Tuesday, 26 February 2013

Italy: Political Fracture Changes Everything

Credit where it's due - Wolfgang Munchau wasn't wrong, even though he was writing in the FT a month ago: 'Judging from the latest opinion polls, the most likely election result is gridlock, perhaps in the form of a Bersani-Monti coalition of the centre-left, possibly with a centre-right majority in the Italian senate, where different voting rules apply. This would leave everyone, more or less, in charge. Nobody would have the power to implement a policy. Everybody would have the right to veto one.'

With a busted political establishment and the EU's 'technocratic' post-democratic settlement rejected, it is difficult to see where Italy's next usable political architecture will be found. It is little short of tragic, since protracted political uncertainty can be expected to undermine and nullify the real gains made in Italy's economic structure during the past few years. More likely, the pay-off of austerity will simply be. . . deepening economic atrophy.

Let's first acknowledge the real gains made.  On a constant-dollar basis, I estimate that by the end of 2012 asset-turns in Italy had been restored to very near pre-crisis levels, albeit at the cost of a capital stock that was shrinking by around 3% a year. In nominal terms, of course, the situation is less attractive: although capital stock is now shrinking by around 1% a year, asset turns on that capital stock have recovered less than half of what they lost during 2008-2009.

More, Italy retains positive cashflow: it had a private sector savings surplus equivalent to around 2.2% of GDP in 2012, up from 0.7% in 2011 and a reversal of the minor savings deficit prior to the financial crash. This savings surplus (calculated as the current account minus the government budget balance), is also a tally of the net cashflows running between the private sector  and the financial system. Capital flight reflecting worries about whether Italy may ultimately exit the Euro may have stripped deposits from  Italy's banking system as a whole, but nevertheless the underlying domestic economy is quietly  generating  a net flow of cash from the private sector and into the financial system.
If this were a normal cycle, this could be an exciting inflection point:  the immediately-negative impact of recession upon returns on capital have been answered by a fall in the capital stock which has allowed asset turns to recover, and (on the constant-dollar reading) to reach pre-recession levels.  Moreover, there is a positive cashflow into the banking system from the private sector savings surplus allowing banks the financial leeway, and commercial incentive, to start extending credit once more. It is precisely at this point that there is both the motive and means to re-start the investment cycle - ie, for recession to be replaced by upswing. This is what normally happens in a business cycle.

But it is at precisely this point that Italy's genuine political instability matters, since it introduces radical policy uncertainty into investment planning. That uncertainty is likely to delay the re-start of investment spending, so the factors of production are most likely to continue to shrink, and with it the economy.  The creative destruction of recession morphs into a simple but protracted shrinkage  of the factors of production.  

And without growth, it is difficult to fashion a path towards debt-stability, given the starting point.
Taking government debt first: at end-2012 the Italian government reckoned its debt as Eu1.988 tr, which was a rise of only 4.3% on the year.  However, since nominal GDP contracted by an estimated 1.1%, the debt/GDP ratio continued to rise, hitting 127%, up from 121% in 2011 and 119% in 2010.

As a result, despite all attempts at fiscal control, the mathematics of continuing to service this debt have become more daunting, not less.  One can illustrate this by calculating the nominal GDP growth rate needed to merely to stabilize current debt levels (ie, by not allowing the interest paid to be capitalized), at recent interest rates. What interest rate? During 2012, 10yr Italian government bonds yields average 5.43%, with a standard deviation of 58bps.  If, generously, we accept a bond yield at the low end of the range (ie, one standard deviation below average), we reach an interest rate of 4.85%.  Quite by chance, that is also the yield which the market is asking today in the wake of the election result: up from lows of around 4.1%.  

Let us, then, consider a range of between 4.1% and 4.85% as representative.  In those circumstances it would require nominal GDP growth of between 5.2% and 6.2% a year in order to stabilize government debt at current levels, assuming no further fiscal deficit and payment of interest rates.

How likely a prospect is that? Even taking the lower hurdle growth rate of 5.2%, nothing approaching that level of growth has been achieved since 2000: the average nominal growth rate between 2001 and 2012 has been  around 2.3%.   Even if that 2.3% nominal growth rate can be attained once again, that will not merely not stabilized the nominal debt, it will not stop debt/GDP ratios continuing to rise.

Without nominal GDP growth, it seems impossible that debt/GDP ratios will stabilize, let alone improve.

The conclusions are grim:

  • Italy's recession could have produced conditions in which an investment upturn was likely: indeed, in real terms, contracting capital stock has allowed asset turns to return to pre-crisis levels, whilst the economy generates a private sector savings surplus of about 2.2% of GDP - liquidity which would normally be expected to fund the subsequent capital investment upswing.
  • Political fracture and instability are likely to choke off investment spending just at the point when the investment cycle should be responding to rising asset turns and the liquidity generated by a rising private sector savings surplus. 
  • The recession is therefore unlikely to heal itself, but rather is likely to turn into a sustained contraction in the factors of production.  
  • This is no longer a question of regained international competitiveness, but rather of political roadblocks to cyclical upturn.
  • Italy's government debt levels cannot be stabilized without growth.  Government debt to GDP has risen to around 127% of GDP by end-2012, up from 119% at end-2010.
  • Even if 10yr yields sink to 1 standard deviation below average 2012 yields (ie, around 4.1%), it would (theoretically) require nominal GDP growth of 5.2% with no fiscal deficit, in order to stabilize current debt levels. 
  • Since 2001, Italy's nominal GDP growth has averaged just 2.3% a year. There is no reason to expect it to achieve that under current circumstances. 
  • The price of the EU installing a post-democratic 'technocratic' government in Italy is thus extraordinarily high, since its subsequent popular rejection cancels out even those economic and financial gains which might have been made in time.  Italy is back to where it was when the crisis broke, only deeper in debt, and with a weaker structural base to its economy and no plausible political response to its plight. 

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