Article / 16 July 2014 at 7:46 GMT

Retreating Renzi is proving to be no Italian saviour

Managing Partner / Spotlight Group
United Kingdom
  • Italian Prime Minister Matteo Renzi retreating from reformist agenda
  • Italian debt-to-GDP ratio at 133% with prospects of reduction to 60% minimal
  • Renzi on collision course with fellow Italian Mario Draghi at ECB over debt

By Stephen Pope

Matteo Renzi is the 56th Prime Minister of Italy and its third consecutive unelected leader having assumed office on February 22 at the tender age of 39. He is the youngest person to assume office since the unification of Italy in 1861.

For a nation never far from the news when Eurozone troubles are mentioned, his “Democratic Party” (PD) did well in the European Parliamentary elections of May.


Italy EP Elec 2014
Source: Italian Electoral Commission, European Parliament

Renzi has been hailed as the saviour and reformer that the Italian economy has been waiting for.
For example, on March 11, he won approval from the Chamber of Deputies for a sweeping electoral reform law. This would tackle head on the murky waters of the Italian electoral system. 
 
One month later, he was at it again as, within his programme of industrial reform, Renzi forced the CEO’s of Italy's largest state-owned enterprises such as Eni, Terna, Finmeccanica, Enel and Poste Italiane, to resign. To replace them he turned to several well-qualified female candidates. This marked the first time that women had served as the heads of such organisations.

Sound the retreat

As the second half of the year began and Italy assumed the six-monthly rotating Presidency of the European Union. Renzi immediately struck a chord that opposed the “core” Eurozone nations who have insisted since 2009 that austerity, reform and stability were paramount compared to further state sponsored investment. 

He has called for a wide level of latitude in interpreting the fiscal rules and has urged greater flexibility in their implementation so as to drive investment and growth.

The trouble is with this 180° turn is that Renzi has been somewhat sparing in providing any detail. There have suddenly developed changes in the perception of the Renzi/Italian agenda leading the spread of Italy over Germany at the 2-year level to rise from the mid-July low.
It Ger 2 Yr Spread
Source: www.investing.com, Spotlight Ideas

The issue that is starting to trouble the centre of the European Union and the capital markets is that Renzi is now making statements once again indicating that finding a way to wean Italy off its excessive level of debt is going to prove elusive.

Many nations that currently share the euro are in breach of the old metrics that enshrined the foundation of the euro. 

“Stability and Growth Pact” (SGP) 

• Government Budget Deficit ≤ 3.0% 

• National Debt:GDP ≤ 60.0% 

The ongoing Italian scenario is that while the budget deficit has been settled at 3.0 percent in both 2012 and 2013, the debt-to-GDP ratio stands at 133 percent. The prospect of Italy bringing this down to a 60 percent target over an extended period of time, and I am talking decades, not years, is next to impossible given that the average level of economic growth since 1994 is just 1.0 percent. 
 
GDP growth was actually contracting in Q1. It was measured at minus 0.1 percent quarter-on-quarter and minus 0.5 percent on an annualised basis. CPI barely rose at plus 0.1 percent month-on-month and by just 0.3 percent year-on-year. On this basis, the task of bringing the debt target in line would require that Italy books a primary surplus of 7.0% per annum for many years so as to be in line with the directives of the old SGP.

The SGP has been reformed, diluted and now appears rather abandoned, having been breached on so many occasions that one has to wonder if it a meaningful concept any more. Sadly though even with an offer of generous flexibility in the interpretation of the budget rules to allow for the impact of the economic cycle, Renzi wants even more accommodation.

He is not settling for a soft process to measure annual targets defined by using three-year average deficits. Nor is he impressed by the view from Brussels that allows targets to be relaxed in the event of an unexpected economic dislocation. One wonders why? After all, France and Spain have been regularly resorting to such an accounting trick.

Prime Minister Renzi wants any state investment expenditure that is targeted toward a growth objective to be excluded from debt and deficit targets. Of course he can point to any number of projects on a wish list …but this really is a dilution too far. Once Italy is allowed to do this, the entire periphery will be forming a queue for similar accommodation. Once again, the finances of the Eurozone are built on the shifting sands of economic denial, delay and delusion. 

z

 Italian Prime Minister Matteo Renzi wants tax cuts for low-income workers.
Photo: bizoo_n \ Thinkstock

Who would buy Italian debt?

The default position of Italian politicians is to point out the large percentage of debt that is held by domestic investors. At 59 percent (Dipartimento del Tesoro), it is the largest among the major Eurozone nations and the banks account for 22 percent. 

However, much of this can be traced to the fact that following the measures taken by the ECB in terms of relaxing collateral conditions and backstopping any stressed sovereign, the Italian banks have soaked up domestic sovereign debt simply earning the margin that Italian debt yields over ECB funding. 
Debt holders 16-07-14
Source: National Treasury Departments

Even with the accommodation that has been offered by the ECB, Italian banks are almost at their saturation point of acquiring Italian government's bonds. One can have too much of a good thing.

The ongoing Asset Quality Review (AQR) and the third stress test that will cover 15 Italian banks will play a major role in determining how much further the domestic banks can go in soaking up new issues from the Tesoro. Already, the most powerful Italian in Europe, Mario Draghi in his capacity as President of the ECB has been explicit in his warnings that Italian politicians have to tackle the debt problem and lose no time in delivering meaningful economic reform.

It is by no means certain at what time and in what form the ECB would commence its own QE operations. So far all the talk from the central bank has been focused on using asset backed securities. I have argued that sovereign papers should be used, but what I think and what the ECB does are often different things. The sad point is that while QE is needed, it is another let off for Europe’s politicians.

If it is the case that the Italian banks have to begin restricting their intake of new debt at the auctions, then it will fall to Tesoro to find new buyers. The Italian economic research firm, Prometeia, has estimated that with the scale of maturities and need to roll over old debt, Italy must issue a total of EUR 65 billion in 2014. To place such an amount of paper, it will have to produce instruments that are attractive to domestic households and foreign investors. Of course, many fund managers are extremely yield hungry and if Italy offers an attractive spread against the core, it should not find too many problems in placing its paper this year.

However, the need for urgent reform is such that if it is not forthcoming, Italy may fail get away with successfully placing its debt issuance in future years.

Renzi the reformer or a man in retreat?

The central government of Italy has also to address the estimated EUR 75 billion owed to the private sector. Renzi want extra time and a new schedule of payment to be agreed whilst issuing ever more debt. I wonder, does there not come a time when the markets who can see the European Union doing nothing about the profligacy of its third largest member should take action into its own hands.

Nowhere else would any borrower be given more capital and more time when it has made little headway in delivering economic reform. Instead of actually tackling the serious flaws that have bedevilled Italy for the past 60 years, what we see is the latest in a long line of politicians that simply do not have the will to do the right thing.

As just one example, Renzi has said that by making EUR 5 billion of cost savings… which have not been realised yet…he will finance an EUR 80/month tax cut for lower income workers. Renzi said income tax would be reduced by a total of EUR 10 billion annually for 10 million low and middle income workers from May 1. He claims the cost savings will come from cutbacks in state expenditure, 

However, we wonder where is the detail.

The 39-year-old said his agenda was the most ambitious Italy had ever seen yet these are promises that should not be made as they cannot be delivered unless one cooks the books. Given the promises amid such little detail, it was no surprise to see the European Union put Italy on a watch list of three countries that are burdened by severe macro-economic imbalances. In this regard Italy is ranked alongside Slovenia and Croatia, due to its weak productivity and massive debt.

Sooner or later the tide will turn and roll out of the Italian economy and budget. Italy should be dragged to reform by the market forcing yields higher…but while OMT may have saved the euro, it has actually proven to be two years of wasted time as Italy has made little progress and the new saviour is finally being seen as the same old short-term, quick fix, easy solution politician.

Such economic mismanagement would be heavily criticised if it were in Africa or Latin America. However, because it is in the Eurozone, it is accepted because the ECB has skewed the system away from economic reality. One day this house of cards will fall…just as the Roman Empire did.

-- Edited by Martin O'Rourke

Stephen Pope is a 30-year plus veteran of the markets
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