Aside from the ongoing banking sector saga, further pressure on Italian public finances is due to reconstruction costs related to the earthquake that struck the country at the end of August. The November referendum will be closely watched, as it has been charged with political value and is seen to be a vote of confidence. Markets favour stability.
Andrea Iannelli, fixed income investment director at Fidelity, shares his outlook on the Italian economy with Euromoneys Giada Vercelli.
Giada Vercelli: Andrea, keeping in mind stability and growth, how can Italy make itself more attractive to international investors such as Fidelity?
Andrea Iannelli: From an international investor point of view, there are really five points that we need to see for the country to become more attractive:
1) Stability. Italy has experienced 64 changes of government since the end of WWII. Markets have grown accustomed to the idea that Italy is politically unstable. Anything that can help change this will be welcome, and as you mention, the referendum in November will be very closely watched in this sense. More importantly for us, we need an indication that the set of structural reforms will continue to be implemented.
2) Growth. Italys capital stock has fallen consistently since the 1990s and needs to be replenished with new investment. We need to go from being a nation of savers to being a nation of investors. To do this, confidence needs to increase.
3) The banking sector. The health of the Italian banking sector has weighed down on the investment climate. The NPL issue remains key and needs to be resolved, and bank capital levels need to strengthen further.
4) The labour market. It has improved in Italy, thanks to the reforms implemented by the government last year. More needs to be done, however, particularly on the tax wedge, as it is still very high.
5) Lower taxes are essential but any reduction should be carried out in a way that keeps overall government finances in check, particularly given Italys high debt burden. A focus on lowering public administration costs is key, as is an efficient execution of the privatisation programme.
GV: At a time when the focus is on avoiding secular stagnation, some economists have recommended embracing low yields to borrow more in order to finance investments. Some have labelled this stance as fiscal incontinence, but surely there must be a way to make good use of low yields...?
AI: Low yields are already having a positive effect on both Italian public and private sectors. The Italian Treasury has seen its interest costs fall considerably over the last few years, and can now refinance itself relatively easily. The Italian government has been disciplined over the last four years, building a primary surplus that helps keep the debt burden in check. At 133pc of GDP however the debt stock represents a strong fiscal constraint for the government.
On the private sector side, lower yields are being passed on to consumers, who are borrowing more, and corporates. While borrowing for consumption can support growth in the short term, in order for it to structurally increase the countrys growth rate, it has to translate into higher investment. It is important, however, that investments are channelled towards productive activities in an effort to improve the the countrys productive capacity, and that they are executed in a way that does not squander resources.
GV: You have observed in your analysis that Italy benefits from a primary surplus (a negative net supply of debt before interest payments). This surplus however is expected to fall, weakening the fiscal position and slowing the path to debt reduction. With what foreseeable implications?
AI: The fiscal stance in Italy will become more expansionary in 2016/2017 thanks to the extra leeway that the government has negotiated with the EC. This will reduce the countrys primary surplus, weakening the fiscal position and slowing the path to debt reduction. Relative to other Eurozone countries, Italys primary surplus will remain healthy even after the forecasted reduction, meaning a negative supply before interest payments, which should provide a technical support to the BTP market.
GV: What is your outlook on the BTP future market, which has traditionally been highly liquid, setting a competitive advantage for Italy vis-a-vis other European countries? And how do you compare it with a country like Spain, whose Bonos have been affected by the political uncertainty over the past year?
AI: Bond market liquidity is a key issue for investors today and derivatives can provide an efficient, cost-effective alternative to gain exposure to a particular market segment. In such an environment, having a liquid futures market, as Italy does, is a competitive advantage. The BTP future allows investors to gain exposure to Italy, and to the periphery more generally, in a very cost effective way. This ultimately translates into more liquidity in the underlying cash market, as investors can invest in BTPs with more confidence if they know that there is a liquid instrument for them to hedge their risk should they wish to.
Compared to other European government bond futures, liquidity in the BTP future has been healthy all year, with circa 250k contracts of open interest. This is a good level of liquidity, and compares to about 3k contracts for the futures contract on the Spanish Bonos.
There is a drawback. Futures are often used by more tactical investors to trade in and out with high frequency. This means that futures can witness a bit more volatility than cash, but overall this is a small issue when compared to the extra liquidity they provide to bond market investors.
GV: One common perception is that the euro has been a failure for its third largest member country, Italy. Our analysts at BCA say that this is based on the economys apparent underperformance during the single currency era. Todays unemployment rate is 9% in core Italy and 4% in core Germany. But 10 years ago, it was the other way around: 4% in core Italy and 9% in core Germany. Todays gap simply reflects the cyclical positions of the two economies. The more important takeaway is that the two unemployment rates have been moving in an identical 4-9% structural range during the 18 years of the single currency. Can we really bash the single currency as the Pandoras Box of Italys troubles?
AI: The single currency has crystallised long standing structural issues of the Italian economy, which were there even before it adopted the EUR.
Productivity growth in Italy has been stagnant since the early 90s compared to other Eurozone countries, as have investments. For firms this translated in higher unit labour costs as wages have remained sticky, lower competitiveness (as shown by the European Commissions ULC-based REER, which for Italy is down 10 points vs. other Eurozone countries) and lower margins.
These are all issues that structural reforms need to keep addressing, particularly on the labour front.
Being part of the EUR however also offers an opportunity to firms in the form of access to cheap capital that can and should be put to work towards productive investments. Again, confidence is key.
GV: Only the large corporates issue debt, all other corporates (95% of Italian corporates are SMEs, with less than 10 employees) rely on banks for funding. Corporate issuance would be too small and illiquid for international investors.
AI: As we mention before, liquidity is a key part in the investment decisions that investors take. It is therefore natural that we would prefer to invest in corporate bonds issued by the larger companies that, because of their size, issue in sizes that are big enough for us to manage our portfolios efficiently.
For Italian corporates, who are by and large small and medium enterprises, this essentially greatly reduces the chances of diversifying their funding sources and leaves them reliant on bank funding.
In order for this to change, measures that favour an increase in the average firm size will be welcome. To this end the removal of Article 18 was a step in the right direction, as it was a disincentive for firms to grow beyond a certain, small size. However, more needs to be done on the regulatory front in order to foster competition by removing regulatory barriers.
GV: Are we really missing the tools, or are we missing good investment stories?
AI: I think the tools are there, its just a matter of creating an environment that favours economic growth and confidence. Going back to my initial point, government stability, a healthy banking system and a more dynamic labour market are all essential to foster a dynamic investment environment.
GV: Intellectual capital has been depleted over the years, with the so called brain drain that has seen many talented Italians looking to move abroad. How do you see the country creating an ecosystem, a cluster of intelligence, where growing industries such as fintech could thrive?
AI: I think there are three main things that should be done to foster a more fertile start up and fintech environment, following the example of the likes of Silicon Valley and the Silicon Roundabout in the UK.
1) Competition needs to be fostered and regulatory barriers need to be removed. It takes 1200 hours for example to enforce a contract in Italy, compared to 400 hours in France and 500 hours in Spain. The cost of setting up a company in Italy is 10 times that of France and twice that of Germany.
2) Improve higher education and links to the corporate sector. There is a lack of innovation strategy at a country level with funding that is still very much bank driven rather than capital market/crowdfunding.
3) Create a cluster. An ecosystem and a centre of excellence where start-ups can thrive. The interchange of ideas and knowledge is easier where smaller companies are clustered together.
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