the ECB to the ESM. Meanwhile, the UK chose Brexit and its politics must today range among the most unpredictable and messy ones around. But more on politics below.

Fair or not, I can’t help but reminding those hedge fund guys referred to in McCrum’s piece that if had had bought 10-year BTPs in late 2011 (instead of shortening them), they would have had an average annual return of 8.5% until now (which would have beaten most hedge fund returns), vs. a 4.4% annual return (in sterling), if they had bought Gilts (4.1% in euros). If they had bought Italian equities (MSCI) back then, they would have returned an annual average of 4.7%, while the MSCI-UK would have given them 6.3% in euros. (For good order, I have also had my share of poor calls along my way.)
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But let me now turn to the present and the future for Italy, and specifically to the four key perceptions of Italy. I address them in turn::

■ Italy has suffered decades of stagnant-to-no-growth and there is little hope of improvement because Italy has become uncompetitive, tied down in rigidities.
■ The public debt is excessive, probably unsustainable and definitely weighing on growth.
■ Italian banks are unreformed zombies, weighing on growth as well and possibly causing systemic threats.
■ The politics is a mess and the population is about to vote Italy out over the deep end and into the unknown abyss.
I attach a number of charts from the impressive library of our Lead Economist for Italy, Loredana Federico, to illustrate my points below. The charts are pretty self-explanatory and I won’t refer to them all – and I’ll try to address each of the four (mis)perception in a way that does not require that you look at charts at the same time reading the note. The charts are here: Italy – Perception and Reality
1. Italian growth: Why it has been weak – and why the short and medium-term outlook is okay.
Italy has suffered more than two decades of growth below its European peers, as illustrated in charts 3 and 4. Importantly, however, it’s not like Italy never grows. Rather, the picture has two key messages: First, almost every year, real GDP growth (whether total or per capita) has been positive, but a bit below the rest of the Eurozone, and, second, Italy suffered two more severe crises than the rest of Europe, obviously taking down the average for the period.

The low average has two distinct characteristics: A structural weakness and a cyclical one. I am going to argue that some of the structural weakness has now been addressed, and that there are some low-hanging fruit, which could be dealt with quite easily, providing substantial upside. And I’m going to argue that the cyclical downturn is over for now.

First, the structural stuff: At just below EUR 26,000, Italian per capita GDP is about 12% below the eurozone average. This lower level of average national income is predominantly explained by a lower participation rate in Italy – at 65% vs. 73% for the eurozone average: If a smaller share of the population works, it’s no surprise that the average income for the entire population is lower. (Interestingly, those who do work in Italy, work considerably more hours per year than in the rest of the eurozone – all illustrated in chart 5.)

The low participation rate in Italy is predominantly an issue of almost half of working age women not participating, although the rate has been drifting higher in recent years, as illustrated in chart 6.

Structurally, the single most important thing the Italian government could do for growth would be to encourage women to participate actively in the labor market, e.g. via changes to taxation for couples, provision of more affordable child care, etc. Broadly speaking, if Italy manages to lift women’s participation rate to German levels during the next ten years, it would add about 0.7pp to annual GDP growth, even if only half of those entering the active labor force actually got a job. That’s stuff that needs to be done!

Other parts of the structural weaknesses have already been addressed to some extent. The lazy commentator always seems to talk about rigidities in the labor market and/or general competitiveness of the Italian economy.

Yet, as illustrated in chart 7, on OECD data, following the Italian Jobs Act, Italian labor market rigidities are no worse than, e.g., Germany and Sweden, and less severe than, e.g., the Netherlands. Of course, it’ll take a year or two for the positive effect of these changes to fully kick in, but there is no reason not to expect that that will happen.

And yes, competitiveness was an issue in the past, but with reforms and the weaker euro, since 2014, Italian export growth has comfortably outpaced global import growth, meaning that Italy has been gaining market share around the world in traded goods (illustrated in chart 8). That’s hardly consistent with a claim of being uncompetitive!

And now the cyclical story: Yes, it has been ten brutal years for Italian households, first as the global financial crisis hit, and then as the European sovereign crisis forced then PM Monti to introduce eye-watering tough fiscal tightening. As illustrated in chart 9, real disposable income took some severe hits during those two periods, and Italian households adjusted their real consumption broadly in sync, although cushioning the blow a bit by lowering their savings rate from around 14% to 10%-11%. Now, real disposable income is growing nicely again, providing a solid base for growth in consumption – and maybe some restoration of savings rates back to traditional very high levels.

So, not surprisingly, Italian PMIs are moving higher in line with the rest of the eurozone, having now passed 55, which for Italy is consistent with annualized GDP growth of close to 1.5% (charts 10-11). For a country with virtually no population growth, that’s not bad because it’s mostly, therefore, productivity growth.
2. The public debt: Bigger than desirable, but less of an issue than the number suggests.

Few things dominate the conversation with casual observers on Italy more than the public debt, standing at 132% of GDP, which is the second highest in the eurozone (chart 15).

There are two – related – key issues when it comes to the public debt, namely sustainability and whether it is a drag on growth, which could make the sustainability concern self-fulfilling.

To be sure, public debt to GDP in Italy is a lot higher than desirable, but the related issues deserve much more attention than what transpires from just one number.

First, the issue of debt sustainability: Debt sustainability is a simple function of nominal GDP growth, primary surpluses and funding costs over the cycle.

As argued above, the Italian recovery is in good shape, and structurally, there is no reason to think real growth will not be (at least) about 1% over the cycle, and that the GDP deflator will move closer to 2% as the output gap closes. (Importantly to any skeptics out there, it not reasonable to both argue that Italy’s potential growth is very low, and that inflation will never pick up – output gaps do matter!) That gives you a nominal GDP growth rate of close to 3%. But for these calculations, let’s be conservative and call it 2.5%.

Neither is there is any particular reason to worry about the fiscal stance. As illustrated in chart 16, come rain or come storm, Italy has been running one of the largest primary surpluses in Europe – in spite of changing governments. Keeping a steady primary balance does not take much political effort, and it has no net impact on growth. Indeed, when the cyclical upswing comes through, the fiscal balance tends to strengthen for a while.

There is – of course – greater uncertainty with respect to future funding costs because these will increasingly be set by markets as the ECB begins to taper – and in markets, perception is sometimes more powerful than reality. This is an area that I think deserves attention. On balance, however, I’m not worried because with the growth and fiscal outlook, there is good room for yields to move higher without triggering an increase in debt/GDP:

First the simple math: With nominal GDP growth at about 2.5% and a primary surplus of, e.g., 1.5%, as was delivered in recent years and as the European Commission forecasts for this year, debt-to-GDP will not rise so long as the average funding cost does not exceed 3.9%, or about 100bp higher than today. If the average funding cost were to settle over multiple years at, e.g., 4.5% while neither real GDP growth nor inflation moves higher (i.e. still sticking with the conservative 2.5% for nominal growth over the cycle), then the primary surplus would have to be increased to a range of 2.0%-2.5% of GDP, which would not be an insurmountable task in any normal political set-up.

Second, as Italian cost of issuance almost certainly begins to increase later this year with expectations of ECB tapering, remember to use for this calculation the average cost of the debt, rather the cost of issuance. As illustrated in chart 17, the average cost is, of course, higher than recent years’ cost of issuance (because of QE) – and, incidentally, it has fallen less than the marginal cost because Italy has – wisely – used the opportunity of low yields to lengthen the average maturity, which now stands at the eurozone average of 6.7 years. This means that it’ll take several years of higher cost at issuance before the average of the entire stock moves measurably.

Third, if markets were to get on a self-fulfilling, yield-increasing, upward spiral, which challenges sustainability, the ECB has the OMT with which to knock it back. To be activated, the OMT requires the country to have a program with the ESM, which includes policy conditionality. My view is – firmly – that if Italian funding costs, over an extended period of time, move away from underlying fundamentals and the Italian policy stance – as judged by Frankfurt, Berlin and Paris – then an ESM program will be agreed swiftly with conditionality basically in line with those existing policies. (If the yield increases are caused by policy slippage, however, it’s a different story, which I’ll return to in Section 4 below.)

Then there is the issue of whether the debt is a burden for growth, as suggested by some. To answer that question you have to consider whether the debt is held by domestic or by foreign creditors – i.e. whether the debt service payments are payments to economic agents in the country (which wouldn’t hurt growth per se as it’s a “simple” domestic reallocation issue), or to foreign creditors (which is equivalent to a tax on the economy.)

As illustrated in chart 19, only 33% of Italian public debt is held by foreigners (down from 47% six years ago). And even better, 11% of the debt is now held by the Eurosystem (which means that interest payments are virtually recycled via the central bank and higher profits back to the budget, at zero cost.)

Finally, there is surprisingly little attention paid to the issue of the governments’ contingent liabilities; i.e. entitlements stemming from the aging population in the shape of future pensions and healthcare costs.

By any reasonable political calculation, such liabilities put a burden on fiscal policies which easily matches that posed by explicit debt obligations. As illustrated in chart 27, on IMF calculations, the net present value of such contingent liabilities stands at just below 40% of GDP in Italy, which is well below most other countries. This leaves the Italian government a degree of fiscal flexibility not enjoyed by most other countries (but not used), and broadly matching the lack of flexibility usually highlighted by the existence of the contracted debt.

3. The banks: A political dilemma, but not a financial or systematic one.

My bottom line on Italian banks is that it’s a political dilemma because successive governments didn’t recapitalize the banks they wanted to keep (and close the rest) at the time when everyone else in Europe mobilized taxpayers’ money to fix their banks – but it is neither a systemically important issue, not is it a measurable issue for Italian growth.

First the NPLs: On latest available data (at mid-2016), the Italian banking system had EUR 356bn in NPLs, split between EUR 214bn of “bad debt” and EUR 142bn of “less troubled debt”. (The number now is lower, not least because one fine bank has taken matters in its own hands and started a restructuring process, which included a sale in December of about EUR 17bn of NPLs.)

If you account for the coverage ratios for the two categories of NPLs, and assume you can sell the rest for 20 c/euro for the “bad debt”, and for 40 c/euro for the “less troubled debt”, then the total bill for cleaning up all Italian banks for all NPLs stands at EUR 95bn, or 5.5% of GDP (illustrated in chart 28.)

Nobody is suggesting that this is the route Italy should take, but it puts the magnitude of the problem in perspective. As illustrated in chart 29, there is hardly a country (apart from Italy and France) which did not spend 5.5% of GDP or more on their banks during the crisis, and only the US, Belgium, Spain and the Netherlands have since recovered enough to now be sitting on a net bill of less than 5.5% of GDP.

In other words, putting the politics of bail-ins aside, the size of the key issue in Italian banking is not even remotely a systemic one out of proportion to what virtually all other European countries have been through. (If deciding to eliminate the NPLs by providing government guarantees for them, Italy’s place on the list of government’s contingent liabilities would not even move one place, as illustrated in chart 27.)

And is it an issue for the economy (apart from what damage the issue does to perception)? I find that hard to argue. There is a lot of noise in the Gross Value Added (GVA) data, but as illustrated in chart 30, Italian banks (and a few others boxed into this category) contribute about 3.8% to the country’s GVA, ahead of the eurozone average.

All this is not to say that medium-sized banks do not need to be sorted out, but the magnitude of this task is not of systemic proportions. The issue is that Italy signed on to the bail-outs-only-with-bail-in (in spite of the large number of households holding bank securities in Italy) – and that has turned into a political issue – and one of perception.

4. Political risk

And that leads me to politics, which is – undeniably – complicated in Italy. But, again, you need to put this in perspective – like most business people seem to do:

In the most recent survey, out this past week, by the Economic Research Council, of 600 eurozone based firms’ perception of political risks to their business (conducted between mid-January and mid-February), 28% named Brexit as their key concern, 27% named Trump and the US administration as their key concern, 18% worried mostly about the minority government in Spain, while 17% named the Italian political climate as their key concern (less than 15% worried about the French election). To me, that ranking is about right.

Let me first make three points:

First, I suggest one has to be careful not to feel too certain about the predictability of shifts and movements in the political landscapes these days; after all it is the UK and the US – and so far none of the Western European countries – that has fallen to populism, and just as most people thought Austria would elect a nationalist president, and the Netherlands a xenophobic party as their biggest, the tide seemed to turn. Also, as illustrated by the opinion polls in France and Germany, the population seems quite happy to embrace a pro-European political line, so long as it’s delivered by relatively newcomers.

Second, while there is not any great difference between the share of the population actually supporting populists (with the exception of Germany), whether populists actually gain power or not largely depends on the institutional specifics of the democratic systems in each country. Trump lost the popular vote with almost 3 million votes, but won the election. The UK is throwing into jeopardy decades of policies – with huge inter-generational consequences – on the back of a single, simple-majority guiding referendum, something that would run into constitutional barriers in any of the Continental European countries.

Third, from a markets perspective, the Italian political landscape is more complicated – and indeed, on the face of it, more troublesome – than in most other countries because of two issues: (i) They have no less than three nationalist, or populist, parties, namely The Five Star Movement (M5S) with a support of about 30% of voters, the Lega Nord (LN) with about 12% support, and the Brothers of Italy (FdI) with about 5% support. But while that adds up to almost 50%, it is difficult to see a scenario in which these three parties would cooperate; and (ii) the mainstream parties are presently in a good deal of disarray as the Democratic Party (PD), now with about 25% support, has split, while Forza Italia (FI) continues to struggle with support of only about 13%. At the same time, the cumbersomeness of policy making in Italy, which many would argue is one of its weaknesses, is also safeguarding against too radical changes – which may turn out to be one of its strengths.

With the caveats of all this, I think the most likely outcome of the next election in Italy (latest by spring 2018) will be an extended period of either a caretaker government or a rather ineffective one, held back by one or the other chamber of parliament. For a year or two, that’s not a major issue when the underlying macro balances are okay and the recovery is under way – not least in a scenario where a new German-French initiative next year seeks to deepen the eurozone policy set-up, e.g. via the completion of the banking union, capital markets union and possibly a set of labor market and social policies, maybe via a “Juncker Plan” for youth unemployment and targeted public investment.

For M5S to gain power they’ll have to break – in this environment – the apparent glass ceiling of about 30% support (not made easier by the trouble they have administering Rome) and move through 40%, and/or break their pledge not to go into a coalition. I’ll happily bet my money against M5S getting more than 40% of the votes – and it takes quite some imagination to see them co-govern with any of the potential parties sharing their anti-European views.

But if it happens – you would expect them to try to deliver a possible exit from the euro. But they’ll be unsuccessful because it would require changes to the Italian constitution, which entail a long process, as we were reminded of last year, with two rounds of voting in both chambers of parliament and a wide parliamentary majority (a 2/3 majority is needed), if not a popular referendum will be required. To believe that they would be able to pull this off, you’ll need to create a political earthquake-like scenario. Possible? Sure, but very unlikely indeed.

But while almost certainly unsuccessful in this endeavor, a populist government would likely introduce market unfriendly policies, thereby challenging the “European consensus” – and most likely trigger ratings downgrades. My guess would be that – just like in 2011 – market pressure would win out. Maybe there would be a program (or a shadow program) with the ESM, and maybe we would have to go through a couple of iterations of policy changes, but chances are that we would then reverse to better policies again.

Just over five years ago, the hedge fund community was betting on a collapse of the eurozone, but it didn’t happen. Two years ago, they were betting on Greece leaving, but it didn’t happen. Then – as I argued last Sunday – we got Brexit, Trump, a radicalized Erdogan and PiS in Poland, and voters (actual and in opinion polls) in Western European seemed to pull back from the populists once they saw their unpleasant faces.

It seems an odd time to double-down on people’s long-held (but misplaced) skepticism towards the political commitment to the European project.

But there is one odd – if not completely serious – thing about Italy: By most important indicators and any casual observation, life is very good in Italy – but Italians are still a rather unhappy bunch:

This past week, the new “Bloomberg Global Health Index” was released, ranking 163 countries according to life expectancy, a number of debilitating diseases, including mental health, quality of air and water, etc.

Coming out on top, as the world’s healthiest people, came Italy! – ahead of Iceland and Switzerland and with France and Germany at number 14 and 16, respectively, ahead of the UK (number 23) and the US (34).
https://www.bloomberg.com/news/articles/2017-03-20/italy-s-struggling-economy-has-world-s-healthiest-people .

Are Italians happy about that? Apparently not! Also released this past week was the “World Happiness Report 2017” (where health is a major component, but it’s supplemented with a number of surveys on how people feel), and Italy ranks a pathetic 48.

There is no country in the world with such divergence between health and happiness! Maybe Italians read too many Anglo-Saxon and German tabloids, which seem to keep telling them that they are miserable?

Or maybe the Happiness Index got it all wrong this year – after all, Denmark was dethroned by Norway for the first time. By Norway! How can they be happy up there in the rain, living by EU rules, paying into the EU budget, but having zero influence? Funny world. http://worldhappiness.report/

And on that note, my apologies for what become a rather lengthy Sunday note (but it’s important issues!) – I’m off for a long walk along the Thames. Tomorrow, you’ll see me enjoy some of that healthy Italian life style (in Milan).

Best

Erik

Thank you Erik for another stimulating and thought provoking piece.
Tommaso Arenare