Italy Financial Outlook Update

The Italian economic recovery is over before it ever got going, with significant risk of the economy returning to recession in H2 2011. The weak increase outlook increases the likelihood of fiscal slippage and the need for additional budget measures.

• Italy’s government has approved austerity packages in an effort to achieve fiscal balance by 2013.
• Tight budgets will depress increase, weaken the employment outlook, and curb incomes.
• Almost a third of Italian firms statement difficulty in obtaining bank credit.
• Although the ECB is buying Italian bonds, yields remain above 4.9%, a critical level for government finances.

Italy's economy is heading into recession. After increase accelerated in the second quarter of 2011, the economy appeared to stall in the third and is estimate to shrink through the first quarter of 2012. Italian GDP is losing momentum because of weakening domestic request, slowing export increase, and tighter credit caused by uncertainty about Europe's banking system.

The outlook for Italy has worsened substantially over the past few months. The new data confirm that fiscal austerity has depressed household spending, weakened employment prospects, and curbed income increase. Real gross disposable income in the first half of 2011 was only 0.2% over the same period a year before , and fell on a quarter-to-quarter basis in the first and second quarters of this year. Consumer confidence hit its lowest level since July 2008, suggesting households are growing additional pessimistic.

Under pressure from financial markets, the government has enacted austerity packages, aiming to reach fiscal balance in 2013. Italy's deficit equaled 4.6% of GDP in 2010, and is projected to fall to 3.9% of GDP this year and to 1.6% in 2012. The government expects a balanced general budget and a primary surplus of 5.4% in 2013. Around-thirds of the planned fiscal tightening comes through higher-price-added and excise taxes, while the rest is from spending cuts. Rising taxes, lower welfare benefits, and a public-sector wage and hiring freeze will reduce disposable incomes and undermine already deteriorating household spending. Moreover, these projections are based on an optimistic GDP estimate. With the economy slipping into recession and tax receipts weakening, the government will be pressed to tighten even further to meet its fiscal goals.

Italy’s unemployment rate fell to 7.9% in August from 8.5% last October, but employment expectations are worsening. According to the new business surveys, firms expect staffing levels to fall over the next few months and continue to rely on temporary workers. High wages and institutional constraints in Italy’s labour market remain drags on long-term economic increase. Unit labour costs rose 1.9% y/y in the first half of 2011, faster than the euro zone average; in Spain unit labor costs fell 1.5%. Productivity has not kept pace with wages, reducing local companies' competitiveness in international markets.

Debt crisis slows trade

Export-oriented manufacturers remain under pressure as the escalating European debt crisis weakens intraregional trade. With the luck of a recession estimated at 70% for the wider euro zone, which receives 44% of Italian exports, and with the U.S. economy vulnerable as well, Italy's exports will likely slow further. Falling profit margins and weakening export orders will weigh on industrial production and business spending. The closely watched Italian purchasing managers’ index for manufacturing has fallen off sharply from before in the year, and indicated contraction in August and September. The fourth sharp monthly decrease in new orders as well suggests weak request for Italian products. The composite PMI suggests the wider economy shrank at the fastest rate since August 2009.

Renewed tightening in credit conditions will give the economy a final push into recession. Italian banks have difficulty raising funds in interbank markets, and thus obtain loans from the European Central Bank. ECB loans to Italian banks totaled €89 billion at the end of August, up from €34 billion in May. This has a knock-on adverse effect on private-sector lending, where increase slowed to 4% over the three months to August, from 4.8% in the three months ending in May.

Credit is likely to tighten further as risks rise of a new banking crisis. Italian financial institutions are heavily exposed to the euro zone's fiscally troubled members, and uncertainty is rising about the extent to which banks will have to write down their debt portfolios. According to the Bank of Italy’s new quarterly survey, the proportion of firms reporting difficulty in obtaining bank credit increased to 28.6% in September from 15.2% in July.

Long-term yields rise

Rising borrowing costs combined with weakening request at home and abroad will squeeze profits and limit output and investment. Half the firms polled in the quarterly survey conducted in September by the Bank of Italy reported a deterioration in investment conditions. Moreover, surging sovereign bond yields increase interest payments on Italy's public debt—the second highest in the euro zone after Greece—crowding out private investment and raising concerns about long-term economic prospects.

Italy’s government promised to accelerate deficit cuts in exchange for the ECB buying its bonds, after a selloff sent Italian 10-year bond yields to 6.2% at the beginning of August. After the ECB purchases began, yields on Italian bonds fell but remained above 5%, significantly higher than before the crisis. Analysts project that bond yields above 4.9% could raise Italy's government borrowing costs to unmanageable levels, forcing it to seek aid from the European Union and International Monetary Fund.

Risks to the forecast

Our revised estimate assumes the euro zone will avoid a new debt crisis and that policymakers will respond appropriately and in a timely fashion—increasing the stabilization fund so it can help recapitalize weak banks and arranging an orderly restructuring of Greek debt. We as well assume the Italian government will implement its promised spending cuts.

Rising sovereign bond yields, however, suggest deepening concerns that the Italian government will fail to meet its fiscal targets. Although the parliament approved austerity measures for 2011, the shortfall jumped to 3.2% of GDP in the second quarter of 2011, from 2.5% a year before . Worryingly, the primary surplus dropped to 2.1% from 2.3% before. To reduce rising public debt, the government has to run a primary surplus of about 3% of GDP.

Global economic cooling

The world economy could cool additional than expected and European leaders could fail to build adequate firewalls to transaction with a Greek default. Investor confidence in Germany, where 13% of Italian exports are shipped, dropped to a three-year low in October. This is consistent with a recession in Germany in the last quarter of this year and first quarter of 2012.

Although G20 finance ministers agreed to retool the stability fund, the German government this week dampened enthusiasm by saying that a definitive solution to the euro zone's sovereign debt crisis was unlikely by the new deadline. Further escalation of the European debt crisis would increase market tension and deepen the recession in Italy and in the euro zone.