Country Report Italy
In 2012, GDP contracted amid harsh fiscal austerity measures and ongoing European debt crisis. The weak growth outlook in both the short and the long-term requires firm action by the government. The recent election outcome casts doubts about the willingness and ability of the next government to pursue the right mix of macroeconomic policies and implement necessary reforms. Financial institutions remain relatively healthy, but large downside risks emerge from increasing (i) household indebtedness, (ii) company bankruptcies, and (iii) stock of government debt on domestic banks’ balance sheets.
Recession is the word
In the final quarter of 2012, Italy’s GDP contracted (-0.9% q-o-q) for the sixth consecutive quarter, making the current recession longer than that in 2008 and 2009, though not as deep. For 2012 as a whole, GDP contracted (-2.4%) after two years of subdued growth. Due to disappointing growth Italy’s budget deficit missed the target (2.4% of GDP) in 2012 and public debt-to-GDP ratio rose to 127%. On the bright side, the deficit did fall from 5.4% in 2009 to 3% last year and the government actually ran a primary budget surplus  (2.6%).
Italy’s economic activity has been under heavy pressure due to the continuation of the European debt crisis and the government’s harsh austerity agenda in 2012. One consequence of the latter was high inflation due to indirect tax increases in the autumn of 2011. Although inflation is on a downward trend since the final quarter of 2012, expected to fall to 2% in 2013, unemployment is rising and heading towards 12% this year (compared to 6.8% in 2008). The recently accelerated narrowing of the current account deficit, unfortunately, was not the result of improved productivity growth and booming exports, but mostly stemmed from large import contraction. External rebalancing has, therefore, been achieved at the cost of moving away from internal balance. Due to rising unemployment, tightened financial conditions, and the uncertain election outcome, domestic spending is expected to act as a drag on growth this year. Although we expect exports to pick up again in the course of the year, external demand will presumably not be strong enough to pull the Italian economy out of recession in 2013.
 ^ If interest rate spending is excluded.
Italy’s long-term challenges
Mario Monti and the ECB president Mario Draghi together were able to partly restore trust in the Italian government bonds. The austerity and reform measures carried out by the technocratic government in 2012 made it clear that Italy was serious about improving public finances and bolstering the country’s long-term growth prospects. The pension reform implies that ageing will now no longer automatically worsen public finances over time. As regards improving long-term growth prospects, a liberalisation package for professional services, simplification of administrative rules, and measures to reduce red tape have been adopted, and these are expected to improve competitiveness. While the success could have been much larger if initiated reforms by the Monti-government would not have been watered down, the technocrats also succeeded in improving the functioning of the labour market. They facilitated entry into the labor market for young workers on apprenticeships, standardized job contracts, encouraged labor mobility and differentiated tax provisions to discourage employers from offering short-term contracts.
That said, the potential for more reforms is still enormous and it is of upmost importance to do more in order to outgrow the large debt stock and safeguard the country’s debt sustainability. Note that Italy’s high debt and low (potential) growth challenges are not created by the current crisis, but already existed long before. Despite the formation of a broad coalition government headed by Enrico Letta (center-left) two months after the inconclusive election outcome in February 2013, we do not expect sufficient reforms to be introduced in the short-term that will deal with Italy’s deep-seated economic problems.
Political and financial market risks
In the near-term, Italy’s main challenge, while not neglecting sluggish growth prospects, is to maintain financial market confidence. A rise in bond yields will have negative implications for the sustainability of the country’s high public debt, as gross financing needs are large (accounting for 56% of GDP in 2013-14). The market reaction to the unfavorable election results has been rather muted so far. In fact, after the broad coalition government was sworn in, 10-year government bond yields were even pushed below 4%, reaching a 2-year low. Investors seem unwilling to drop out unless they are certain the next government is not dealing with Italy’s deep-seated economic problems. Furthermore, the pledge of the ECB to support countries in financial need, subject to strict conditionality, is also maintaining market calm for the time being. That said, the fact that Letta was able to form a grand coalition should not be regarded as an end to political instability. Firstly, ideas on resolving Italy’s economic troubles differ widely across the political spectrum. Secondly, any coalition gaining support in the opinion polls has an incentive to pull the plug in order to quickly return to the polls. The risk of this scenario in the near-term is small since recent polls show that no single party is able to win a workable majority in case of new elections. Finally, Letta has announced that if insufficient reforms will be passed by the parliament in the coming 18 months, he will resign. For this reason, the forthcoming period is likely to be dominated by political uncertainty, and there is a distinct possibility of new elections before the end of the coalition’s term. Moreover, bond yields might still soar if it appears that the next government will not engage in sufficient austerity and reform measures to guarantee debt sustainability. But also if the ‘Troika’ signals that it will not support Italy in times of financial stress if the country were to ask for help while struggling to comply with the accompanying conditionalities.
Private sector suffering
When turning from the public to the private sector, it becomes clear that while households, as opposed to the government, entered the crisis from a relatively healthy financial position owing to a low debt build-up and a high savings ratio in the past, economic headwinds are strong enough to cause troubles. In 2011, household debt amounted to 85% of disposable income - well below EU average. However, 8% of the households are nevertheless struggling with excessive debt levels. In addition, more businesses are running into liquidity problems as the recession worsens. Especially small businesses, which are the core clients of midsized banks, are suffering, due to weak domestic demand. These debt and liquidity problems affect banks via bad loans. In January of 2013, the ratio of bad loans to total lending reached a 12 year high as it increased to 6.4% (compared to 3% in June 2008). While the banking sector has remained quite unaffected during the crisis as a result of relatively strong capital buffers, contingent liabilities from the industry are a potential concern if Italy’s recession deepens and continues (the provisioning for doubtful loans is only 40%). Furthermore, banking sector risks are strongly linked to Italian sovereign risk as the banks own about EUR 351.6bn (February 2013) worth of Italian government bonds. Deterioration of public finances can thus have a devastating effect on bank balance sheets, which will worsen the adverse sovereign-bank feedback loop. Against this backdrop, banks may be forced to increase their provisioning. Needless to say, that this will lower profitability and further tighten credit conditions.