Could Italy go the way of Greece?
Italy has hogged the headlines in recent weeks mostly for political reasons rather than financial ones. But in a few months we may be concentrating on its fiscal woes and unsustainable debt burden.
Last week credit rating agency Moody’s announced it was putting Italy on review for a possible downgrade to its Aa2 credit rating. These reviews typically last three months or so, and although a downgrade would still leave Italy at the higher end of investment grade, it is not good news to be sliding down the scale, especially when a sovereign debt crisis is raging further along the Mediterranean coast.
The reasoning behind the move by Moody’s was firstly challenges to economic growth, and secondly difficulties in bringing its debt levels down. A lot of attention has focused on a Greek default hitting Portugal and Ireland hardest, but Italy has a public debt-to-GDP of close to 120 percent of GDP, thus it is extremely vulnerable to investors dumping its debt, which would push up interest rates and make its debts too expensive to service.
Nearly a quarter of all debt issued by the euro zone comes from Italy and yet its growth remains stubbornly sluggish. Its average quarterly growth rate since 2000 is just 1 percent. Italy now risks becoming a long-term low growth/high debt economy.
Although its budget deficit is at a manageable level just below 4 percent of GDP, it has more than €300 billion of debt maturing this year and needs to get access to the capital markets in order to fund these bond redemptions.
So what is Italy’s problem? It is mainly an issue of low productivity and rigid labour laws. Its labour laws are some of the stiffest in the developed world. Article 18 of the Labour Code states that after a short probationary period, an employee fired from a company with 15 or more employees can bring a lawsuit against their former employer. Although they have no right to reinstatement, they would be entitled to compensation ranging from 2.5x to 6x monthly pay. That explains the low unemployment rate, since firms can’t fire inefficient or sub-par workers without a hefty cost.
Its work week was also shortened in 1997 to 40 hours from 48 hours. Italy’s competitive record is dismal and it is already trailing in the wake of fast-growing, innovative emerging markets. If there was a crisis in Italy’s sovereign debt market it’s easy to see how its economy could stagnate for a generation or more.
Investors in credit markets are forward-looking and they can see that this situation is unsustainable. If labour laws don’t change or Italy’s public debt burden is not cut then it may face both a sovereign credit rating downgrade and the wrath of the bond market vigilantes.
There is a caveat to this, and Italy isn’t in hot water when it comes to exposure to other peripheral nations. Its financial sector has less than €40 billion exposure to Greece, Ireland, Portugal and Spain combined. In contrast, French banks are exposed to Greek debt to the tune of €60 billion.
Likewise, its budget is forecast to have a deficit of less than 4 percent this year, one of the lowest levels in the euro zone, and private debt levels are also manageable.
But even though this might mean that Italy is out of the immediate firing line from bond investors – there are easier targets including Greece, Portugal and Ireland – it is difficult to muster much enthusiasm for the third largest economy in the currency bloc.
Italy’s structural economic deficiencies are only expected to get worse. By 2030 there will be less than two workers for every retired person aged 65 years or over, that compares with three today. If you think productivity is low now, imagine what it could be in the future. It has one of the fastest aging populations in Europe and its pension costs are set to continue to expand rapidly.
This is the major challenge it faces in the coming decade. Without easy access to the capital markets it is easy to imagine a Greek-style situation for Italy as it drowns in its enormous public debt.