Country report Italy
Italy’s economy shrank for another year in 2014, and is expected to only recover slowly. Political stability has improved somewhat and the government’s reform agenda is promising. Some major reforms have already been achieved or are underway, but progress is and will remain slow.
Strengths (+) and weaknesses (-)
(+) Low household debt and high savings
Households are substantially less indebted than their peers and the amount of net financial assets ranks third of all eurozone countries. Furthermore, financial assets tend to be of the less risky type such as deposits and bonds and debt is mostly held by high-income households.
(+) Access to European financial support measures
The ECBs promise to do “whatever it takes” (2012), the existence of the Outright Monetary Transactions framework and quantitative easing by the ECB help to lower government bond yields, despite the country’s large debt stock and the apparent inability to bring it down.
(-) Political instability and large public debt stock
Large primary deficits between the mid-sixties and early nineties, in combination with political instability and the apparent inability to improve Italy’s growth potential, have resulted in negative debt dynamics (high yields and low growth) and a very persistent debt problem.
(-) Weak institutions
Productivity growth and competitiveness are constrained by regulatory rigidities, high entry barriers in several sectors, a lengthy judicial system, a relatively low level of education, a high tax burden, inefficient public spending, a sizeable unofficial economy, and corruption.
1. Another year of recession, economy will only recovery slowly
In 2014, GDP volume contracted for the third year in a row, with 0.4%. Accordingly, gross domestic product is about 10% below its pre-crisis peak (figure 1). Unemployment is very high (12.7% in February, figure 2) and inflation very low (0.0% in March). House prices dropped for the seventh consecutive year in 2014 (with 4.2%). The very large debt ratio increased further to 132%. Looking forward, the economy is expected to grow slowly in 2015 (around 0.5%), while unemployment will remain very high. The debt-to-GDP ratio is expected to increase for another year.
2. Banking system still in dire state
The banking sector’s asset quality remains weak due to the weak economic environment. Profitability remains low, due to, amongst other things, the low interest rate environment and high (cost) inefficiencies at the countries multiple small and mid-sized banks. The latter is expected to be reduced by the recent reform of the small populari banks. The reform paves the way for consolidation due to mandatory listing and a change in voting rights. It might take a few years, though. Finally, capitalisation is still rather weak and overall banks are susceptible to unexpected shocks (except at the largest banks).
In February 2015, total bad loans reached a new record high (Bank of Italy). The bad debt ratio of households stood at 8.5% and that of non-financial corporations at 16.5% (up from respectively 7.7% and 13.7% in February 2014). The realisable value of bad debt is currently estimated to be less than 50% of total bad debt and the time of debt recovery is rising (seven years on average, Italian Banking Association). Non-performing loans are expected to increase further in 2015 due to the still weak economic environment. To cope with the increasing stock of bad debt, Italian banks have raised loan loss provisions in the past year. Nevertheless, coverage ratios have slightly fallen. Furthermore, S&P has estimated at end 2014 that banks need about EUR 72 billion additional credit provision to cope with expected losses until 2016. This is about 4% of the total loan portfolio. The government has plans to facilitate the sale of non-performing loans which should help to revive the banking sector. These plans are still in planning stage, though.
3. Reform agenda looks promising
The government’s reform agenda incorporates many recommendations made by international institutions (like the IMF) and has the potential to raise economic growth (six percent over 10 years, OECD). In his first year of office, PM Renzi has succeeded in advancing several of these far reaching reforms, especially in the context of the labour market and at the institutional front (see below). Yet, progress on most items on the reform agenda is slow (e.g. on competition, tax system, justice, public administration). This results from the lack of a working majority in parliament and frequent opposition from within Renzi’s own party. Many proposals are either still pending in parliament, inadequate to meet objectives or yet to be presented. Besides, implementation of some legislated measures is not completed, due to poor capacity at governing bodies. The reform progress is expected to continue, but to remain slow. This will ultimately benefit political stability (institutional reforms) and Italy’s growth potential (economic reforms), i.e. public debt sustainability.
4. Labour market and institutional reform
So far, especially the enacted labour market reforms are a major achievement. Institutional reforms, i.e. electoral reform and reform of the parliament, are still pending, but chance of success is substantial and their impact on political stability and thus the legislative process is possibly large.
Enacted reforms in the labour market contain measures that increase exit flexibility on (new) permanent contracts and tax incentives to hire employees on a permanent contract (only in 2015). Further legislation waiting to be enabled by the government will contain measures to increase incentives to work, improve active labour market policies, further reduce segmentation of the labour market and improve the system of unemployment benefits. Most of these reforms do not provide large short-term gains for economic growth, but they certainly improve the outlook.
Most advanced institutional reforms constitute a reform of the electoral system for the lower house and a reduction of the powers of the upper house. The impact could be large, but only if both are approved. As it concerns constitutional reforms they require multiple voting rounds and possibly a referendum. The reform of the electoral system is expected to be approved by end-May and to come in to effect by July 2016. The Senate reform is unlikely to be approved before early 2016.
Italy is the third largest economy in the eurozone, but growth has been sluggish in the past decade (less than 0.5% on average). The main reason is that Italy has been losing competitiveness owing to extremely weak productivity growth in combination with rising wages; partly due to the very large share of total value added produced by SMEs (over 70%), and more specifically microenterprises (33%). Italy’s growth potential seems to have stalled in 2013 and the IMF expects it to only rise to 0.5% in 2018. Therefore, it will be very difficult for the country to grow its way out of debt, which has reached uncomfortably high levels. Large primary surpluses during the last two decades have been insufficient to compensate for large debt dynamics. Note, though, that ageing does not automatically worsen public finances due to, amongst other things, a contribution-based pension system and a retirement age linked to life expectancy. Nevertheless, ageing could be a problem for Italy, as it implies that the labour force is bound to shrink. As opposed to public balance sheets, Italy’s financial sector now benefits from the strong discipline in the past decades. Prior to the crisis Italian banks have built up strong capital buffers owing to conservative banking regulation. Furthermore, the depositors base is strong and dependence on wholesale funding relatively low. Accordingly, a banking sector crisis has not occurred, despite of the harsh recession. At the same time, banks have excessively increased the stock of government bonds on their balance sheets (about 10% of total assets). And while the reduction of debt in hand of non-residents (34%) has lowered default incentives and rollover risks, it has also intensified the vicious feedback loop between the sovereign and domestic banks. This makes the latter, and therefore also short-term economic growth, extremely susceptible to deteriorating public finances. As an aside, also firms would suffer as higher sovereign yields rapidly feed through in firm lending rates.