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16.03.12

Special Series: European Economies At Risk - Italy

Stratfor

After a turbulent 2011, Italy regained some financial stability when the technocratic government of Prime Minister Mario Monti came to power. Monti's government introduced a rapid series of economic reforms that, along with the purchase of government bonds by the European Central Bank (ECB), temporarily took Italy away from the center of the European crisis. The government also benefits from a political environment in which the main parties want to preserve the status quo. However, Italy has economic, social and political issues that are far from resolved. Slow economic growth, a large public debt, high levels of tax evasion and persistent illegal activities undermine Italy's chances to exit the current crisis.

Domestic Conditions

Economy

Monti's appointment as prime minister in November 2011, along with the ECB intervention in the sovereign bond market, reduced the urgency of Italy's financial situation. During its first 100 days in office, Monti's government introduced some 30.4 billion euros (about $40 billion) in new taxes and spending cuts, representing 3.25 percent of Italy's gross domestic product (GDP). The government also liberalized many sectors of the economy and promised labor reforms designed to encourage job creation. The immediate effects of Monti's measures (and the ECB assistance) were positive. Italy's benchmark borrowing costs fell to around 5 percent in early March from a peak of nearly 8 percent in November, and the spread against safer German bunds has declined to less than 3.2 percentage points (its lowest since September) from highs in excess of 5.5 points.

Although the "Monti effect" improved Italy's short-term situation, it will not be sufficient to solve Italy's long-term problems. Italy's main difficulty is that its economy simply does not grow enough. Even before the financial crisis, the Italian economy's growth rate was among the lowest in Europe. Since 2001, the country has experienced four recessions, and GDP is expected to decline 2.2 percent this year, according to the International Monetary Fund (IMF). Without sustained growth, Italy will find if very difficult to reduce its public debt, which now exceeds 120 percent of GDP. Italy's economy would need to grow at an average of more than 1 percent annually and maintain a surplus of nearly 6 percent to reduce its debt burden in the next decade, but this is highly unlikely -- from 2001 to 2010, Italy had an average growth of 0.41 percent annually.

The prospect of long-term growth is constrained by Italy's demographics. Twenty percent of the country's population is over 65 years old, but only 13.5 percent is under age 14, according to 2010 data. This means that in coming decades Italy will have fewer people joining the labor market generating taxable income, even as the less economically active segment of the population grows.

As the world's fourth-largest borrower, and with its sovereign debt amounting to almost 2 trillion euros (about $2.6 billion), Italy is vulnerable to cooling economic growth and to increases in market interest rates. If Italy were to lose access to the capital markets, even the combined funds of the European Stability Mechanism (ESM) and the European Financial Stability Facility (EFSF) would not suffice to bail out Italy. The 230 billion euros left in the EFSF combined with the ESM, which is expected to take effect by July, will have a total funding capacity of only 500 billion euros. 

Italy's banking sector is also suffering. In February, Standard and Poor's gave the Italian banking system a negative outlook, anticipating persistently weak profitability for the banks over the next few years and a risk-adjusted return on core banking products that could be insufficient for banks to meet their cost of capital. The same month, a report from Italy's central bank warned of the danger of a credit contraction as Italian lenders tightened their standards for both corporations and homebuyers. However, Italy's private sector carries moderate debt at 128 percent of GDP, while household indebtedness, at 45 percent of GDP, is low compared to levels in peer countries. Additionally, Italian households' financial wealth is about twice GDP, which sustains their creditworthiness in case of financial difficulties.

The size of Italy's informal economy poses other problems. According to a study conducted by the Italian Labor Union in 2010, funds earned through illegal employment equated 10 percent of national GDP. Illegal workers amounted to 13 percent of the working population in the north, 15 percent in central Italy and 21 percent in the south. Italy's National Institute for Statistics estimated that the country's informal economy is worth 255 billion to 275 billion euros, or 16.3-17.5 percent of GDP. Tax evasion alone is equal to 8 percent of GDP.

Politics

In his first three months in office, Monti managed to pass numerous important reforms, including state spending cuts, economic liberalization measures and a restructuring of the pension system. These reforms were controversial but were approved because Italy's two main political parties, the center-right People's Freedom Party (PDL) and center-left Democratic Party (PD), share long-term strategic goals and want to preserve the status quo. The parties want to keep the current technocratic government in power until its expected end date in early to mid-2013.

The PDL, former Prime Minister Silvio Berlusconi's party, and the PD, led by Pier Luigi Bersani, theoretically are ideologically opposed, and both are against some of Monti's policies. For example, the PDL openly criticized the government's liberalization plans because it hurt economic interests important to the PDL's voting base. On the other hand, the PD harshly criticized Monti's spending cuts because they supposedly were meant to reduce benefits for workers. However, when voting on both policies in the Parliament, the two parties supported the government and Monti managed to get both laws passed with support from a large majority.

This apparent contradiction between the parties' words and actions stems from their shared short-term and long-term objectives. In the short term, the PDL and PD want a technocratic government, not a political government, to approve the controversial economic reforms Italy needs to reduce its financial stress. It is easier for both parties to say they are making "a sacrifice for the nation" if a non-partisan leader is in charge who can absorb all social criticism. It helps that the current government is quite popular, with the support of two-thirds of the Italian public, according to several opinion polls. Moreover, a recent poll suggested that if Monti's Cabinet created a political party it would get more votes than either the PDL or PD.

The PDL and PD also share the long-term goal of reforming the electoral law to consolidate into a two-party system and eliminate smaller parties. The last electoral law, which Berlusconi passed in 2005, sought to build strong governments by giving additional seats to the party that obtained the most votes in the general elections. Now, the PDL and PD want to go further and reduce the possibility that small parties will have access to government positions. The issues the parties are discussing include a proposal from Berlusconi that would set a higher electoral threshold. Even if the parties disagree over technical details of the new law, they agree that a two-party system should be enforced.

Internal difficulties within the two main parties add to the complexity of Italy's political landscape. The PDL, the main force in the Italian Parliament, is having an identity crisis in the wake of Berlusconi's resignation. The party is divided between those who still support Berlusconi and those who believe the party should find a younger leader. And there are divisions between those who want a coalition with the Union of the Center and those who want to rebuild the PDL's traditional link with the Northern League political party. The PD is experiencing an identity crisis to a lesser extent, as candidates opposed to Bersani's leadership won recent local primary elections. Monti, meanwhile, is benefiting from this intricate political environment. As long as the PDL and PD want to keep the system functioning, the technocratic government will serve the remainder of its mandate.

Society

Italy's main social problem is rising unemployment, which reach a record 9.2 percent in January. The situation is particularly serious among people between ages 15 and 24, where unemployment reached 31.1 percent. However, two factors have so far mitigated the effects of unemployment: the family economy and the informal economy. In Italy, the family serves as a containment structure for those who lose their jobs or earn low salaries. It is very common for Italians to return to their parents' homes after losing their jobs. This costs less than living alone and allows men and women access to their parents' savings and pensions. Meanwhile, it is common for young people in Italy to agree to work without being registered as part of the informal economy. The different illegal organizations operating in the country also serve as important sources of contacts for finding both legal and illegal work.

The government intends to reform the labor law as a way of responding to the unemployment problem. One of the most controversial parts of the reform plan is a measure to make it less costly for companies to fire employees. Italy's biggest union, the Italian General Confederation of Labor, has pledged to defend the controversial Article 18 of the labor statute, which was adopted in 1970. It obliges firms with more than 15 employees to reinstate workers found to have been wrongfully dismissed, with full payment of lost salary. While Monti's government has met with all the union leaders, it has also stated it plans to implement the reform even without the support of the unions.

Labor reform is the most important social and political challenge the Italian government will face in the second quarter of 2012. It will allow the government and unions to measure their strength and influence. In the second half of the year, Monti's greatest challenge will be to improve employment levels and demonstrate the reform's usefulness.

Comparison with Greece

The economic and political situations in Italy and Greece at the end of 2011 were similar and placed serious doubts on the future of both countries. In Italy, Berlusconi's government was paralyzed by the progressing loss of support in Parliament, and every political decision was accompanied by uncertainty about how and when the government would fall. In Greece, then-Prime Minister George Papandreou had to deal with international pressure, discontent within his own government and growing social unrest. His idea of holding a referendum on the Greek bailout only further irked both Brussels' and Greece's political forces. Market pressure on Italy and Greece grew along with political instability. Also, in both countries, sitting governments were replaced by technocratic administrations -- with Monti's totally apolitical Cabinet and Papademos' Cabinet comprising the main political forces in parliament.

To a large extent, the similarities between Italy and Greece end here. In Greece, the Papademos government continued to see social discontent and market pressure in a turbulent political environment, while Monti managed to calm Italy's political and financial situation. Moreover, Monti managed to approve austerity measures without much political or social tension and with the support of the main political parties. But in Greece, austerity measures were accompanied by violent protests, and the New Democracy party (one of the main members of the ruling coalition) demanded early elections. These differences occurred largely because Greece had experienced harsh austerity measures and social tensions longer than Italy, facing pressure from the troika -- the European Commission, IMF and ECB -- for more than a year and a half.

Overall, Italy's political, economic and social environment is much more stable than Greece's. In part this is because Italy is much richer and more economically integrated into Europe than Greece. Unemployment in Italy is less of a problem, and Italy's economy is contracting more slowly than Greece's. Finally, the size of Italy's economy and the risk that an Italian default would pose to the rest of Europe means the European Union is giving Rome more political support than it is giving Athens.

Looking Ahead

In the short term, Italy's financial and political situation is stabilized. Monti's government will almost certainly finish its term in early to mid-2013. Political stability in Rome and the ECB's intervention will keep Italian bond yields at sustainable levels for the immediate future.

However, political tensions are likely to increase in the second half of 2012 as the election date approaches and political parties begin defining their electoral strategies. The main parties, which have supported the government thus far, will begin feeling the need to differentiate themselves from the government (and the other parties) ahead of elections. In that sense, it is likely that Monti's reformist momentum will slow down in the second half of the year.

Labor reform and rising unemployment likely will lead to strikes and protests in the second half of the year. These protests probably will not lead to an early downfall of Monti's government, although the government's popularity is likely to wane toward the end of the year.

In Italy, economic instability is to a great extent a consequence of political instability. Therefore, while the current political calm has brought with it some relief, the country's long-term problems are unresolved and financial instability is likely to return after political life in Italy returns to normal.

Source: Stratfor

Post-Crisis World Institute