August 23, 2017 / 3:30 PM / a year ago

For all its problems, it's risky to bet against Italy

LONDON (Reuters) - Heavily indebted and politically fractious Italy has moved back into the crosshairs of financial market investors this week, but some funds may be cautious about doubling down on bearish bets that have failed to pay off so far this year.    

    Bonds and shares in the euro zone’s third largest member looked set for a slump at the end of 2016 as one of its biggest banks headed for a bailout and its prime minister resigned after a referendum defeat.

    It has been a bumpy road, but the Milan stock exchange has gained over 10 percent in 2017 so far and Italian government bonds have held ground with benchmark German peers.

    When former Prime Minister Silvio Berlusconi refloated his long-standing proposal for a parallel currency in Italy on Saturday, big international banks circulated it to their clients as a reminder of the risks that remain in a country that has the clout to destroy the whole euro zone project.

    Below are the most common concerns raised about Italy among financial market professionals and the different ways of interpreting them.

1. The debt mountain

Investors always worry about unpredictable ‘black swan’ events that can wreak havoc across markets. But with sky high debts and low growth, Italy ranks with the likes of China as a ‘grey rhino’ - a clear and present danger - according to Michele Wucker, an analyst who coined the term.

UniCredit’s global chief economist Erik Nielsen argues that debt sustainability fears in the euro zone’s third largest economy are overblown, however, and that levels should stay stable even with a moderate rise in interest rates.

“Growth of 1-1.5 percent is not impressive, but it’s enough to put the debt sustainability fears to bed” he said.

GRAPHIC: Growth versus public debt in Italy

2. Fiscal wiggle room

Italy has done fairly well in holding down its budget deficit and as long as it maintains this trend, it should be able to keep repaying its debt on time.

But Eric Lascelles, chief economist at RBC Global Asset Management, questions if this can last, with a rapidly ageing population set to turn from taxpayers into pension takers.

“From a debt sustainability perspective, its demographics are truly atrocious over the next 30 years,” said Lascelles.

GRAPHIC: Euro zone primary balances

GRAPHIC: Italy's working age population

3. Tackling the banks

Another factor adding pressure to the public purse is the growing list of banks that need help. A series of state-led capital injections have been added to the rescue plan for Monte dei Paschi recently approved by the European Union.

Italian lenders are still saddled with around 300 billion euros ($354 billion) of bad loans, hurting their already weak profitability and crimping their ability to lend more. But UniCredit’s Nielsen says there is now a clear downtrend in bad loans, and taken in the context of weaker demand for credit in Italy because of its lower growth, lending levels are consistent with European peers.

GRAPHIC: Italy's bank loans in decline

GRAPHIC: Lending levels now positive

4. Central bank support

As the European Central Bank prepares to rein in some of its monetary stimulus, including sub-zero rates and trillions of euros of bond-buying, investors may focus more closely on Italy’s fundamental problems.

“When markets anticipate tightening monetary conditions, the most obvious place to look is at countries with relatively high debt and instability in their banking system. So it’s natural that investors would keep a close eye on Italy,” said Wucker.

The biggest hint that ECB President Mario Draghi was considering changing policy came in late June.

But the shake out in Italian bonds didn’t last long. Just weeks later the gap between Italian and German yields was at a 2017 low.

GRAPHIC: Bond yields and bank stocks

5. Political cloud

After Britain’s vote to leave the European Union and the election of anti-establishment figure Donald Trump in the United States, Europe was seemingly destined for a similar political earthquake in elections across the continent in 2017.

That hasn’t happened...yet.

The biggest investor worry - victory for far-right, anti-euro candidate Marine Le Pen in France - was averted in May. Now concern is focused on Italy, where the eurosceptic 5-star movement has gained on the ruling Democratic Party (PD) and is now ahead in some polls before elections due by May 2018.

On top of this, Berlusconi’s plans for a parallel currency could unite his Forza Italia party with others campaigning on an anti-euro platform, analysts warn, further isolating the PD.

“It is little wonder that there is periodic speculation of an Ital-exit” said Neil MacKinnon, global macro strategist at VTB Capital.

GRAPHIC: Italy's election race

Graphics by Ritvik Carvalho; Writing by John Geddie; Editing by Mark Trevelyan

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