Wednesday, June 13, 2012

Analysis: Spanish bailout raises the bar for Italy

MILAN (Reuters) - Italy must step up efforts to curb its colossal debt and revive growth to reverse negative investor sentiment that threatens to push it to the brink, despite a reform drive and a banking system sounder than Spain's.


But economists and the central bank say Rome can still tap a large domestic savings pool to help fight the mounting cost of servicing its 1.9 trillion euro ($2.4 trillion) debt.

After initial investor euphoria at the appointment of technocrat Prime Minister Mario Monti last year, Italian bond yields have been rising since March, topping 6 percent and making bank loans to families and companies in a credit-starved economy hugely expensive.

Even though Italy's deficit and unemployment are lower than Spain's and its banks are not exposed to a real estate crisis, doubts about Rome's ability to turn itself around during a deep recession are keeping international investors at bay.

On Monday, Austria's Finance Minister Maria Fekter said Italy may have to seek aid from European partners in the coming months, as Spain just did for its banks, drawing an angry rebuke from Monti.

"On substance, Italy is a totally different case than Spain and it is now even more important that Italy works further on its own reform steps," said Daniel Gros, Director at the Centre for European Political Studies. "Italy has the resolve to do it.

But reforms take time and market sentiment can turn in 10 seconds." Investors have welcomed Monti's austerity drive and a radical pension reform. But support has been waning after Rome failed to balance tax hikes with bold pro-growth reforms.

If the economy does not start to grow after a decade of stagnation, it will face mounting difficulty in bringing down its debt, now at 120 percent of gross domestic product - second only to Greece's debt mountain in the euro zone.

"The markets say: what is Italy doing to tackle the fundamental problems that have stopped it growing? Because if those problems remain, Italy will always stay in political and economic difficulty," former European Central Bank executive board member Lorenzo Bini Smaghi told Reuters.

Bank of Italy Governor Ignazio Visco said last week Italy's emergency is not over and pressed Monti to speed up reforms. Yet the unelected premier, appointed after the collapse of billionaire Silvio Berlusconi's scandal-plagued government last November, appears on the defensive.

He reacted bitterly last week to criticism by two leading Italian economists in top daily Corriere della Sera.

NOT THE BANKS

Contrary to events in Spain and other European countries, Italian banks - including top lenders Unicredit and Intesa Sanpaolo - have managed to bolster their capital base by tapping private investors and not the state.

But questions remain about the ability of No.3 bank Monte dei Paschi di Siena to plug a 3 billion euro capital shortfall.

There is no real estate bubble, but the banks face a risk from bad loans, which have nearly doubled in the crisis to 11.2 percent of total lending. Ed Parker, director of sovereign ratings at credit ratings agency Fitch, said the Spanish bailout had no direct implications for Italy or other countries.

"The Italian banking sector is very different from Spain, they didn't have a credit boom and property bubble in a way that Spain did so we don't see the kind of bank sector problems in Italy," Parker told Reuters in Oslo.

If the economy contracts much beyond the 1.2 percent fall forecast by the government in 2012, the growing share of non-performing loans held by banks would hit their profitability.

This would come on top of their exposure to Italian government bonds, which at 26 billion euros is particularly large for Monte Paschi.

"The decline of the Italian economy isn't that severe yet in order to have a major impact on loans. This of course could change if investor sentiment deteriorates further," said Markus Huber, a senior trader at ETX Capital.

Despite the worrying outlook for non-performing loans, Citi analysts calculate the capital shortfall for the entire banking system at just over 50 billion euros in an extreme stress scenario, an amount they see as manageable.

UNTAPPED RESOURCES

Italy is nearly halfway through an annual bond issuance plan estimated at 215 billion euros. Domestic buyers, including cash-rich households, may be the last line of defense if Italy's reform path does not quickly convince foreign investors, who now hold only about a third of Italian bonds compared to more than 40 percent a year ago.

Sitting on net financial wealth of 2.6 trillion euros at the end of 2011, Italian citizens used to funnel a larger chunk of their savings into government bonds until yields started to fall in the 1990s as the country joined the euro.

The Bank of Italy sees ample further margin for tapping domestic investors - banks, insurers and households - to boost purchases of governments bonds.

These accounted for 6.9 percent of residents' total financial assets in 2011, slightly up from 2010 but nearly half the late 1990s level of 13.2 percent. "They key strength of Italy is its own domestic savings. Italy should mobilize these savings," said Daniel Gros.

"Italian banks buy dozens of billions but households are the ultimate anchor for a solid public debt." If Italian households were to go back towards the levels seen in the 1990s, this could potentially mobilize around 200 billion euros of additional funds.

But convincing Italians that government bonds are a safer bet than stashing money under the mattress or putting it into bricks and mortar may not be easy if panic sets in, said Nicholas Spiro, Managing Director at Spiro Sovereign Strategy. In a drive to tap small investors, the Treasury recently launched innovative inflation-linked bonds.

The debut issue in March saw bumper demand, raising a much larger than expected 7 billion euros. However, a second issue this month was a lot less successful, coming at the same time as tax payments are due.

The government is planning another such issue by year end. As party squabbling in parliament increases less than a year before a general election, Rome must hurry to turn the tide.

"The Monti government has less than 12 months to carry out further reforms. If the economic recession deepens, it will be even more difficult," said Erik Jones, director of European Studies at the Johns Hopkins University.

yahoo.com

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