A Tale of Two Italys: One Exciting, the Other, Terrifying

By FeaturesDow Jones Newswires

All eyes are on Italy ahead of its general election on March 4 -- but they are not seeing the same thing.

Europe's political class sees only risks in a country where the antiestablishment 5 Star Movement looks certain to emerge as the largest single party in the new parliament and the best hope of defeating the populists appears to hinge on a newly-resurgent Silvio Berlusconi.

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Investors see opportunity.

The Italian stock market is up 9% already this year and Italian 10-year bonds are yielding 2.2% with the spread over German bonds back to the levels last seen before political concerns started rising in the run-up to the 2016 constitutional referendum that cost former Prime Minister Matteo Renzi his job.

Recent economic data explains the market's enthusiasm. Italy, like the rest of the eurozone, is enjoying a robust cyclical recovery helped by global growth and ultraloose monetary policy which is keeping borrowing costs down.

Growth in the third quarter of 2017 hit an annualized rate of 1.7% and the latest indicators suggest growth may be accelerating toward 2%. Admittedly, that is still among the slowest in Europe but impressive in the context of the recent worst depression Italy has ever endured.

Household spending, capital expenditure and exports are all contributing to growth. And unemployment is finally falling, down 0.9 percentage points to 11% from a peak of 13% in the year to the end of November.

This growth pickup appears to be structural as well as cyclical, which means that the recovery should be at least partly self-sustaining. No one doubts there is still much that Italy could do to raise its growth potential, not least by overhauling its institutions.

But it took important steps over the past years to root out corruption, improve tax collection, reduce red tape and boost public sector efficiency. A major 2015 overhaul of labor market rules is also likely to have encouraged hiring, particularly when combined with tax incentives designed to encourage the creation of higher quality permanent jobs, according to the Bank of Italy.

The corporate landscape has also been transformed: companies that survived the recession tend to be more resilient and flexible and so better placed to take advantage of buoyant conditions.

Crucially, the worst of Italy's banking crisis is clearly over. Bad debts have finally been written down to realistic valuations, as is clear from a booming secondary market for nonperforming loans that is attracting strong foreign interest. And bank capital ratios are now well above regulatory minimum levels and in line with Eurozone averages.

True, the stock of bad debts remains eye-wateringly high at EUR66.3 billion ($82.2 billion) or 13.4% of all loans, but this is down by 24% in the past year. The rate at which loans are turning sour is back to precrisis levels. As a result, banks are now in a position to lend again, with credit growing by 2.3% in December.

Of course, the real risk in Italy relates to the public debt, which stands at 133% of GDP. This is primarily a function of the collapse in GDP which still stands 8% below precrisis levels. The debt stabilized in 2017 and should now fall naturally so long as interest rates remain low and the government continues to run a healthy primary budget surplus. That means that it only needs to borrow to pay for interest costs and to roll over existing debt.

The markets seem to be betting that interest rates will continue to be held down even after the European Central Bank winds down its bond buying, most likely later this year, by a strong domestic market for public debt and growing current account surplus which further reduces Italy's reliance on external funding.

Are the markets too complacent? The only party willing to talk seriously about the need to reduce the debt is the Democratic Party, but it is currently languishing at 23% in the polls. Yet even its leader Mr. Renzi, has proposed tax cuts.

The other parties, including Mr. Berlusconi's right-wing coalition and the Five Start Movement, have spent the early stages of the campaign competing with each other to see who can promise the most extravagant tax giveaways and welfare entitlements. Those include promises to unwind past reforms including a vital pension system overhaul widely considered vital to Italy's long-term debt sustainability.

The response of many Italian politicians is that none of what is said in the campaign matters. They argue that there is virtually no chance of the 5 Star Movement finding its way into government, either on its own or in a coalition since no other major party would partner with it.

Similarly, they argue that there is little chance of the right-wing coalition ever being obliged to implement its campaign commitments since Mr. Berlusconi's calculation has all along been to form a coalition with Mr. Renzi's Democratic Party, providing him with cover to dump his promises.

But for this strategy to work, the Democratic Party needs to secure sufficient support to join a coalition. The danger is that Mr. Berlusconi's populist campaign succeeds too well and that he accidentally wins an election he expected to lose and feels bound by promises he never expected to have to keep. Sound familiar? No wonder Europe's political class are anxious.

(END) Dow Jones Newswires

January 24, 2018 17:38 ET (22:38 GMT)

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