Struggling Italian economy poses potential threat to whole of Europe

Italy could quickly descend into chaos if new government fails to turn around struggling economy, threatening whole of Europe

PUBLISHED : Monday, 28 April, 2014, 4:43am
UPDATED : Monday, 28 April, 2014, 4:55am

Italy may be the land of fast cars, high fashion and stunning design. But the country has been living the good life for far too long. It is now living on borrowed time.

Italy's economy is in dire straits. The country is struggling to emerge from its longest post-war recession. Unemployment is at record levels. The nation is burdened by a groaning mountain of public debt.

Italian politics remain a powder keg. Unless Prime Minister Matteo Renzi's centre-left government comes up with quick fixes, Italy will be heading for a new crisis. It could be the crisis that plunges the euro zone into a new realm of uncertainty and calamity.

Italy is the Godzilla of event risk for the euro zone. The country's bond market is a behemoth worth roughly €2 trillion (HK$21.44 trillion) - the third-largest in the world after the United States and Japan.

The European Central Bank did as much as it could to prop up confidence in Italian debt when the market imploded at the height of the euro-zone crisis in 2012. A repeat crisis in confidence would risk bringing the whole house of cards crashing down.

When the euro-zone contagion was raging, the European Union, the International Monetary Fund and the ECB managed to pool sufficient resources to keep the minnows - Greece, Ireland, Portugal and Cyprus - afloat. Italy would be a different kettle of fish.

If Italy's political climate takes a turn for the worse, or the market loses faith in government efforts to stabilise the debt situation, it could quickly descend into chaos. A deep crisis in Italy would be the Armageddon scenario, potentially unstoppable because of unimaginable bailout costs.

It is all down to confidence now.

The trouble is that Renzi's government is between a rock and a hard place - the austerity-weary Italian electorate angry on one side and the expectant markets petulant on the other. It will be a tough nut to crack.

Renzi came to power on an anti-austerity ticket. If he fails to deliver better times to the country, the government will fail.

And unless the markets see strong proof that Renzi is succeeding in taming the debt question, investors will vote with their feet.

It looks like an impossible balancing act. Renzi's economic reform agenda includes promises of job creation, sweeping tax cuts and spending programmes to promote growth. The weakest link is how these electoral pledges will be funded.

Italy's public debt remains dangerously high, about 135 per cent of gross domestic product. Ensuring a rapid decline in the debt ratio requires a much more ambitious programme of underlying budget austerity. The economy will also need to grow much faster to help make a bigger dent in the debt pile.

But the euro-zone crisis, debt deflation, fiscal consolidation and tight credit conditions have left the economy in very poor shape. The economy is only just emerging from a two-year recession. Economic confidence has taken a hard beating.

National output is still 10 per cent lower than pre-crisis levels. Business investment is down by a quarter. Domestic demand is dead in the water. Unemployment has hit a new record high of 13 per cent. Consumer spending power has been hit hard by the squeeze on wages. It is unlikely to recover any time soon given the uncertain economic outlook.

Excess capacity in the economy, weak competitiveness, low productivity and a poor investment record all mean employment and wages are likely to struggle for years to come.

The government is banking on a recovery in Italy's exports to take up the slack, but there are significant risks there. The deepening crisis in Ukraine, the slowdown in emerging markets and the loss of momentum in China's economy pose potential drags on Italian export growth.

It looks like Italian growth will be pinned down for years. The government expects the economy to grow by only 0.6 per cent this year. Italy's debt-to-GDP ratio will continue to rise, and the odds of an impending showdown with the Italian electorate, the markets - or both - will mount accordingly.

What Italy desperately needs is a return to a non-partisan, technocratic government similar to the one under Giuliano Amato's administration in the early 1990s - one that is capable of making objective and hard decisions to get the nation into better budgetary shape.

It implies years of enforced economic austerity - and an abrupt end to Italy's La Dolce Vita. It is a hair shirt that Italy's electorate refuses to wear any more.

With or without that austerity, the economy still looks doomed to years of subpar growth and continuing recession risks ahead.

Italy's economy is too big and too important to the euro zone to fail. Renzi's political options are limited, and time is running out - not just for Italy but for the euro zone, too. If Italy's crisis blows up again, it could be the final endgame for European Monetary Union and the euro.

David Brown is chief executive of New View Economics