If you set out to make a positive investment case for Italy 20 years ago, the best hope was to play down the myriad structural inefficiencies that blighted the corporate sector and argue that this was a good economy burdened by an unworkable state. Now, after years of no growth accompanied by stubbornly high public debt, a positive case looks even harder to make, especially after the No vote in Sunday’s referendum on the constitution.
In such circumstances history can help. Two overwhelming events have been substantially responsible for derailing the Italian economy. The first is membership of the European monetary union. Before 1999, Italy habitually responded to competitiveness problems by devaluing the lira. Thereafter, internal devaluation through declining real wages was the only available option.
At the same time, any resort to fiscal expansion was constrained by the stability and growth pact rules. For many years Italy, far from being the profligate spender of northern European imagination, has run a primary budget surplus before interest, with the sole exception of 2009. Its daunting level of public sector debt, currently about 133 per cent of gross domestic product, is essentially a legacy of the high-spending 1980s. It remains high for want of economic growth. The International Monetary Fund does not expect a return to pre-2007 output levels before the mid-2020s. Meantime the fiscal straitjacket means that the country has limited ability to respond to shocks, notably from an ailing banking system.
The twin uncertainties of the referendum and a high level of non-performing loans in banking have caused capital to flee the country. Policy options to address capital flight are also cut short by membership of the monetary union. The European Central Bank sets interest rates by reference to the eurozone as a whole. It cannot plug a capital leak in Italy. Nor can the Banca d’Italia defend (or not defend) the currency. All it can do when official reserves run out is borrow to maintain its euro peg under Target 2, the settlement system for the euro. As of September, Italy’s Target 2 balance was above 20 per cent of GDP, its worst reading to date. On standard definitions of financial distress these are crisis-level reserve losses, according to Carmen Reinhart of Harvard University’s Kennedy School of Government.
The other big trauma came when China joined the World Trade Organisation in 2001. Italy was more exposed than most to Chinese competition because its exports were heavily concentrated in price sensitive, low value added goods. As Shweta Singh of Lombard Street Research points out, this was a natural result of using devaluation — that is, cheapening exports — as the chief tool of demand management for so long before 1999. The result is that Italy’s share of global exports has plummeted. The loss of competitiveness was exacerbated by sluggish productivity, reflecting a worsening of the structural inefficiencies that have long been a drag on the economy.
Much of the anti-establishment populist protest around Europe comes from those in society who have been left behind by globalisation. In the case of Italy it is the whole country that has been left behind. Small wonder that the campaigns of the main challenger parties, the Five Star Movement and the Northern League, resonated on Sunday with an electorate desperate to snub the political establishment. Both favour abandoning the euro. The threat that Italy poses to the survival of the monetary union in its present shape has thus increased, albeit from a low level, against a background of greater political uncertainty following the offer of resignation from Prime Minister Matteo Renzi.
Today it might be possible to make a short-term case that Italian government debt is oversold. Any additional risk premium for these uncertainties has probably already been built into Italian asset prices. The economy will continue to benefit from Trump-induced strength of the dollar against the euro and from the probable extension of the ECB’s unconventional measures at its meeting on Thursday. A domino theory for the eurozone, starting with Italy, looks needlessly alarmist — for now. Structural reform nonetheless looks more elusive after the referendum and further recapitalisation of the banking system more difficult.
Italy is a country that historically has galvanised itself in response to big shocks, but seems able to pursue incremental reform only at a glacial pace. Sunday’s result was simply not big enough to transform the economic prospect.