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):
- Organic revenues growth (exports are
barely growing, domestic consumption is dead, so that's out of the window);
- 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);
- Equity (forget this one - tightly held
family firms just don't do equity, preferring to cut back on production) and
- 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?
