Mediobanca hints at Italian euro exit unless Germany shifts on EMU policy

The exchange rate is bringing Italy's worrying matters to a head.

Tightrope walker Andrea Loreni performs in front of the Coliseum in Rome
Tightrope walker Andrea Loreni performs in front of the Coliseum in Rome Credit: Photo: AFP

Italy remains stuck in depression. We now know that the spectacular spike in consumer confidence in June was a ruse, a white lie to talk up prospects and hold back the debt-deflation tide.

Hedge funds, banks and investors from around the world poured into Italian assets without reading the fine print. They made quick money, of course. Yields on 10-year Italian bonds fell 40 basis points within a week. Milan's MIB index of stock touched bottom near 14,860 just before the release. It then surged, reaching 19,496 this week.

The euphoria was understandable. The economy component of the confidence index jumped miraculously from 71.7 to 91.6 in one month. If Italy really was turning the corner so dramatically after a peak-to-trough fall in GDP of 9pc and two years of double-dip recession, it would indeed mean that Europe's crisis was behind us. We could breathe a little easier about Italy's €2 trillion debt, the world's largest after the US and Japan.

In reality, Italy's data agency Istat changed the survey. It looked at a different "socio-demographic structure" and "sample structure". Istat quietly revealed some details a month later, but only a handful of Italian economists were paying attention. "They played with the data and I am shocked," said one.

He described the episode as an attempt to talk up momentum and lift growth to "escape velocity". Italy's authorities - in thrall to the Bocconi Boys, free-marketeers from Milan's Bocconi University - give great weight to theories that confidence alone can overpower fiscal austerity, an overvalued currency and tight money.

And money is certainly tight. Italian M3 has contracted over the past five months (falling from €1.329 trillion to €1.312 trillion). Simon Ward from Henderson Global Investors says his gauge - six-month real M1 - has rolled over. "Italy is flashing red," he said.

It is true that market confidence can grease the economic wheels in certain circumstances. But to rely on morale alone to pull an economy out of full-blown depression is like a bayonet charge into Krupp guns, the St Cyr spirit of "elan vital" in 1914, so brave and yet so futile. Nobel laureate Paul Krugman derides this sub-branch of economics as the "confidence fairy".

The hard data catch up soon enough in any case. Industrial production fell 4.4pc in August, and new orders fell 6.8pc. The Bank of Italy said credit to non-financial firms fell 4.6pc in August (year-on-year), worse than in July. Business confidence fell back to 79.3 in September and is now at post-Lehman crisis levels. Istat said this week that the economy is weaker than previously thought. GDP will shrink yet again in the third quarter.

"The recession has flattened, that is all," says Antonio Guglielmi from Mediobanca. "The debt-to-GDP ratio has risen by 15 percentage points [to 133pc] over the past 15 months because there is no growth. It is all because of the effects of austerity and the fiscal multiiplier. We are making the same mistake they made in Greece."

Mr Guglielmi said the government has pencilled in growth of 1pc next year, rising to 1.7pc, 1.8pc and 1.9pc thereafter. It is make-believe. (Citigroup said it would be closer to zero all way to 2017). "We barely grew 1pc a year during the best years of the global boom. How are we going to do this now in much harder times?"

Professor Giuseppe Ragusa from Rome's Luiss Guido Carli University said the government is clutching at straws, hoping that a world recovery will somehow lift Italy out of the slump. "They are not doing anything. The policy is completely passive but it is not going to work because we are in a debt trap, and unlike Spain we have continued to lose labour competitiveness against Germany over the past three or four years."

Prof Ragusa calculates that the debt will jump by another 5pc of GDP each year even if growth returns to pre-crisis level of around 0.6pc. This would send the ratio spiralling up to nearly 150pc, beyond the point of no return for a country with no sovereign currency .

He said the European Central Bank's rescue policies have induced the Italian treasury to borrow on short maturities, since the ECB-backstop only covers debt up to three years. This has cut the average debt maturity from 7.6 to 6.4 years, storing up ever greater "roll-over" risk. "I fear that all of this is going to be tested by the first quarter of next year," he said.

The exchange rate is bringing matters to a head. The euro has has risen almost 8pc against the dollar - and therefore the Chinese yuan - since June. This is a bizarre state of affairs for a region mired in record unemployment and likely to trail the rest of world yet again next year by wide margin, according to the EU authorities themselves.

Austria's ECB governor Ewald Nowotny says there is little Frankfurt can about this. Yet the Bank of Japan has just driven down the yen some 22pc by embarking on a massive reflation strategy. The Swiss National Bank is holding the franc at €1.20, vowing to defend it against the entire world. It is very easy to weaken a currency. What Mr Nowotny means is that the EMU is politically incapable of mounting such a campaign.

For Italy this is excruciating. Mediobanca says Italy economy's has 67pc "gearing" to the exchange rate due to the kinds of products it makes (price sensitive), compared with 40pc for Germany. Its latest report traces how Italy's productivity growth and competitiveness has faltered each time it pegged its currency to Germany over the past 40 years, and how it roared back with each devaluation.

The report said EMU had allowed a "Chinese-like" Germany to lock in trade advantage, accumulating a surplus of €1.4 trillion, or 50pc of German GDP, and that this amounts to "a dangerous ‘beggar-thy-neighbour’ zero-sum game for the eurozone".

It said Italy entered a "negative productivity spiral" only after it fixed the pre-EMU exchange rates in 1996. Refusing to acknowledge this "means denying the evidence". It accused the EU authorities of forcing the entire burden of post-crisis adjustment on the weaker Club Med states, of refusing to see the risk of a "negative recessionary spiral" in the South, or to see that these countries cannot stabilise their debt trajectories with a minimum of growth. The North must "meet the periphery halfway".

The report said the risk is a repetition of Argentina's fate as the dollar-peg fell apart in 2001. It cited the so-called "Frenkel Cycle" as it moves into its final seventh phase of "collapse", the brutal denouement of every fixed-exchange rate system and every monetary union that fails to meet the four basic conditions of an optimal currency area. These are labour mobility across borders, wage and price flexibility, fiscal transfers and aligned business cycles. The euro area meets none of them.

Mediobanca is Italy's second biggest bank. It does not call for a withdrawal from EMU and a return to the lira, stocially accepting that discipline is the only way forward. Yet the logic of their Magnum Opus is that Italy would be far better off outside EMU, and the implicit threat is that Italy will have to do so if the Northern creditor powers persist with their destructive regime.

Italy is not a basket case. Its net international investment position is -30pc of GDP, compared with -92pc for Spain, and -100pc for Portugal. It has very low mortgage debt. Their median wealth is €173,500, making them four times richer than Germans at €51,400.

It is the most virtuous of the big EMU states, with a primary surplus of 2.5pc of GDP. This of course means it can leave the euro whenever it wants without a funding crisis, and it is big enough to weather the shock.

Everything comes down to the national mood in the end. There was a time when the cause of Europe was unquestioned in Italy, but the long slump has taken its toll. An Ipsos poll this week found that a record 74pc of Italians are dissatisfied with the euro. It is a loveless marriage now. One more spat with Berlin and it will turn acrid.

Europe's leaders can stop the rot at any time by embarking on a reflation strategy that entirely changes the contours of the crisis and lifts the South off the reefs. But if they do not do so - and there is no sign yet - Italians will be forced to take back their own sovereign destiny.