Cash & Investment Management

Update on Italy – Q4 2016

Thursday 10th November 2016

The general theme across Europe this year has been that economic growth is in line and that the recovery has been on track. However, its strength has been insufficient to generate positive inflationary pressures and the ECB continues to adopt a highly supportive stance. Consumer spending has largely maintained a solid pace of growth, despite the partial recovery in crude oil prices. Italy, continues to struggle against this tepid backdrop, Italian GDP will grow 0.8% both in 2016 and 2017 according to the Organization for Economic Cooperation and Development (OECD). The country desperately needs economic growth to accelerate, to help ease the huge debt burden that the banking system is facing.

It has also not been helped by very poor recent demographic trends. For instance, 2015 saw fewer babies born in Italy than in any year since the modern state was founded 154 years ago, and the population shrank for the first time in three decades. Adding to the gloomy picture, the number of deaths jumped more than 9% over the previous year. That left the country with its highest mortality rate since World War Two as life expectancy levels unexpectedly dropped.

The Prime Minister, Matteo Renzi, embarked on a policy of constitutional reform, as soon as he was elected in 2014. This was seen as a brave decision as the nation was saddled by a huge public sector debt burden. But the electorate backed his mandate to inject some dynamism into the Senate process and also offer an electoral overhaul, with emphasis on enhancing social representation. The country votes on this reform on the 4th December, with either an approval or a rejection.

The polls have thus far shown a split of opinion on the reform and a rejection vote would see Renzi resign. If he steps down, many believe that would trigger a general election and Italy’s anti-establishment Five Star Movement could make a grab for power.  Although a general election would probably only occur at the end of the current parliamentary term, in early 2018. Such renewed political instability would mean an absence of the much needed banking and economic reforms. The party is now the largest single party in the Chamber of Deputies.

The Five Star Movement does not define itself as left or right wing. Rather, it runs on an anti-establishment platform that has won support from across the political spectrum. Left wing voters are attracted to its pro-environment stance and its criticism of big business. Right wing voters support its call for controls on migration and its attacks on the EU and the euro. Beppe Grillo, the party’s comedian, joint leader, has long been an admirer of the former Ukip leader Nigel Farage, and M5S has said it would seek to call a referendum on the euro if it came into power.

A rejection vote could clearly lead to contagion in the rest of Europe and it may well increase the likelihood of a credit downgrade for Italy. Most likely from the current A- rating to the BBB arena. Unfortunately this would heighten the pressures and the risks on the banking system, most notably the shackle of EUR 360 Billion of non-performing loans.

The country’s third largest commercial bank and oldest, Monte dei Paschi di Siena (MPS) is currently going through the third emergency fund raising in as many years. MPS must raise up to €5 billion as part of an emergency rescue plan to stave off the risk of being bailed in. On a more positive tack, there have been reports recently that the Qatar Investment Authority could step in, as the anchor fund raiser. The bank plans to cut 2,600 jobs by 2019, out of nearly 26,000 employees. It will shut about 500 branches out of about 1,900 outlets and dispose of €28 billion of impaired loans.

Some analysts suggest that a rejection vote will hit Intesa bank the hardest due to its liquidity and business positioning. Indeed, Fitch has recently revised its outlook to negative primarily as a large proportion of the capital is tied up in unreserved impaired loans. In the end, Italy has simply failed to restructure its banks in a significant fashion. And the financial sector’s woes have only been exacerbated by persistently sluggish economic growth. Throw in low yields on Italian government bonds and falling interest rates, which weigh on interest income, and it is no surprise Italian banks are suffering.

There have also been issues with the country’s recently announced budget, which hiked previously agreed targets for the budget deficit and the public debt. The Government insist that it needs fiscal leeway to deal with the migrant crisis on its Mediterranean borders and reconstruction after a huge earthquake in August. The European Commission has numerous concerns about the plan and they wrote to Prime Minister Matteo Renzi asking him to explain why Italy’s projected budget deficit for 2017 had risen from 1.8% of GDP earlier this year to 2.3% now. This goes clearly against EU rules which say that countries have to cut their structural deficit by at least 0.5% of GDP every year until they reach balance or surplus.