Italy: politics and banking sector threaten the modest economic recovery
- Moderate economic recovery continues on the back of domestic demand
- We expect the economy to grow with ¾% in both 2016 and 2017, after 0.6% in 2015
- The weak banking sector and political instability are the most important downward risks
Recovery continues, but the economy is still weak
In the first quarter of this year, the economy grew for the fifth consecutive quarter (by 0.3% q-o-q), due to a positive contribution from domestic demand (figure 1). The Italian economy is slowly picking up, but the recovery still has a long way to go. The economy is still more than 8% smaller than before the crisis and real disposable household income still more than 8% lower. Growth is also well below the eurozone average (figure 2).
Unemployment is also still high (11.5% in May), despite growing employment, and there are huge problems in the banking sector. Looking ahead, we expect to see growth of ¾% in 2016 and 2017, after 0.6% in 2015 (table 1). In 2016, domestic demand drives growth. In 2017, an acceleration of investment and export growth compensates decelerating consumption growth. Our forecast is subject to many uncertainties, as a result of risks that are mainly to the downside.
Economic growth by expenditure components
The higher growth of domestic demand in 2016 compared to 2015 is due among other things to an expansionary fiscal stance, accelerating job creation, rising housing equity, loosening credit standards, improving business profit margins, and less spare capacity in the industry sector (figure 4). Investment growth is however hampered, since the outlook for exports is less favourable than it was last year. Furthermore, in the first half of 2016, order books of businesses were worse than for the largest part of 2015 (figure 5). In 2017, growth in domestic demand will lose speed as the government has to tighten its belt and the growth in household purchasing power will slow. As oil prices have started rising and upward wage pressure is limited, inflation will increase faster than growth in wages. In both years, the crisis loss in income and capital will restrict consumption and investment spending, and the balance sheet problems at the banks and uncertainty regarding the strength of the recovery will hamper credit growth and therefore also investment growth.
Export growth decelerates in 2016 as the euro depreciates less than in 2015 and growth in world slows. Especially lower demand for imports from Germany, the US and France hurt Italy’s export sector. Export demand will pick up in 2017, especially from the US, as their economy performs significantly better than in 2016. Moreover, the euro will depreciate a bit more against the dollar than in 2016. The deteriorated situation in the UK and the weakened pound, as a result of the Brexit-vote, have a limited effect on Italian exports, due to their limited trade relation.
Confidence is key to the recovery
Household and business confidence are key to the continuation of the recovery in the Italian economy. Despite a recent dip, confidence is now at a good level (figure 6). That said, there has been no new polling after the Brexit-vote and bank share plunge, yet. Besides, potential political instability after the referendum on reform of the Italian parliament in October, the refugee crisis and difficulties associated with the Brexit negotiations are all threats to sentiment. Furthermore, the referendum in October could bring about a political crisis, while the problems at the banks could ultimately lead to an economic crisis.
October referendum of large importance for Italy’s future
Officially, the referendum is about a sharp reduction in the power of the Senate, the Upper House of the Italian parliament. This should make Italy more governable and much of the population supports it. Unofficially however, it is a confidence vote on Renzi, who has said he will resign if the people reject the reform. As a result, there is significantly less chance that the reform will be carried; in fact, those who say they will vote in favour or against seem now more or less in balance. If Renzi were to resign and a new election is called, the populist anti-establishment M5S protest movement led by Beppe Grillo would have a good chance of victory. This would cause major concerns regarding future policy; Italy’s position in the eurozone; the sustainability of public debt; and, due to the resulting worsening economic outlook, also with respect to the solvability of banks.
A banking crisis is an important downside risk
The profitability of Italian banks is low and banks have to deal with a large amount of loans which are unlikely to be fully repaid (see this report). It is possible at any time that some banks will have to raise capital in the market to meet their capital ratio requirements. There is a real risk that several banks will not be able to do so at that time. Under new European regulation, in that case there would first have to be a bail-in before the government could use public money to shore up bank balance sheets. A bail-in would mean that shareholders and (junior) bond holders in the banks concerned would have to participate in the bank rescue and as such take losses.
In Italy, a significant amount of bank bonds is held by retail investors like households. But also SMEs and other financial institutions would be hit by a bail-in. The loss of capital (and confidence) that would result from a bail-in would negatively affect consumption and investment growth. It could also weaken other banks with a potential domino effect in the financial sector. The latter risk increases if arisen uncertainty regarding the strength of other banks led to a capital flight and withdrawal of deposits. All the uncertainty regarding the future of the financial sector and the economy could also lead to higher government bond yields, with implications for the sustainability of the huge public debt (130% of GDP). In that scenario a full-fledged banking crisis and an economic recession cannot be ruled out.
Despite the measures the government has taken over the past year, much more needs to be done to make the Italian banking sector healthy. Bank balance sheets should be cleaned and the sector restructured. But the government also needs to improve the insolvency law and the inefficient judiciary. The number of years currently necessary to obtain collateral if borrowers default should be lowered drastically. As long as the above issues are not adequately dealt with, the banking sector will put a break on economic growth and a banking crisis will remain a downward risk. Especially, with the results of the ECB stress tests end of July and the referendum in October in view.