Italy faces another year of recession as capital drains

Italy will be stuck in recession for at least another year and is facing some of the same developing problems that have pushed other European countries to request outside aid, the International Monetary Fund reported Tuesday in its latest review of the country’s economy.

The fund painted a muddled picture of the euro zone’s third-largest economy. The government is enacting major changes to improve growth and is getting public deficits under control. Yet investors are pulling money from the country, banks are at risk from rising numbers of bad loans and the economy continues to contract.

A similar dynamic pushed Spain to request $120 billion in European aid to help bolster its financial sector and forced Greece, Portugal, Ireland and recently Cyprus to ask for broader bailouts.

On Tuesday, Prime Minister Mario Monti said Italy would not require that sort of major help. But he did suggest that Europe’s bailout funds might be needed to buy some of his country’s bonds to help hold down interest rates — and avoid the larger problems Italy would face if its borrowing costs continue to rise. The Italian government is increasingly reliant on local banks for loans, deepening what is considered an unhealthy dependency and putting the banks at risk if the government’s problems worsen.

Italy “may be interested” in asking for European bailout funds to stabilize its borrowing costs if private investors continue to abandon the country despite its reform efforts, Monti told reporters in Brussels, according to news­ serv­ice reports. “It wouldn’t be prudent to say that Italy will never need to use this or that fund.”

Monti was speaking as euro-zone finance ministers were developing a plan to pump bailout funds into Spanish banks and establish a regional system for regulating financial institutions to try to stabilize Europe’s economy.

Also Tuesday, European officials were watching hearings before a German constitutional court, which was reviewing whether a permanent $500 billion bailout fund is legal. The European Stability Mechanism is scheduled to become operational this summer but is on hold under the German court ruling and pending final ratification by national governments.

Establishment of the fund is one of the major steps European leaders have taken to quell their more than two-year-old crisis, and it is that pool of money that Monti suggested may need to be tapped to help Italy. The exact terms of the fund’s use are unclear, but Monti and some others have suggested that it could be a backstop to ensure that governments working to control deficits and boost growth remain able to borrow money at reasonable prices.

Italy has long maintained that it can manage its problems, and many analysts consider that a virtual necessity: The country’s more than $2 trillion in outstanding government bonds and its importance to the euro-zone economy make it too big to bail out and too big to fail. But the IMF report, despite acknowledging the extensive work done by the government to control costs and push economic reform, said even slight shocks could push Italy’s public borrowing to unsustainable levels.

The country’s debt as a percent of annual economic output is considered high, expected to top 126 percent in 2013. Unlike other euro-zone countries that have gotten into trouble, however, Italy is expected to run what is known as a primary surplus by next year — meaning it would raise enough in revenue to pay for promised services, excluding any interest payments on its outstanding bonds. The figure is considered an important measure of a country’s ability to stabilize its total debt and begin paying it off.

But that scenario would be thrown off course if economic growth falls short of expectations in future years or if interest rates remain elevated — “downside risks” that have played out in many countries during the financial crisis.

“Years of high debt and low growth have left Italy exposed to heightened concerns about the euro-area crisis and the global outlook,” the fund noted in its report.

The ability of Italy to fix its problems without needing to tap Europe’s bailout funds or turn to the IMF is critical to the euro zone as a whole. The country’s banks are heavily invested outside the country, and other financial institutions in Europe and the rest of the world have extensive Italian holdings. Its trade ties throughout the region are deep.

The IMF also noted that Monti’s technocratic government has only a few months to complete its reform agenda before elections in the spring. That could pose risks if an election campaign weakens support for economic reforms that could target the perks of Italy’s powerful public sector unions.

“The key going forward will be forceful and expeditious implementation” of labor market and other changes that Monti has tried to legislate, IMF Deputy European Director Aasim Husain said in a conference call. “To the extent public support weakens . . . then this will become more challenging.”

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