Country risk: Make-or-break time for Italy

Mario Draghi is a master of the arts when it comes to international finance, but will Covid-19 blot his big picture for Italy?

Italy’s investor risks increased in 2020 as the country was hit hard by the Covid-19 pandemic, pushing the economy into a nosedive and worsening the fiscal metrics.

At a time when the country required solid leadership, Giuseppe Conte’s fragile government eventually collapsed, and the economic risks failed to ease with another deadly wave of the coronavirus emerging.

More than 2.6 million cases have been officially registered in Italy, with in excess of 92,700 deaths among a population of 60.3 million, resulting in the fifth-highest death toll per capita worldwide, behind Belgium, Slovenia, the UK and Czechia.

The economic impact has led to analysts assessing Italy as a higher risk, with the country falling 10 places this year in the global risk rankings, pushing it further down the third of five tiered categories to 57th out of 174 countries.

That makes Italy a similar risk to Oman and Mauritius, and less safe than its European compatriots Spain (39th), the UK (34th) and France (28th), as well as the highest risk G10 nation:

Indicators of bank stability, the GNP-economic outlook, employment/unemployment and government finances all score less than five out of 10 in Euromoney’s risk survey, which is extremely low for an advanced industrialized nation.

Only the monetary policy/currency stability indicator stands out, underpinned by low borrowing rates and inflation, and participation in the euro, limiting exchange-rate risk.

And it is not hard to see why the economy receives such a poor assessment.

GDP contracted on a real-terms basis in every quarter last year, at a faster year-on-year pace of 6.6% in Q4 after a 5.1% drop in Q3 as the strong quarter-on-quarter rebound petered out. This led to a year-average decline of 8.8% – though even in the five years that the economy grew between 2015 and 2019 it never got above 2% per annum.

Meanwhile, the harmonized unemployment rate, which fell to a seasonally adjusted 8.8% in November from 9.5% in October, according to Eurostat, rebounded to 9% in December, and it is expected to go higher as the crisis and cost rationalization continue.

Moreover, the government’s prediction of 6% real GDP growth for 2021 is already looking ambitious. Although the country is out of a national lockdown, a regional tiering system is in place, with some local authorities declaring lockdowns in particular hotspots.

The tourism industry, of course, is struggling and Roberto Gualtieri, the minister of economy and finance, has already signalled the GDP forecast will be downgraded.

On February 3, Mario Draghi, the former head of the European Central bank (ECB), accepted a mandate to form a new Italian government.

There is a lot hanging on Draghi, who might be able to engineer some improvement. In that respect, analysts are becoming more confident, at least for the short term.

“Mr Draghi’s reputation and credibility among investors is extremely high,” says the team of survey contributors at ABN Amro. “[He is] credited as the man who saved the euro and who subsequently introduced unconventional monetary policy to the single-currency area.

“Indeed, Italian assets have performed spectacularly since it became clear that he would be asked to form a government.”

ECR expert José Miguel Infantozzi, regional investment manager at TodoCalculado, says: “Italy has the perfect opportunity to restructure under the leadership of one of the world’s most appreciated, respected and talented professionals with roles at the top of the most important national and international institutions.”

Another survey contributor, Marco Vicenzino, director of the Global Strategy Project (GSP), believes the Covid-19 crisis and the resulting European recovery fund provides Italy with an historic opportunity to pursue its long-overdue systemic and structural overhaul.

“Seizing it effectively remains essential in determining the future of the European project and whether Italy assumes its proper role in the Union, and beyond, in the 21st century, or whether it continues its precipitous slide away from even being considered the least of the great powers – with practically no economic growth during the past 20 years,” he says.

“Draghi is now being entrusted to form not just a government of national unity but largely one of national economic salvation as Italy confronts its greatest existential crisis since the end of the Second World War.”

The biggest risks are political parties that could be against a technical government 

 - José Miguel Infantozzi, TodoCalculado

Vicenzino believes Draghi will try to leverage this reality to his advantage in the immediate future “as much of Italy’s political establishment lacks credibility among most ordinary Italians and at the higher EU levels that will be administering the recovery funds”.

Few, if any, in Italy’s establishment have the knowledge, experience or expertise to manoeuvre in this process like Draghi, he argues.

ECR expert and independent sovereign risk expert Norbert Gaillard, of NG Consulting – who keeps his finger on the pulse of European credit risk – believes Draghi is considered highly credible in political and economic circles.

“As former director-general of the Italian Treasury in the 1990s, vice-chairman of Goldman Sachs and governor of the Bank of Italy in the 2000s, and president of the ECB in the 2010s, he has an extensive knowledge of international finance,” he says.

“He is very likely to be the next prime minister now several key political parties [the League, the Democratic Party, and Forza Italia] have supported him. Such backing is underpinned by Draghi’s credibility and profile, of course, but more importantly by the economic context.”

Gaillard also believes Draghi’s task is much more comfortable than that which Mario Monti faced between 2011 and 2013. Monti had to decide how to cut public spending, but now the situation is the opposite: Draghi will have to assess how he allocates Italy’s share of the EU’s recovery plan.

Most experts such as Gaillard believe that a Draghi government will reassure international investors, and Italy’s government bond spreads will remain low during the next few months, with the country eligible for €208 billion of loans and grants from the European recovery fund from 2021 to 2023, worth around 12% of GDP.

Moreover, the economic recovery in 2021 could be significant. Reflecting this, the IHS Markit manufacturing purchasing managers’ index (PMI) climbed further above 50 (dividing expansion from contraction) to 55.1 in January from 52.8 in December. The services PMI also improved, despite lagging at 44.7.

The questions are whether these funds will be put to good use and how quickly they are spent.

Much depends on Italian political realities, although the difference this time, GSP’s Vicenzino says, “is the gravity and immediacy imposed by the pandemic, which requires firm and timely action by party leaders who remain exposed with little room to manoeuvre”.

He adds: “Failure to act decisively risks public repudiation during this fast-moving existential crisis.”

Draghi will nevertheless need to appoint an effective cabinet that strikes a realistic balance between credible technocrats and competent politicians.

As TodoCalculado’s Infantozzi warns: “The biggest risks are political parties that could be against a technical government, causing difficulties to find cross-party support on structural reforms and key decisions to tackle medically and financially Covid-19.

“Draghi will need the majority of Italian political parties to support him in parliament on how to invest the European Union recovery funds to reactivate the economy.”

Italy’s credit position is also fragile, with the pandemic worsening an already high debt burden to 154.2% of GDP at the end of Q3 2020.

It is predicted to end the year as high as 161% of GDP, according to Euro Zone Barometer, a monthly survey of economic experts. ABN Amro is even predicting a debt burden as high as 171% of GDP.

In October, warnings and recommendations for action were issued by Stefano Micossi, whose various positions include director-general of the Association of Italian Joint Stock Companies (Assonime), a board member of UniCredit and chair of the Luiss School of European Political Economy.

Writing in an article for the Centre for Economic Policy Research, Micossi stated that “sovereign debt externalities remain important in the euro area, even in the new environment of permanently lower interest rates”.

He says the problem is being “kept under the carpet by the ECB flooding the system with liquidity to address the impact of the pandemic, but it will return when economic output returns to pre-crisis levels, and because of the present rise in debt”.

For Micossi, only coordinated policies can deal with the problem effectively, otherwise the “doom loop” between a bank crisis and sovereign crisis may reappear after, for instance, a rating downgrade of a highly indebted sovereign below investment grade.

He wasn’t just talking about Italy, but clearly the implication is there with Italy presently rated BBB by S&P, but BBB-/Baa3 by Fitch and Moody’s.

Draghi must try to tackle several problems all at once, including the immediate health crisis and the long-running problem of ensuring strong, sustainable economic growth.

“On many estimates, Italy’s trend level of economic growth is around zero,” according to ABN Amro. “That partly reflects demographics, but more importantly is down to chronic weak productivity growth.

“A combination of well-focused public investment and structural reforms could start to change this narrative.”

So, can he deliver, they ask? There is certainly some confidence that he might, but the risks remain heightened.