Being a staunch believer in the European project, the past five to six years have given me nothing but sorrow. However, with the election of French President Macron I thought we could possibly, hopefully, change the trajectory of European politics. And it is therefore with grief I notice that my January 2018 warnings of global consequences from “…another leg in the Euro crisis, propelled by the world’s 8th largest economy and 3rd biggest bond market” are nonetheless materializing. Since then, we have returned to this subject a number of times. Let us start by framing the discussion with a familiar graph of the Italian economic situation; a worryingly high debt ratio is to some extent balanced by a rather strong (albeit sensitive) primary balance and long maturity of government debt.
This time, however, I thought we could also take a look at a number of graphs on the Italian economy and debt situation that are circulating in media and elsewhere. The first graph illustrates how ownership of the massive Italian public debt load is distributed in comparison to other major Euro Area countries and with the situation ten years ago (shaded columns).
There are a number of things going on in the graph above. An across country observation is the ECB’s QE-induced increase in holdings by central banks compared to ten years ago. Notice also that this increase has taken place while there has also been a massive increase in government indebtedness. Of course, the ECB’s asset purchases (QE) go some way to explain why the ownership share of both Residents and Non-Residents have mostly decreased. Here, nonetheless, Italy stands out. For Italy, it is the share of Non-Residents’ holdings that has born the brunt of the decrease as the share of Residents’ holdings has – uniquely – increased. For Italy, the crisis years have meant a substantial domestication of public debt.
Looking at the various sub-sectors in this data adds additional information.
Despite the ECB’s asset purchases, the so called ‘doom-loop’ between the sovereign and its banks still seems to be active and it is mainly ‘Other Residents’ that have decreased their relative share during the ECB’s QE program. A pertinent question is how this fit with the current Italian government’s plans to expand the budget? Because, as a matter of causality, the by now infamous Target 2 balances (mirroring Italy’s (intra-Euro Area) financial account) could suggest that investors are fleeing Lira denomination risks.
If there is indeed a general wish from holders (outside banks) to shed Italian government debt it could imply that Italy will experience strong crowding out effects from a fiscal expansion. This, in turn, risks making the already weak productivity outlook deteriorate further.
Even if differences in productivity growth seemed to be more pronounced in the years preceding the global financial crisis, there is still a clear tendency for overall Euro Area productivity growth to outpace the Italian ditto. As wage growth has been broadly in line with Euro Area peers, this means that Italy’s competitiveness – here measured with unit labor costs (ULC) has been continuously deteriorating. The weak overall income and productivity growth in Italy is, at least to me, the main challenge facing Italy. Higher productivity and income growth are probably the only thing(s) that can save Italy from an eventual debt crisis (I shudder). If I sported a more optimistic persona, this is probably also where I would be looking for potential to resolve Italy’s broader woes. There should be ample room for structural improvements of the Italian economy.
Another recurring theme in ours, and many others, analysis on Italy is the amount of bad debt in the financial sector, where different numbers are being pushed. This data set, monthly data from Banca d’Italia covers deposit and credit institutions and represent loans to insolvent borrowers.
IMF and most other commentators choose to put these numbers in relation to total gross loans (implying a halving of the shares), but I am not sure I like this approach since it mixes and splices data and methodology. This is why I (above) have chosen to put it into relation to ‘total loans’ from the same release. This, nonetheless, also means that we fail to take into consideration that loans are extended also from other financial companies outside of credit and deposit institutions. (If you download the document you can choose between the above and the “IMF-version” as well.)
Another approach to look at this data is by using the broader, Non-Performing Loans (NPL) definition and also studying a wider financial sector. This implies looking at annual or quarterly data and makes the absolute numbers swell somewhat. That said, this approach also makes the NPL-shares shrink somewhat. (In the document there is also a version of this graph where you see the full banking system, on an annual basis)
OK, other than finding the most interesting sets of data, are there any conclusions to be drawn? – Well, the IMF has recently published its Article IV-consultation, which is a much more comprehensive analysis. But, to be honest, I think the best way to summarize what risks Italy is facing is found in a table buried deep in the Debt Sustainability Analysis (DSA) and which uses the same approach that we did when supplying a tool for calculating debt scenarios back in May.
You see, at this juncture, whenever growth disappoints, and for whatever reason, I’m quite certain that real interest rates (via increasing risk premia) will move decisively upwards. Long overdue structural reforms might not even suffice (size of debts matter, when you plan on getting Greek-style debt restructuring). That is the only dynamic we should pay attention to. Too bad the Italian voters and politicians haven’t.