Saturday, June 19, 2010

FIFA World Cup 2010 goes to ...

  • Italy? Perhaps. The king maker from 2006, Marcello Lippi, is back on board, Italy has qualified early for only the third time (on the past two occasions it then won the World Cup trophy) and Inter Milan became Italian champion and Coppa Italia winner this year – as was the case in 2006 (pages 7-8). Whether this will be enough to defend the title? Si vedrà! 
  • Germany? Oh well. We are not among the top favorites – irrespective of what "hit list" one looks at. Even in our transfer value model, Germany ranks seventh (pages 4-6). The only thing in our favor is that we have a relatively homogenous team that can raise its game in the course of a tournament. It could be enough to reach the semi-finals. But for more than that? Schau mer mal! 
  • Spain! The Spaniards are the top favorites everywhere, be it with the bookies, in the FIFA ranking or in surveys – and also with us. The Spanish national squad has a "market value" of a whopping EUR 650mn and is streets ahead of all other teams. Furthermore, Spain also has a homogenous team, i.e. an above-average reward-risk ratio in terms of portfolio theory. Première for Spain? ¡Vamos a ver! 
  • Surprise. Every tournament has its surprise teams. For us, they are the US (p. 9-12) and South Africa. The home advantage should never be underestimated: One third of host nations became champion, two-thirds advanced to the final round and all survived the preliminary round. How far will South Africa and the US advance? Ake sibone or we will see! 
  • Cup of Good Hopes. But irrespective of who becomes the 2010 world champion, we are looking forward to a colorful tournament, lively, exciting and hopefully peaceful matches – in a fascinating country! 
  • Further topics:
    Weekly Comment: Why Italy is different (page 2).
    South Africa: UniCredit's view on the host nation 2010 (page 13). 
    Data outlook: ZEW index already reached its peak (page 18). 
    Market outlook: EUR recovers, but the trend remains biased to the downside; top-rated government bonds remain in demand (page 24).

This Time, Italy Is Different

Italy is probably the “swing factor” in the current European crisis: as the largest of the vulnerable countries, and the most vulnerable of the large, its ability to withstand current market tensions will likely determine whether and how the eurozone can weather the storm. Italy accounts for nearly one fifth of the EMU economy, and over one quarter of its marketable sovereign debt: its stability is therefore essential to the eurozone’s ability to navigate the current crisis. So far, Italy has been a paradoxical success: the country had long been regarded as the weak link, with some investors periodically wondering whether it might eventually leave the EMU; yet when it came to the crunch, Italy proved extremely resilient compared to its “periphery” peers, namely Greece, Ireland, Portugal and even Spain. Contagion-driven tremors have been felt in Italian fixed income markets too, however, and recently spreads on Italian government bonds have suffered the opaque ECB’s interventions in the sovereign debt market.
It therefore seems to be an appropriate time to take stock of Italy’s strengths and vulnerabilities, to assess whether and to what extent Italy really is different from its periphery peers. The main conclusion is that the tensions which have recently affected Italian bond markets are probably a blessing in disguise: Italy is genuinely stronger than its periphery peers, but its resilience is eroding and fragile; a decisive acceleration in structural and fiscal reforms is needed to put the country on a stronger sustainable footing.
Improving competitiveness and boosting potential growth should be seen as the uncontested number one priority. Italy’s chronic poor growth performance is well known: the country has consistently underperformed the eurozone average and has experienced three recessions over the last ten years. The first quarter of this year has proved to be a positive surprise, but we expect growth to fall back sub par, with real GDP expanding by a mere 1% this year and next. In an environment where global trade is the EMU’s main engine of growth, Italy’s poor competitiveness is a dramatic handicap. Over the past ten years, Italy’s competitiveness relative to Germany has deteriorated by 26% based on unit labor costs and 40% based on export prices, worse than most other eurozone countries. As we have pointed out in previous analyses, this loss of competitiveness stems mostly from a dismal performance in productivity, which actually declined by a cumulative 6% over the last ten years compared to 7% growth for the eurozone as a whole.
This is exacerbated by non-price factors, including the relative labor intensity of Italy’s industry, insufficient investment in Research and Development, poor performance in education and training and rigidities in labor, products and services markets. This lack of competitiveness poses a threat in at least two dimensions. First, poor productivity undermines wage and income growth, thereby limiting domestic demand as well as preventing the country from taking full advantage of stronger external demand. Secondly, poor competitiveness could gradually contribute to undermining Italy’s external balance.
Compared to other peripheral countries, Italy’s external position is strong, with a current account deficit of just over 3% of GDP last year compared to double-digit deficits for Greece and Portugal, for example. This in turn reflects the more robust position of Italy’s household sector, which unlike its peripheral counterparts has not been running up substantial levels of debt during the credit boom period. This is undoubtedly an important strength, signaling the country’s limited reliance on external financing – indeed the strong household savings help to ensure that over 50% of Italian government debt is held domestically, an important element of stability. However, Italy’s C/A balance has suffered a slow but steady deterioration, from a surplus of about 2% of GDP in 1998 to a deficit of over 3% of GDP in 2009. This deterioration reflects largely a decline in national savings, in turn driven by a marked drop in corporate savings as firms went through a significant leveraging process – something else that we have analyzed in detail in past studies.
Just like for the C/A balance, when we look at the financial leverage of Italian companies we find that the current level is reassuring, but the trend is a source of some concern. The debt to GDP ratio of Italian Non Financial Corporates is well below the eurozone average and much lower than in other periphery countries (just half of Portuguese and Irish levels); over the last ten years, however, the debt ratio has risen fast, and somewhat faster than the EMU average. The ensuing financial vulnerability is likely to provide a headwind to investment. Note that while the household sector is stronger, a somewhat similar consideration applies: while Italian household debt to GDP is one-third lower than the eurozone average and less than half the level of other peripheral countries, the household savings rate has been declining, and last year for the first time dropped below the EMU average.
What does this all mean once we look at Italy’s public finances and sovereign debt? Italy’s public debt has been uncomfortably high for some time, and is now expected to stabilize at just under 120% of GDP in the next couple of years. The government is well aware that the high debt limits the scope for discretionary fiscal policy: last year, no fiscal stimulus was provided, so that the budget deficit at 5.3% of GDP settled one full percentage point lower than the eurozone average; recently, the government has announced additional tightening measures worth a cumulative 1 ½ % of GDP over the next two years, to bring the deficit clearly below 3% of GDP by 2012. The commitment to fiscal sustainability is concrete and credible, and underpinned by previously adopted rounds of pension reform. Meanwhile, years of living with high debt have been a precious learning experience for the Italian Treasury, and as a consequence Italian government debt is well managed, with a relatively long average maturity and a smooth redemption profile – and as we mentioned above, it benefits from strong domestic demand. Having said all this, however, it is still simply too high. While Japan demonstrates that debt can be kept stable at even higher levels, there is no doubt that a debt to GDP ratio in excess of 100% reduces the room for error, increases vulnerability to shocks, and hinders economic growth. The commitment to fiscal discipline must be maintained.
But above all, Italy should now accelerate efforts to improve flexibility, productivity, competitiveness and growth. This is needed also to help ensure fiscal sustainability, but first and most importantly to guarantee a sustainable improvement in living standards and incomes. This in turn would help reverse the ongoing deterioration in Italy’s main strengths: its strong private savings and robust external position. The European crisis provides a call to action, and the timing is fortunate: Italy’s relative strengths are still clear, Italy still is different than the rest of the periphery in some important ways; but the difference is eroding, and the trend must be reversed now. 


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