Italy’s austerity drive, enacted in exchange for European Central Bank (ECB) bond purchases driving down borrowing costs, may backfire as it chokes the economic growth needed to ease Europe’s second-biggest debt burden.
Prime Minister Silvio Berlusconi’s Cabinet approved ¤45.5 billion ($66 billion) in deficit reductions in Rome on August 12, the nation’s second austerity package in a month, to balance the budget in 2013 and convince investors that Italy can trim debt of about 120 per cent of gross domestic product. That’s the biggest ratio in Europe after Greece, whose financial woes sparked the sovereign crisis last year.
While the back-to-back packages aim to eliminate Italy’s budget gap, spending cuts and tax increases risk damaging the economy at a time when the global recovery is stumbling. The measures, already in effect, require parliamentary approval that starts today as Senate committees review the law before both houses vote in September.
“There are clear downside risks to growth emanating from such a sharp fiscal tightening profile, which could tip Italy’s fragile economy into a recession,” said Vladimir Pillonca, an economist at Societe Generale SA in London. That could “weaken revenue growth and undermine the ongoing fiscal adjustment” in the face of other challenges, such as “shocks to risk premiums and/or interest rates.”
ECB LETTER
Berlusconi rolled out the second package after ECB President Jean-Claude Trichet wrote to him demanding more deficit measures in return for supporting the country’s bonds. The ECB started buying Italian and Spanish bonds on August 8, helping push 10-year yields below five per cent after they had surged to euro-era records amid concern contagion from the debt crisis had infected both countries.
Italy’s 10-year bond yields about 4.92 per cent, and has closed below five per cent for four consecutive trading sessions. Investors demand 282 basis points of extra yield to own the debt rather than benchmark German bunds of similar maturity, down from a euro-era record of 416 on August 4.
The success of Italy’s austerity drive, which is also expected to include structural moves to liberalise the labour and services markets, hinges on growth matching Berlusconi’s forecasts. That looks increasingly challenging as equity markets from Tokyo to Milan plunge and economists revise down growth predictions amid concern the global expansion is slowing and the debt crisis will further damage Europe’s banking system.
STANDING BY FORECASTS
Italy’s government expects economic growth of 1.3 per cent next year and 1.5 per cent in 2013, according to the most recent forecast in May. Tremonti said on August 13 the government stands by those targets, a view dismissed by several economists.
Giada Giani, an economist at Citigroup Inc in London, said on August 12 that GDP growth is likely “to slow to close to zero in 2012 and 2013” in Italy, an outlook shared by Pillonca of Societe Generale. Morgan Stanley analysts including Elga Bartsch in London expect the austerity plans, coupled with slowing global demand and tighter credit, to spark “an outright recession next year” in Italy, according to an August 18 note to investors.
“If you go through this kind of fiscal adjustment, which is absolutely tough, you are going to see private consumption suffering,” said Fabio Fois, an economist at Barclays Capital in London. Lowering his Italian outlook, he said GDP is likely to advance 0.7 per cent next year from the previous projected growth forecast of 1.1 per cent.
RATING REVIEW
Both Standard & Poor’s, which grades Italy at A+, and Moody’s Investors Service, which has an assessment of Aa2, warned that Italy’s weak growth prospects would make it difficult to cut a debt of ¤1.9 trillion in announcing rating reviews in May and June, respectively. Growth in the euro-region’s third-biggest economy has lagged behind the euro- region average every year since 1995.
The euro region’s economic growth slowed in the second quarter to 0.2 per cent from the January-March period, when it increased 0.8 per cent. That was the worst performance in two years. GDP in Germany, the region’s biggest economy, rose just 0.1 per cent in the second quarter, missing analysts’ 0.5 per cent estimate. Italy, the currency area’s third-biggest economy, grew 0.3 per cent.
Stabilizing Italy’s debt ratio requires a primary surplus, or the budget surplus minus interest paid on debt, of at least three per cent, assuming an average financing cost of 5.5 per cent, according to Pillonca. The government’s forecast, which didn’t include the effects of the latest austerity plan, sees a primary surplus of 2.4 per cent next year, which Bank of Italy Governor Mario Draghi said on July 13 would be Europe’s biggest.
ACHIEVABLE GOAL
The goal of balancing the budget in 2013 is “achievable, at least arithmetically,” when savings from the last austerity moves are included, Pillonca said. Still, amid slowing economic growth, “far-reaching structural reforms” will also be needed to maintain “a high primary surplus on a consistent basis” to begin driving down the debt ratio, he said.
Those overhauls, such as opening up closed professions and giving companies more leeway in negotiating job contracts, are “not ambitious enough” and may not be included in the final package amid intense “lobbying pressure” to amend them, Nomura International economists including Lavinia Santovetti in London wrote in a note on Friday.
Under the government’s worst-case scenario, the economy will grow 0.8 per cent in 2012 and one per cent in 2013, with debt staying at around 120 per cent of GDP, according to the document published in May. While Nomura still predicts marginal growth for those two years, public debt will “balloon to 137 per cent” if Italy stops expanding in that period, Nomura said.
“Ultimately, all this means that one cannot rule out that Italy may be forced to enact further fiscal adjustments down the line,” Pillonca said.
