RaboResearch - Economic Research

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Italy: Cyclical upswing – what will 2018 bring?


  • The Italian economy has notched up a gear, catalysed by an improved external environment. We expect growth to have accelerated to 1.6% in 2017
  • We believe growth will decelerate slightly to 1.4% in 2018 and 1.2% in 2019
  • The political backdrop has improved slightly, insofar as the risk of an outright majority for the Five Star Movement has decreased
  • The centre-right coalition, led by Forza Italia and the Northern League, is leading the polls
  • But there is very little scope for further structural reforms
  • Despite the cyclical recovery in the next two years, Italy’s potential growth rate remains low at 0.5%-1.0%. Absent any structural austerity or growth raising measures, it will take a long time before public debt to GDP will return to moderate levels

Next year will be election year in Italy. Before May 20 at the latest, Italians will go to the ballot box as the legislature ends on March 15. However, according to national media outlets, the actual election date is more likely to take place in March. Several newspapers have reported that President Mattarella will dissolve parliament between Christmas and New Year’s Eve and then call for elections on March 4. The last hurdle to be taken before the President can proceed along this path is the parliamentary approval of the 2018 budget bill. This looks to be only a matter of time.

In this publication we will first sketch the economic and fiscal context in which the elections will take place. Thereafter, we will present a first assessment of how we think the elections will play out, including their impact on financial markets.

Budget bill paves the way for elections

While the final budget bill is not known yet, it is expected to be slightly contractionary next year in order to comply with the European budgetary framework. This tightening stance would come after several years of accommodative fiscal policy. Nevertheless, the draft bill contains some measures that could support both short- and medium-term growth. It goes beyond the scope of this piece to comment on all of these, but we address two measures that we regard as important.

There will be tax incentives for investment in machinery, research and innovation. We’ve seen over the past years that these incentives have been quite effective, so we expect these to support investment growth next year. Going forward, this might also support Italy’s growth potential when the rise in investment leads to higher productivity growth. Secondly, there will be fiscal measures that incentivise firms to give permanent contracts to employees younger than the age of 30. Even though this only covers a small part of the working age population – and risks crowding out older employees – the overall effect on employment growth is expected to be positive. Moreover, if it helps reducing youth unemployment (currently at 35%), it might prove beneficial for longer-term growth as well. It is essential that youth unemployment declines quickly, in order to lower the risk of an extended brain drain and of a lost, angry and disillusioned generation.

Whether the entire bill will structurally improve public finances by as much as necessary to please the European Commission remains to be seen. Several of the expansionary measures are unlikely to be self-financing, while at the same time it is unclear whether some of the proposed contractionary measures will yield sufficient budgetary results. That said, the general budget balance is likely to improve anyhow due to the relatively strong economic environment.

Cyclical recovery strengthens

The global economy had a strong year and this didn’t go unnoticed in Italy. Catalysed by an improving external environment the Italian economy notched up a gear and economic growth accelerated to an annual rate of 1.7% in the third quarter. Even though such a growth rate isn’t bewildering in international comparison, it’s pretty close to the fastest growth rate in Italy in the past fifteen years. The short-term outlook is quite rosy as well. Both producers and consumers are very optimistic and the manufacturing PMI is even close to a record high, signalling that the economy may continue to benefit from strong external and domestic demand. We expect the annual growth rate to rise from 1.1% in 2016 to 1.6% in 2017.

Figure 1: Private consumption largest growth driver, investment is catching up
Figure 1: Private consumption largest growth driver, investment is catching upSource: Macrobond, Rabobank
Figure 2: High confidence bodes well for short-term economic outlook
Figure 2: High confidence bodes well for short-term economic outlookSource: Macrobond, Istat

Looking forward, we believe growth will remain rather strong from an Italian perspective, but will slightly decelerate to 1.4% next year and 1.2% in 2019. In both these years, the main contribution to growth will stem from a cyclical recovery in domestic demand. Buoyant sentiment and employment growth underpin consumption spending and residential investment. The upward potential for household spending is however limited due to negative or muted real wage growth (see figure 3) and the large share of hiring on temporary contracts.

Business investment is likely to get a boost from positive sentiment, increasing capacity utilisation rates, improved profitability and balance sheets, strong order books and tax incentives. That said, election uncertainty might temper investment growth a bit in the first quarter. The outlook for recovery in construction and real estate remains weak and not much should be expected from construction investment.

Government spending won’t add much to growth either. According to current drafts, fiscal policy will become less accommodative or even contractionary, depending on which budget indicator you look at. Finally, moving to international trade, we expect both export- and import growth to moderate. The net contribution of international trade is forecast to remain around zero in 2018 and 2019. After the cyclical recovery in the next two years, we forecast growth to fall back to its potential of between 0.5% and 1.0%. Due to the country’s low growth potential, it will be very difficult for Italy to significantly bring down its debt to GDP ratio (132%) without additional structural budgetary measures (read: more austerity) or structural reforms that lift Italy’s growth potential. Yet the momentum for reforms seems to have come to an end, as we will explain later in this text.

Figure 3: Real wage growth is being squeezed
Figure 3: Real wage growth is being squeezedSource: Macrobond
Figure 4: Debt to GDP has stabilised
Figure 4: Debt to GDP has stabilisedSource: Macrobond

Temporary convergence

It will take a long time before Italy’s debt ratios can possibly return to more moderate levels. But looking near-term there is evidence that its debt metrics have stabilised and are about to turn the corner. Of course, the strengthening cyclical upswing is of keen importance to this. The figure below shows that there is a welcome convergence between real GDP growth (↑), inflation (↑), bond yields (↓) and public debt growth (↓), with each trending in the right direction.

This convergence touches upon the issue of Italian debt sustainability, something that we will discuss in a forthcoming special. For now, we limit ourselves to the observation that the convergent forces may weaken in the medium term.

Crucially, as explained above, we forecast GDP growth to gradually return to potential in 2019 and 2020 as the positive cyclical tailwinds dissipate. Italy is currently also benefiting from a QE premium that keeps borrowing costs lower than suggested by Italy’s perceived riskiness. Our Rates team have valued this premium at around 50 bps for the 5-year rate, basing the calculations on the difference between a 5-year 'Italian risk-free rate' and a 5-year euro risk-free rate (see figure 6). They argue that this premium may eventually fade when the ECB winds down QE in the second half of 2018 or when there is a poor prognosis for Italian structural reforms. This is not unlikely. That said, stress tests by several institutions and also our own Rates team suggest that even in case of a 100 bps yield shock, the debt to GDP ratio would remain on a declining path.

Figure 5: A welcome but temporary convergence
Figure 5: A welcome but temporary convergenceSource: Macrobond Note: We took a 7-year bond yield based on the average residual maturity of Italy’s debt portfolio
Figure 6: Italy's ‘QE premium’ is valued at around 50 bps
Figure 6: Italy's ‘QE premium’ is valued at around 50 bpsSource: Bloomberg

Finally, we would want to highlight that high debt ratios don’t necessarily imply imminent debt sustainability issues. What it does mean, however, is that Italy’s economic policy is vulnerable to shocks and in a weak position to support growth, especially when the next crisis looms on the horizon.      

Politics main risk to outlook

The main risk to the economic and fiscal outlook stems from politics. At this stage, conclusions about election outcomes are of course highly speculative, but our base scenario is that Italy gets a fragmented parliament that is not very conducive for structural reforms. The new electoral system, known as the Rosatellum, hasn’t changed this much. For readers who want to know how this system came about, please refer to the blue box below.

Box 1: Italian politics in 2017

A little more than a year ago the Italians voted against a set of constitutional reforms that would have stripped the Senate of most its powers and made an end to perfect bicameralism. The rejection led to the fall of PM Renzi, the installation of a caretaker government and – crucially – a botched electoral law. This law, known as the Italicum, was designed on the premise that the plebiscite would turn out in favour of the reforms. Ultimately, the two legislative chambers ended up with very different electoral laws that lacked uniformity and cohesion. The Senate was to be elected proportionally, while the electoral law of the Chamber of Deputies was based on a two-round system with a winner-takes-all bonus. In fact, the majority prize was deemed so excessive that the Constitutional Court ruled it unconstitutional. In short, Italian politics was in shambles.

One of the caretaker government’s tasks therefore was to set this straight before the end of the legislature in 2018. After long deliberations the government came up with the Rosatellum electoral law, which was ultimately passed by the Chamber of Deputies on October 12 and the Senate on October 26. Crucially, the law was supported by the centre-left Democratic Party and by opposition parties including the centre-right Forza Italia and the eurosceptic Northern League. The Five Star Movement voted against this new electoral law. For good reasons, as we’ll explain now.

The revenge of Rosatellum

There’s no getting round some psephology to appreciate why Five Star voted against Rosatellum. It’s an electoral system that is based on an 'additional member system'. Roughly two thirds of the seats in both houses are elected on the basis of proportional representation, the remaining one third is elected first-past-the-post (FPTP) in single-member districts. In these districts, the candidate that wins the largest number of votes goes directly to Rome. This system benefits established and well-organised parties, and also those with a strong local character such as the Northern League (LN). Indeed, characteristics that do not apply to Five Star. At the same time, the electoral system should also yield moderately proportional election results. The idea is that the final seat count is not as skewed as in the UK but not as proportional as in the Netherlands. In the table on the next page we list the main features of Rosatellum.

Table 1: Seats in the Italian parliament
Table 1: Seats in the Italian parliamentSource: Rabobank

The entry thresholds and the partial FPTP system explicitly encourage parties to enter into coalition agreements before the elections. Parties risk being marginalised when they fail in the FPRP districts and win only a fraction of the PR seats, or, even worse, fail to cross the thresholds. Moreover, the 10% hurdle that is set for coalitions suggests that smaller parties have little option but to join either the centre-left bloc (CSX) or the centre-right bloc (CDX).

Figure 7: Five Star: largest party, third coalition
Figure 7: Five Star: largest party, third coalitionSource: Ipsos, SWG, Tecnè, EMG, Rabobank calculations Note: 3 observation moving averages, pre-coalition LeU results calculated as sum of individual parties

The left is highly disorganised since the split within the Democratic Party (PD) last February, which resulted from the loss of the referendum vote in December last year and the centrist policies advocated by ex-PM Renzi. The dissidents have now teamed up with other small left-wing parties and started a new coalition, Free and Equal (LeU), earlier this month. Even though polls suggest that LeU won’t cross the 10% hurdle, the political rift costs the CSX (i.e. the PD) hundreds of thousands of votes and possibly the elections. Based on current polling, the centre-left is expected to win around 28% of the votes. The centre-right is much better organised, even as they had their struggles in the recent past. Forza Italia (FI), the Northern League (LN) and the Brothers of Italy (FdI) are expected to join forces and collectively they poll at around 36% of the votes. Indeed, Rosatellum may turn out to be a gross miscalculation for the ruling centre-left

And what about Five Star? It’s evident that the electoral system was designed to hurt them, not the centre-left. This is still true. The party doesn’t have a strong local base yet and rules out to form any alliances with other parties, which have shaped the political system it denounces. So they are likely to go it alone, even as it hurts their prospects. Five Star currently polls at around 28%: the highest of any individualparty but not enough to get behind the steering wheel.

Policy paralysis

Obviously, reduced Five Star prospects have been a positive for markets in recent months, but looking a bit further ahead there’s not much reason for excitement. Admittedly, it’s true that the new law provided uniformity and cohesion in Italy’s two chambers and that it appears to have averted the immediate risk of a Five Star majority. It is however even more true that in non-crisis times 'strong and stable' governments are a necessary condition to push the reforms needed to boost Italy’s growth potential. No such majority is currently in sight.

The political landscape may still change considerably in upcoming months, but a first look at the polls shows that a hung parliament is the most likely scenario from here on. Due to the voting system, the centre-left and the centre-right will get more bang for their votes, but even in optimistic projections (for the left ór right) the largest coalition is likely to fall short of the 316 seats needed for a majority in the Chamber of Deputies. The centrist parties have demonstrated previously that they’re able to tolerate each other, but without external pressures from either the market or Brussels this typically only leads to lethargic policymaking.

Even if the centre-right’s current momentum persists and they do manage to win an outright majority, there’s a risk of policy paralysis. This may certainly be the case when increased Northern League popularity, currently at 14%, shifts the balance of power within centre-right away from the more business-friendly Forza Italia party, which is now at 16%.

A worst case scenario – albeit an unlikely one – is an anti-establishment coalition formed by Five Star, the Northern League and the Brothers of Italy. Such a scenario may also play out after the elections, in particular when Five Star turns out to score even better results than already indicated by the polls. If they win roughly 40% of the vote, it’s getting increasingly difficult for them to ignore the popular mandate and the pressure will be on them to break with their 'no coalition'-rule. This will definitely set the stage for some serious turbulence in financial markets, but we would like to emphasise that the polls over the latest couple of years show that Five Star popularity looks to have hit a ceiling at around 32-35%. An external catalyst, possibly an escalation of the migrant crisis, looks to be a necessary condition to break through this ceiling of Five Star popularity.


The Italian economy is experiencing a cyclical economic recovery that masks its structural problems. Economic policies and reforms that are aimed at raising Italy’s potential growth are imperative. We don’t expect to see many of such reforms, especially when these come with electoral costs. On fiscal policy we only expect a minimum effort to comply with European budgetary rules and not to upset markets too much.

In the short-term markets will nevertheless trade positively if it becomes progressively clear that the Five Star Movement won’t be able to secure a sufficiently large majority to form a populist government with reckless fiscal policies or tough language on 'Quitaly' (even as this is not much of an issue lately).

A hung parliament remains however highly likely, despite the changes in the electoral law. But, Italian politics, the Italian economy and – eventually – financial markets are used to, and able to cope with, uncertainty related to a fragmented outcome as long as it produces a government.

The biggest risks to Italy’s outlook are therefore that the newly elected parliament is unable to form a government or, even more problematic, that populist forces win enough votes to form a government. While chances of the latter are rather slim, the negative impact of an unexperienced populist government on both markets and the economy would likely be large.

Maartje Wijffelaars
RaboResearch Global Economics & Markets Rabobank KEO
+31 6 2257 0569
Stefan Koopman
RaboResearch Global Economics & Markets Rabobank KEO
+31 30 71 21328

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