19/01/09

Italy Slips Slowly But Steadily Into Its Worst Recession In Over 30 Years


by Edward Hugh

The Italian economy continued to contract sharply in the third quarter of 2008 as exports fell sharply - declining at the fastest rate in three years - under the impact of a global slump which weighed down on foreign demand for Italian products, and pushed the Italian economy into its worst recession since at least 1975. Sales of Italian goods abroad fell 1.6 percent from the previous quarter, their biggest decline since 2005.

Pressure is of course on the government to offer a fiscal reponse to the problem, but given Italy's outstanding debt issues and the fact that a large part of the problem is long term structural and not cyclical it is hard to see much of note happening, and indeed Finance Minister Giulio Tremonti's statement this week that additional stimulus packages were pretty pointless could be read as more of an admission of impotence than anything else. What'smore the Italian government announced this week that its budget deficit for 2008 will be 52.9 billion euros, somewhat above the government's earlier estimate which forecast a gap of 45.2 billion euros. It is not clear yet how this deficit overrun will actually affect the final % of GDP number for the deficit, since we still do not have an accurate 2008 GDP number for Italy yet. In any event speculation is rife about the future of the Italian bond spread and the danger of a credit rating downgrade. The Italian government went to market this week and sold 6.949 billion euros of five-, 20- and 30-year bonds. The 10-year Italian BTP/Bund spread was trading at around 144 basis points after Thursdays auctions compared with 141 basis points the day before.

Severe Limits On Stimulus Packages and Bank Bailouts

This week the government did approve a further 16.6 billion euros in public works investments to try to boost economic growth, but little of this actually represents new spending. The projects include an additional 7.3 billion euros in public spending, together with 9.3 billion euros in private investment. Among other infrastructural works some of the additional funding will go toward building the "Moses" retractable dams that are designed to protect the city of Venice from flooding.

This infrastructure package is in addition to the 5 billion euro stimulus package to help poor families, small businesses and boost bank capital that was agreed to by the Italian parliament earlier in the week. Under the bill a sum of around 2.4 billion euros will be used to help Italy's poorest families and pensioners, including some one-off cash payments. Highway tolls will be frozen until April 30 and low-income Italians will benefit from tax breaks on utility bills. Small businesses will get a 10 percent break on a regional tax on condition they are already paying a national corporate income tax.

Following warnings to a number of Eurozone government's over credit downgrades from rating agency Standard and Poor's this week Finance Minister Giulio Trementi said on Thursday that Italy won't follow up its existing stimulus package with more cash injections . Italy currently has the highest debt level in the European Union, which was running over 105 percent of gross domestic product in 2008, according to a Bank of Italy statement today.

Italy's bank bailout is likely also to be pretty modest in comparison with what is going on elsewhere. The 20 billion-euro bank recapitalization plan will probably start operating next week, according to the news source Il Sole/24 Ore, but details are not available since the Finance Ministry is still "perfecting" the rules and regulations that go with it.

Bleak GDP Growth Outlook In The Short, Medium and Long Term

Italy's economy is expected to shrink by 2 percent this year, making the present contraction the worst in more than three decades, according to the latest forecast from the Bank of Italy. "Taking into account the government measures …. the economy will shrink by 2 percent and then expand 0.5 percent in 2010″. The economy's last annual contraction on this scale was in 1975.

These central bank predictions are the worst to have come out on Italy to date, and significantly above the 1.3 percent contraction being forecast by employers organisation Confindustria and minus 0.6 percent prediction from retail lobby group Confcommercio. It is also a substantial downward revision since only six months ago the central bank was predicting growth of 0.4 percent. Ominously Confcommercio added that "Should the employment situation worsen, we will have to cut these estimates". Clearly one of the big dangers with the current contraction in the industrial sector is that it lead to large a scale industrial layoffs, and that this then feed back pushing demand downwards.

The Bank of Italy forecast was described as "realistic" by Finance Minister Giulio Tremonti even though his current government forecasts are for an economic expansion of 0.5 percent in 2009. These differences in forecasts are in fact very important, since the government budget is evidently anticipating far higher revenue levels and far lower social expenditure (on unemployment etc) than is likely to be the case.

Fourth Recession In Seven Years

The last GDP report from Italy's statistics office (ISTAT) confirmed that the euro-region's third-biggest economy slipped into its fourth recession in seven years in Q3 2008. The economy shrank 0.5 percent in the three months through September after contracting 0.4 percent in the previous three months. Imports in Germany and France, Italy's largest trading partners, declined in October, and the German import decline of 5.6% in November over October (following a decline of 3.7% in October over September) was the biggest slide in almost four years. As a result Italian year-on-year GDP shrank 0.9 percent in the third quarter.

Italian imports fell 0.5 percent in the third quarter while consumer spending barely grew, increasing 0.1 percent in the quarter. Year on year household spending was down 0.6%.


Gross fixed capital formation was down 1.9% on the year - with the machinery and equipment component down 3.5%. Exports fell 3.1% on the year in price adjusted terms.

Manufacturing Contraction

And as we look forward all the short term data is deteriorating. Industrial production fell yet again in November with output dropping a seasonally adjusted 2.3 percent from October, while production adjusted for working days fell 9.7 percent when compared with November 2007, the biggest drop since 1991.


And if we look at the index, we can see that output has now been trending down since the end of 2006.

And survey data from December suggest the Italian manufacturing sector remained mired in recession as output, new orders, new export orders, backlogs, employment and purchasing activity all contracted. The headline seasonally adjusted Markit/ADACI Purchasing Managers' Index (PMI) came in at 35.5 in December. Even though this was marginally up from the 34.9 recorded in November, it was the still second-lowest reading recorded in the history of the survey.


And it was the ninth consecutive monthly contraction in production volumes. In their report Markit state that the continued downturn in new business appeared to be the key driver, as firms reduced output in line with falling demand. Steep falls were reported in new business from both domestic and foreign markets. Overall, new order books fell for a 12th successive month, albeit at a slightly weaker rate than November's series record. And perhaps most worryingly given Italy's need to export, new orders from export markets fell at the fastest pace in the survey history.

Protracted falls in incoming work and production volumes resulted in a further month of job-shedding in December. Moreover, the rate of job losses was the fastest in the history of the series. There was also some evidence from those interviewed that redundancy programs had been implemented over the month and that the non-essential workforce had been reduced.

Commenting on the Italy Manufacturing PMI survey data, Andrew Self, economist at Markit Economics, said: "While December's fall in output was less pronounced
than November's series record, the rate at which the manufacturing economy has
contracted throughout Q4 is alarming. Italian manufacturers will hope that the
fiscal packages announced throughout Europe in December will mark the turning
point of the recession. However, with new orders still falling in domestic and
foreign markets the downturn looks set to continue into 2009."

The Services Sector Also Continues to Contract

Italy's service sector also contracted sharply in December (for the 13th consecutive month), although as with manufacturing the rate was marginally slower rate than the record low hit in November, and the Markit Purchasing Managers Index edged up to 40.3 from 39.5 in November. Again this was still the second lowest level in the survey's 11-year history and well below the 50 divide between growth and contraction.


The index has now not been above the 50 mark that separates growth from contraction since November 2007 and the latest survey, like its companion PMI for the manufacturing sector, offered no evidence whatsoever of recovery.

"December … painted a gloomy picture of the Italian services economy as,
throughout the final quarter of 2008, activity contracted at rates unprecedented
in the 11-year survey history," said Andrew Self, economist at Markit Economics.

Retail Sales Contract For The 22nd Consecutive Month

Italian retail sales contracted for a 22nd month in December as the Bloomberg retail sales PMI rose slightlly - to 31.9 from 28.5 .The index, based on a survey of 440 executives prepared by Markit Economics, also showed annual sales fell at the fastest pace in the near five-year history of the data.

Declining sales prompted retailers to cut staff for a 12th consecutive month, the report also said, and the rate at which staff numbers were reduced was the fastest since Markit first compiled the data in January 2004. In the third quarter the number of Italians out of work rose and the unemployment rate held at two-year high of 6.7 percent. Joblessness will rise to 6.9 percent in 2008, the highest in three years, from 6.2 percent in 2007, the Organization for Economic Cooperation and Development estimated on Nov. 25.

Falling Consumer and Business Confidence

Italian business confidence fell to a record low in December, and the Isae Institute's business confidence index dropped to 66.6 from a revised 71.6 in November.

"These figures are consistent with the picture of a deep recession in
manufacturing industry," said Paolo Mameli, an economist at Intesa Sanpaolo in
Milan. "As there is usually a three-month gap between this data and the
industrial production, we forecast that the economy will contract further next
year and won't resume growing anyway until the last quarter of 2009."

About 13 percent of Italian companies trying to get loans don't receive them, either because banks refuse to lend to them or because the costs involved are considered excessive by the company, Isae say in data which accompanies this months report.

Italian consumer confidence also fell in December its level in four months on concern that the recession and the decline in industrial activity would increase unemployment, with the Isae Institute's consumer confidence index falling to 99.6 from 100.4 in November.

Inflation Falling Back But No Sign Of Deflation Yet

Italy's inflation rate fell to its lowest level in 14 months in December, as energy costs fell sharply and the recession made it harder for retailers to raise prices. Consumer prices as measured by the EU's HICP rose 2.3 percent from a year earlier, compared with a 2.7 percent rise in November. When compared with November prices were down 0.2 percent.

So Where Does That Leave US - With Very Little (If Any) Growth In the Future, That's Where It Leaves Us!

Unlike many other Eurozone economies, Italy's current contraction in activity is not a simple result of the global economic slowdown. Itay's problems are endemic, and ongoing: hence the four recessions in seven years. Trend growth in Italy has been slowing over the last few decades, and must now be near to zero. Which raises the question as to whether in the coming decade Italy's trend growth could turn negative, with GDP simply contracting from one year to the next.
Obviously this possibility is only a theoretical one at the present time, but it is one which cannot be entirely included, especially when we look at how - despite all the promises that things would change - trend growth has steadily drifted to zero. Ceratinly also there are reasons to imagine that the productive capacity of the Italian population could drop as median population rises. Italy is currently among the three oldest societies on the globe - with median age of 43, and Germany and Japan being the other two - and as we saw at the start of this post, Italy has not been able to raise its export prowess in the way the other two have. And if it hasn't been able to do this over the last 15 years or so, what good reasons are there for thinking that Italy may start now?

S&P and Fitch last reduced Italy's credit rating in October 2006, with S&P reducing the rating to A+ (with negative outlook), the third-lowest of the eurozone countries after Greece and Slovakia, while Fitch dropped it to AA- from AA. Moody's Investors Service rates Italian debt Aa2, with a "stable" outlook. In November 2005 the ECB announced that would not accept government paper (bonds) in the future from any country which did not maintain at least an A- rating from one or more of the principal debt assesment agencies. Which means of course that Greek sovereign bonds are now very vulnerable to losing acceptable asset status in the longer run, but that Italy is not far behind.

In fact back in October last year, the ECB announced that the Eurosystem would lower the credit threshold for marketable and non-marketable assets from A- to BBB-, with the exception of asset-backed securities (ABS), and impose a haircut add-on of 5% on all assets rated BBB-. But it is important to bear in mind that this expansion of eligible collateral is temporary: "The list of assets eligible as collateral in Eurosystem credit operations will be expanded as set out below, with this expansion remaining into force until the end of 2009." While it is perfectly possible that the ECB will extend this temporary relaxation of credit thresholds for the duration of the current crisis, the problem of default risk in the most vulnerable economies is likely to outlive the current crisis, and the ECB relaxation is unlikely to last indefinitely.

The gap between the interest rates Spain, Italy, Greece and Portugal must pay investors to borrow for 10 years and the rate charged to Germany has now ballooned to the widest since before they joined the euro. In the graph below you can see ten year bond spreads for Greek, Irish and Spanish government paper as compared with the benchmark German Bund.

The yield on Spain's 10-year bond averaged 8.5 percent in the six years before it joined the euro and the gap with the equivalent German bond was 246 basis points. In the next eight years, the average yield fell to 4.5 percent and the spread to 13 basis points. That convergence is now being thrown into reverse. In the past week, Standard & Poor's has downgraded Greece's credit rating, and those of Portugal and Spain are also under threat. The difference between the Spanish and German 10-year bonds rose to 115 basis points today, the highest since 1997. The spread on Italy's bond at 144 basis points was the most in 12 years and the Greek spread was the most since 1999.

Different economists take differing views on the implications of this development. The LSE's Willem Buiter argues that the widening of the spreads is a good sign, as it shows that market mechanisms are finally working. In the past the problem had been the way that markets assumed for too long that governments would be bailed out if they defaulted. But RGE Monitor's Nouriel Roubini makes the very valid point that if financial markets get concerned about the risks of exits, a vicious circle of rising rates and poor debt dynamics may force exit regardless of the will to stay in. The effects can be very similar to a currency crisis or a self-fulfilling run on the government debt or the banking system. Basically, countries like Italy and Portugal have quite low trend growth rates as it is, if fiscal support is withdrawn and bond spreads rise this can easily produce a lose-lose dynamic which virtually forces default.

And this is without any reference to the negative feedback effects that can be produced by the health and pension spending required to meet the needs of a rising elderly support ratio, and a lower productivity from a working population with a higher median age. All in all, a very difficult can of worms for everyone to get to work on.




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