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Italy is headed for a deeper and longer recession than was previously expected, writes Nomura’s senior political analyst Alastair Newton. And the headwinds facing Italy are now bigger than they were three months ago.Italian prime minister Mario Monti is losing popularity, and domestic politics continue to threaten the euro.
Drawing on Newton’s report we highlight the biggest challenges facing Italy right now.
Ever since his technocratic government was appointed in November, Italian prime minister Mario Monti has told European policymakers that without pro-growth policies he would struggle to retain popular and political support for reform and debt reduction measures.
There has now been increasing dissent within Monti's cabinet and cross party support he once garnered has faded after Partito Democratico (PD) and Popolo della Libertá (PdL) both took a hit during local elections in May.
'Popular support for Mr Monti has been in steady decline since March and is now around just half of the 71% approval rating he had when he was sworn in as prime minister.'
Italian sovereign risk has gradually increased since March. Monti has blamed the recent financial market turmoil on Spain where concerns are building that the country will need not just a bank bailout but also a sovereign bailout.
Italy doesn't share Spain's banking sector problems, but given its low growth and high government debt the country is exposed to sudden changes in market sentiment. Investors are wary not just of contagion but of risks that Italian debt will become sustainable.
'Markets are understandably fearful that in the event of a full-blown Spanish bailout, Italy will be next in line for a bailout. And after a Spanish bailout, there will not be any firepower left in the EFSF/ESM arsenal to backstop Italy.'
Italy is heading for a deeper and longer recession. Nomura now projects a 2.2 per cent GDP contraction in 2012, and flat growth in 2013.
Moreover, risks of more austerity will hurt any Italian economic recovery in the near term. Growth drag from fiscal tightening could knock 0.7 percentage points (pp) off GDP growth in 2012 and 1 pp next year.
In the past, trade has acted to boost growth. But with a slowdown in China, the U.S. and Germany, this looks unlikely.
A deeper than expected recession has put the government's fiscal consolidation targets at risk.
Government borrowing requirements (12-month summary) climbed to €67.9 billion in April. Nomura analysts expect that for the government to meet its end-2012 budget target the 12-month rollover borrowing requirement has to decline by €5 billion per month on average from May through December 2012, but this will be very challenging.
Tax revenues, which so far are not in line with government expectations, need to increase for the country to meet its budget targets.
This is especially worrisome since a huge part of Monti's fiscal consolidation plan (policy aimed at reducing debt and deficits) depends on higher tax revenues. There is a chance that revenue could pick up if Monti's 'fight tax evasion' campaign gathers steam. '
Monti himself believes that Italy could miss its budget target and this likely prompted him to announce measures aimed at boosting growth on June 15.
The Italian debt to GDP ratio is expected to rise through 2012 to 124.4 per cent, from 120 per cent in 2011, before stabilizing in 2013. But this assumes that Italian interest rates will decline and it is therefore no surprise that Monti wants market stabilisation measures to reduce funding costs.
'The elevated funding costs are worrying, especially given Italy‟s large refinancing needs in H2 2012. Our European Rates Strategy team calculates that the Italian government will have to access the funding market for more than €220bn, i.e. more than 10% of its total outstanding government debt, with the largest funding needs occurring in the months of July, October and December. Mr Monti is clearly facing pressure from both markets and domestic politics.'
Monti went to the June European summit in Brussels hoping to win concessions from German chancellor Angela Merkel and did in fact persuade her to shift on the use of euro area's bailout funds which took markets by surprise.
But there is less agreement than was originally thought:
- It is doubtful that decisions made during the summit will meaningfully contribute to solving the euro-area crisis.
- Even though all leaders signed on to using the European Stability Mechanism (ESM) to inject aid directly into stressed banks, achieving the pre-conditions for this will be tough. Moreover, while the ESM can act without seeking political authority, Germany's representative on the board has a veto and Germany's constitutional court could still impose additional conditions before ratifying the ESM.
- Monti's claim that the bailout funds could buy Italian bonds at auctions with less weighty conditions than under current rules --is already being disputed by other euro-area members.
The most difficult obstacle in Monti's way, namely the labour reform, seems to have been accomplished. The reform gives employers some flexibility to layoff workers for economic reasons and provides incentives for hiring young people and women. It also offers a universal jobless benefit programme.
While this is a step in the right direction it isn't a game changer because courts can still order firms to rehire laid off workers and only offers a refund of extra payroll tax contributions under certain conditions and finally, political parties can amend the law. So it remains unclear whether this can revive Italian GDP growth.
Italy is headed to the polls in April/May 2013 at the latest and it is unclear if the Monti administration can survive till then. There has been a strong decline in cross-party support for reform and this fall's budget process will likely be even more challenging than usual.
Compromises necessary to pass the budget domestically may be unacceptable for creditor countries in Northern Europe. Moreover electoral reform which is a priority for Monti may prove challenging as well.
The Popolo della Libertá (PdL) could force an early election and some in the part are considering running on a eurosceptic platform. The impressive showing in last May‟s regional elections of Beppe Grillo‟s MoVimento 5 Stella (M5S) could be interpreted as indicative of rising euroscepticism among Italian voters.'
The outcome of 2013 Italian elections is unpredictable and domestic policies are continuing to threaten the survival of the Euro area
Given the fragmented nature of Italian politics it is difficult to forecast the outcome of an election whether it takes place this year or the next. But polls suggest the possibility of a divided and unstable coalition.
For now, Nomura's analysts have a glass half-empty view, with use of bailout funds to inject capital directly into the banking system unlikely to bring Italy back from the bring. And a glass half full view -- the establishment of a single euro-area banking supervisor could be a first step towards fiscal union.
'For now we doubt that Ms Merkel and her allies in northern Europe are ready to cross the proverbial Rubicon by mutualising Italy‟s debts to a paradigm-shifting extent. We therefore remain firmly of the view that Italian domestic politics are a continuing threat to the survival of the euro area.'