Thursday, September 25, 2014

25/9/2014: IMF Dished Out Some Bad News on Italy... here's a snapshot...

Recently IMF released Article IV consultation paper on Italy. I have missed posting this note for some days now due to extensive travel, so here it is, with slight delay.

A depressing read both in terms of current situation assessment and prospects for the medium term future. Which is hardly surprising.

Key struggles are, per IMF: "Exports have held steady, led by demand from non-EU countries, but investment continues to decline and remains 27 percent below pre-crisis levels."

Err… actually no… exports are still below pre-crisis levels by volumes, never mind price effects on value. Exports of goods and services grew by 6.2% in 2011, but then growth collapsed to 2.1% in 2012 and 0.1% in 2013. 2014 projected growth is for healthier 3.0%, and thereafter the Fund forecasts exports to continue expanding annually at just under 3.6% pa on average between 2015 and 2019. Which is handy, but not exactly 'booming'. And worse, net exports having grown by 1.5% and 2.6% in 2011 and 2012 have shown decline in the growth rates to 0.8% in 2013 and projected 0.5% in 2014. Thereafter, net contribution of external trade to GDP is forecast to grow at 0.4% in 2015 and 0.1% every year from 2016 through 2019. Again, this is weak, not strong. And keep in mind: GDP does not grow with Exports, it grows with Net Exports.

Fixed investment is, of course, still worse. In 2011 gross fixed capital formation shrunk 2.2%, followed by an outright collapse of 8% in 2012 and topped by a decline of 4.7% in 2013. Now, the Fund is projecting contraction of 1.1% in 2014, but return to growth in 2015 (+1.8%) and in 2016-2019 (average annual rate of expansion of ca 2.6%). Which means one simple thing: by the end of 2019, investment in Italy will still be 6.2% below the pre-crisis levels.

Now, the IMF can be entertaining all sorts of reforms and changes and structural adjustments, but there is one pesky problem in all of this: investment is something that the young(er) generations tend to do. And Italian young (people and firms) have no jobs and little churn in the marketplace to allow them grow, let alone invest. IMF notes low churn of firms… but misses the connection to investment. 

And, of course, it misses the Elephant in the proverbial Room: Italian families are settled with 30-40 year old sons and daughters still living on parental subsidies. Now, parents are heading for retirement (tighter cash flows) and retirement funds are heading for if not an outright bust, at least for gradual erosion in real value terms. What happens when retired parents can’t nurse their children’s gap between spending and earning?..

Things get uglier from there on. Not surprisingly, due to debt overhang already at play, credit supply remains poor and NPLs continue to strain banks balance sheets. This is holding back the entire domestic demand and is exacerbating already hefty fiscal disaster.

There is no life in the credit market and with this there is no life in the economy. Which, obviously, suggests that credit is the core source for growth. This is not that great when you consider that there are four broadly-speaking sources of investment (and capacity expansion):
  1. Organic revenues growth (exports are barely growing, domestic consumption is dead, so that's out of the window);
  2. Direct debt markets (bond markets for corporate paper, open basically only to the largest Italian corporates and no smaller firms access platforms in place, which means no real debt markets available to the economy at large);
  3. Equity (forget this one - tightly held family firms just don't do equity, preferring to cut back on production) and
  4. Banks credit (aka, debt, glorious debt).

Chart above shows the relationship between Financial Conditions Index (FCI) and economic growth. FCI breakdown is shown in chart below:

All of which confirms the above: improvements in the credit volume and credit standards are being chewed up by the ugly nominal rates charged in the banking system that is now performing worse (in terms of profitability) than its other Big Euro 4 + UK counterparts.

And the IMF notes that: "Financial conditions are closely correlated with growth and FCI shocks have a significant impact on growth. For example, a bivariate VAR under the identifying assumption that the FCI affects growth with a one-quarter lag suggests that a negative shock that raises real corporate lending rates by 260bps through a 200bps increase in nominal rates and a 60bps decline in inflation expectations (to 0.5 percent), would lower growth by a cumulative 0.4 percentage point over three quarters. As a reference, real rates have increased by around 300 bps since mid-2012." No sh*t Sherlocks, you don’t need VAR to tell you that growth in Europe = credit. It has been so since the creation of the Euro, and actually even before then.

Now, do the math: in 2013, Italian banks have posted profitability readings that are plain disastrous:

The swing between ROE for Italian banks and Spanish & French counterparts is now around 21 percentage points. While NPLs are still climbing:

But real lending rates are above those in France and below those in Spain:

Taken together, charts 4-6 show conclusively that nominal rates will have to rise AND deleveraging out of bad loans will have to either drag on for much longer, or worse (for the short run) accelerate. All of which means (back to the above IMF quote) continued drag from the financial sector on growth in quarters ahead. Everyone screams 'austerity' but really should be screaming 'deleveraging':

IMF notes: "The analysis suggests that measures to normalize corporate financial conditions would support a robust and sustained recovery, mainly through investment. Since bank lending rates account for the lion’s share of the tightening in the FCI, domestic and euro area measures to address financial fragmentation, mend corporate balance sheets, and strengthen banks’ capacity to lend would minimize the risk of a weak, creditless recovery."

This is all fine, but totally misses the problem: financial 'normalisation' in the above context is not about investment, but about investment via debt. And more debt is hardly a feasible undertaking for Italian firms and for Italian banks. Supply IS closer to demand that we think, because tight supply (banks deleveraging) is coincident with tight demand (once we control for the risks of poorly performing corporates seeking debt rollovers and refinancing).

And, of course, the IMF optimism for “domestic and euro area measures to address financial fragmentation, mend corporate balance sheets, and strengthen banks’ capacity to lend” capacity have just hit a major brick wall at the TLTROs placement last. As subsequent data showed, Italian banks just started re-loading their hoard of Government bonds instead of repairing the corporate credit system. Who could have imagined that happening, eh?

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