Topic/Theme Reports

Italian Politics & Contagian

Dr. Scott Macdonald

July 14, 2016

We welcome Dr. Scott MacDonald as a research contributor to Viola Risk Advisors, LLC with his specialty in Sovereign & Emerging Markets economic & credit analysis. Scott is the Chief Economist for Smith’s Research & Gradings. Previously, he held senior positions at MC Asset Management, a subsidiary of Mitsubishi Corporation; Aladdin Capital; and Donaldson, Lufkin & Jenrette.

While we were tempted to use the headline "Italian banks getting the boot", we overcame that urge. Instead, we went with "Italian banks, politics and contagion risk". Italian banks were problematic before the June 23rd UK referendum; they are even more problematic after the vote as they are one of the weakest links in the European banking chain, weighed down with troubled loans and caught up in the cross-currents of trans-European angst over the future of the European Union (EU) and Italy's own particular brand of politics. Considering that the Italian economy is the third largest in the Eurozone at $1.86 trillion and has extensive trade and investment linkages with Germany, France and the UK, the systemic shakiness of Italian banks represents a major contagion risk to the rest of Europe.

Italy’s banks have a history of opaqueness, carrying sizeable amounts of bad loans and keeping a number of weak Italian companies on life support. Over the last several years there have been improvements in making the banking system more transparent, dealing with capitalization issues and bringing Italian banks closer to EU banking standards. However, the Italian economy has been weak and the business environment in Europe since 2009 has been difficult.

Europe’s banking regulators have been putting pressure on the Italian authorities to further clean up their banks and force them to either sell or write off bad loans. It is estimated that Italian banks have problem loans worth €360 billion (US$396 billion). The problem is captured by The New York Times Peter Eavis (July 7, 2016), “The Italian government, according to some estimates, needs to spend $45 billion to shore up its banks burdened with bad loans. Fears that European authorities will bar the government from providing that support are adding to the turbulence caused by ‘Brexit’.”

While European banks in general have been under considerable stress since the Brexit vote, Italian banks have been hurt the most by nervous investors. In particular, Banca Monte dei Paschi di Siena (MPS), the world’s oldest bank and Italy’s third largest, is under acute pressure as regulators have upped the amount of bad loans they want the institution to remove from its books. MPS’s stock price has fallen 80% over the last 12 months, which obviously raises questions over capitalization.

While the Italian government appears inclined to make capital available for MPS and other banks to recapitalize, new EU laws make this illegal. The problem is that new EU rules (pertaining to bank resolution) seek to protect taxpayers from assuming the cost of keeping banks afloat and instead transfer that cost to investors (referred to as a bail-in), who would lend money to the banks by buying their debt which would then be converted into equity, which, in turn, would probably be worth less.

In Italy, the situation is complicated by who holds Italian bank debt. According to the economic research organization, Bruegel, Italian families own about a third of Italian bank debt. As Eavis notes: “Not only would bail-ins focus the pain on Italian households, the fear of losses might also prompt investors to stop lending to banks and lead depositors to withdraw their money. This would make a bad, but manageable, situation much worse.”

Although it is in the EU’s interest to help keep Italian banks afloat, it is less inclined to allow a blatant bailout of the banks than it was in the past. This has left significant questions about what happens to MPS as well as other Italian banks. This is not exactly a great time to be off-loading troubled Italian loans or letting an Italian bank fail.

Political factors are complicating the Italian picture. The center-left Renzi government has called an October referendum to push through changes to the country’s constitution, which will help the government to implement badly needed economic reforms. Since Italy adopted the euro in 1999 the economy has barely expanded. Real GDP growth in 2015 was an anemic 0.8%. The IMF is calling for 1.0% for 2016 (but we expect it to be lowered due to the impact of Brexit on trade and tourism). Unemployment remains stubbornly high, over 11% and there are serious issues related to pensions due to the country’s poor demographics. All of this feeds back into the political picture.

The October referendum looms large over the Italian landscape. Prime Minister Matteo Renzi’s center-left Democratic Party did poorly in recent municipal elections, with the populist Five Star Movement’s candidates winning control of the mayor’s office in Rome and a few other key cities. The next election contest is the October referendum. Dublin-based Merrion Stockbrokers’ chief economist Alan McQuaid noted: “This could become a vote against him (Renzi), or the European Union, and sink the government. Banks' collateral might then collapse if markets start to fear the radical Five Star Movement is about to win power and take Italy out of the Eurozone”.

Opinion polls indicate that if an election were held today the Five Star Movement would defeat the Democratic Party. This clearly has implications in terms of risk. The Five Star Movement's platform includes a referendum on Eurozone membership (holding out a possible return to the lira), tax cuts and spending increases. Considering this mix of policy options, it is likely that Italy would face much higher sovereign bond yields, further economic weakness and greater pressure on its sovereign ratings (Baa2/BBB-/BBB+).

To this we would add that the Italian general government debt/GDP ratio is the third highest among advanced economies after Japan and Greece at 132.7% (according to Eurostat). A major crisis in the banking sector could rapidly complicate the sovereign’s access to international capital markets. Italy’s debt is in excess of $2 trillion — quite possibly too big to bail out.

Although Brexit is dominating the headlines, the Italian banks represent a major risk to European and global economic growth, especially if there is some contagion to other European banking systems. The US is to some degree buffered from the Italian problem, though any cooling in markets and growth complicates the policy environment and the job of the US central bank. Looking ahead, Italian banks are likely to loom larger on the risk agenda, making it incumbent on the EU and Italian authorities to find a solution. Timing is everything; a systemic banking crisis in Italy, which hurts households could have political consequences akin to Brexit. Italexit anyone?

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