Italy Faces Challenge of Living Without ECB Alchemy

When European Central Bank President Mario Draghi embarked on a policy of buying government bonds, it was an especially welcome lifeline for Italy, then reeling from soaring interest rates and trapped in the country’s worst economic crisis since the war.

Now, as the central bank unwinds the stimulus program known as quantitative easing 2 1/2 years later, Italy is an important test case for the long-term success of Mr. Draghi’s policy.

Years of cheap money and a robust recovery elsewhere in Europe is nudging Italy to its fastest economic growth in seven years. But while thriving on stimulus, Italy has failed to take big steps on changes such as cutting red tape and reducing the cost of labor.

“QE has been important, but that’s enough,” said Carlo Messina, CEO of Italian banking group Intesa Sanpaolo SpA. “Italy has got to get used to living without it. It has to learn that reforms are important.”

Quantitative easing was instrumental in helping Italy pull itself out of its worst downturn since the war. Low rates helped kick-start the economy; mortgages as low as 1% helped housing prices recover. Companies renegotiated their debt; corporate interest rates fell to an average of 1.60% this summer from 3.60% in 2012.

The weak euro kick-started exports. The trade surplus with non-European countries widened by almost 50% to EUR40 billion in 2016 from two years earlier. All that bumped Italy to its current growth rate of 1.5% — good for Italy, but the worst in the euro zone.

The sharp fall in interest rates under QE provided a windfall to the Italian government, which shells out EUR70 billion ($81.16 billion) a year to service its debt, the world’s third-highest. From the time QE was introduced in March 2015, the Italian Treasury made its debt cheaper for Italy by lengthening the average duration of Italian debt to 6.9 years from 6.4 years at lower interest rates.

The Treasury even sold EUR5 billion in 50-year bonds last year at just 2.85%, a price it paid for three-month Treasury bills at the height of the sovereign debt crisis. All told, Italy saved roughly EUR15 billion in interest payments during QE, some of it plowed into measures that stimulated hiring.

Italian banks also have used the rally in bond prices during QE to reduce their holdings of Italian government debt, a major worry during the sovereign debt crisis. They have cut their holdings by 30% on average.

UBS economists said they expect interest rates to remain low for some time and Italy’s debt, while at a high, to be sustainable for the medium-term.

But without the tailwinds of ultraloose monetary policy, the government expects Italy’s growth to fall back to 1.3% by 2020, citing a slowdown in domestic demand. Italy remains the economic laggard of Europe.

“While necessary and beneficial, quantitative easing has had to some extent an anesthetic effect in Italy, quelling the impulse to do more and more quickly in terms of structural reforms,” said former Prime Minister Mario Monti, who held the post for 17 months from 2011 to 2013.

Several efforts to cut public spending have fallen well short of their goals, with the government concerned that tighter budgets would choke off the recovery.

Red tape and a justice system that can take a decade to deliver rulings on commercial disputes still scare off potential investors. Italy has risen to 50th in the World Bank’s ease of doing business rankings from 87th in 2012, but it figures worse than Ireland, Portugal and Spain.

Italy’s banks are slated to sell about EUR60 billion in bad debts this year, but that leaves them with more than EUR200 billion. And they remain among the last profitable lenders in Europe.

The stronger euro is already starting to bite in a country that depends on external demand to stimulate growth. “For people like us [a few cents] count a lot,” said Enore Ceola, chief executive of Mionetto USA, a distributor of Prosecco sparkling wine. He says that if the euro remains around current levels his costs will rise by about 7% next years.

“Tapering is a much bigger problem for Italy than for the eurozone as a whole,” says Jack Allen, economist at Capital Economics.

And now, political concerns loom. National elections, currently expected in March, are expected to produce a hung parliament, according to analysts including Lorenzo Codogno, founder of LC Macro Advisors Ltd..

That could mean a broad left-right coalition that is too weak to push through unpopular measures such as a reform of Italy’s civil service or opening up closed professions. Nervousness about tapering and the elections have already driven a slow-motion flight out of government debt.

“Everyone in Italian politics thinks…the situation isn’t as critical as it [is],” said Klaus Schrader, an economist at the Kiel Institute for the World Economy. Thus, Italy’s economic decline is “a sluggish lingering process….This is a danger.”
Source: Dow Jones

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