To the Point, No.7, October 31, 2011: After the EU deal: Fear is still spelled “Italy”

1. To the Point
Discussion on the economy, by the Chief Economist October 31, 2011
After the EU deal: Fear is still spelled “Italy”
 Rating institutions, financial markets and policy-makers in the euro zone all
show a shrinking confidence in the Italian government and its plans to balance
budgets and reduce debt while enhancing growth.
 Italy’s high public debt is destabilising not only Italy, but also the euro zone and
potentially the global economy. Despite the EU deal to ring fence Greece, Italy
is still the main fear as market interest rates rise. Italy needs bold structural
reforms in order to create confidence.
Cecilia Hermansson
Group Chief Economist
Economic Research Department Hardly any confidence left
+46-8-5859 7720 On October 14, the Italian parliament gave the Italian ruling coalition and Prime
cecilia.hermansson@swedbank.se Minister Silvio Berlusconi a vote of confidence with a small margin (316 in favour
and 301 against). Contrary to the parliament, various institutions, politicians, and the
financial markets have clearly shown that their confidence in the Italian government
is shrinking.
This is particularly worrying since the EU deal had the objective of ring fencing
Greece and trying to avoid contagion to other countries in the euro zone, especially
the large ones such as Italy and Spain. If investors and policy-makers do not believe
that Italy will take the measures needed to stabilise public debt and enhance growth,
the crisis in the euro zone will continue, and with an even higher level of fear.
There are three ways of measuring the confidence level at the moment.
1) Rating institutions, such as Moody’s in early October and Standard and Poor’s in
September, downgraded Italy’s credit-worthiness, thus borrowing costs were
potentially increased. Three factors were behind the downgrading decision
according to Moody’s: the debt crisis, which was causing a "sustained and non-
cyclical erosion of confidence" in Europe and increasing "long-term funding
risks" for Italy; the increased downside risks to economic growth due to
macroeconomic structural weaknesses; and a weakening global outlook. Another
rating institution, Fitch, stated after the recent EU summit that Italy could be
downgraded again because of the country’s failing economic growth prospects.
2) Policy-makers in the euro zone have started to increase pressures on Berlusconi
to deliver. In August, the ECB President, Jean-Claude Trichet, and his successor
the Governor of the Bank of Italy, Mario Draghi, wrote a letter demanding that
the budget be balanced in 2013, one year ahead of plans; otherwise, the ECB
would not support Italy by buying its bonds. At the EU summit, France and
Germany explicitly and publicly showed no confidence in the Italian premier. In
Italy, not only the weak opposition, but also labour unions, employers’
associations, and academics are finding the lack of consultation in drawing up
new budget and development plans remarkable.
3) The financial markets’ verdict came on October 28 as Italy was forced to pay
6.06 % at an auction of benchmark 10-year bonds, up from 5.86 % a month ago,
and some 4 % a year ago. The world’s third-largest bond market of EUR 1.9
trillion will need to roll over nearly EUR 300 billion next year. The more interest
rates rise, the more difficult will it be for Italy to manage the situation, as it will
No. 7 become more difficult to balance the budget and stabilise the debt, as well as
enhance growth.
2011 10 31

2. To the Point (continued)
October 31, 2011
Chart 1: Italian and German 10 year
What is needed?
government bonds 2007-2011 Italy’s public debt has increased from 106 % of GDP in 2008 to an expected 121 %
this year. This upturn in percentage points is not higher than in other major European
countries, such as Germany, Britain and Spain. However, the level is cumbersome.
On the other hand, Italians are rich, as net wealth is about four times the national
debt. However, private wealth is eroding, and the very large stock of public debt
means that in Italy an unusually large amount of government bonds falls due
annually. In recent years, according to the OECD, Italy has accounted for more than
30 % of all euro-denominated public debt that needs to be rolled over annually,
compared with its share of the area’s GDP of less than 20 %.
Often we hear that a majority of Italian debt is held by residents. This is true, but the
share of 60 % of the total public debt is around the international average. Moreover,
since the public debt is so high, external debt as a percentage of GDP is 54 %, and
this share is the fifth largest amongst OECD-countries (only Greece, Belgium,
Portugal, and Austria have larger shares).
Financial markets are concerned about the higher and higher interest rates, which will
be difficult for Italy to manage with such a low growth rate. The risk of a new
recession has increased, while most forecasts see a growth rate of 0.5 % per year for
the next two years. Thus, interest rates reaching 6-7 % will be difficult and will
require larger austerity measures, which will reduce growth even further. Italy
therefore needs to enhance growth by implementing the following reforms:
Chart 2: Unemployment rates in Italy and  Debt has to be stabilised in order to reduce the risk of turbulence – for Italy, for
Germany 2007-2011 the euro zone and for the world economy. Italy’s debt has exceeded 100 % of
GDP for 58 years out of the past 150 years, and only in 39 years has it been less
than 60 %. Italy has always managed to fund its debt, but, before the EMU, it
took help from inflation and devaluation. In addition, there is a correlation
between low private debt and low investment per capita, which means that high
public debt is crowding out private investments and lowering potential growth.
 Italy needs a better-functioning labour market. Except for prime age males,
participation rates for all other groups are significantly lower than OECD and
EU averages. The Italian unemployment rate is now higher than the German
rate. In the letter of intent from Berlusconi to the EU summit, reforms were
envisaged, but many actors are questioning if there is the political stability
needed to see the reforms implemented.
 While steps have been taken in the area of pension reform, it is equally
important to reform the labour market and take measures to improve human
capital formation, including university reforms. Under current legislation
pension expenditures will remain stabile around 15 % of GDP until 2060, but
retirement ages will be higher and pensions will be lower. The change of
retirement age from 65 to 67 in 2026 is one more step in the right direction.
 In addition, Italy needs to deregulate a number of professions, such as taxi
drivers, lawyers, and workers in transport, retail, and commercial distribution.
Competition can fuel growth and improve the situation for consumers. Public
administration also needs to be made more effective, including by reducing tax
evasion and corruption.
All in all, potential growth can be enhanced by taking measures that increase growth
in productivity and labour supply. To continue as before is no longer possible.
Financial markets will charge too much for taking the risk of funding.
Italia va Avanti!
Cecilia Hermansson
Economic Research Department To the Point is published as a service to our customers. We believe that we have used reliable sources
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