RaboResearch - Economic Research

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Economic growth grinds to a halt in Italy

Economic Update

  • Italy’s economy stagnated in the third quarter of 2018
  • This is likely partly related to the political situation and weak export orders
  • The outlook remains poor despite and because of the government’s expansionary 2019 budget
  • It is unlikely that the Italian government will significantly change its budget draft before the 13 November deadline on the European Commission’s request
  • As such, investors’ concerns and market volatility are not going anywhere soon
  • That said, both a government break-up, an euro area exit and an all-out debt crisis are not imminent
  • But under the current government Italy is becoming more vulnerable to shocks

Economic growth disappointed in the third quarter, as in fact there was no growth. Both net export and domestic demand (gross of inventory formation) made a zero contribution to the headline growth figure, according to the press release of Istat. The former was anticipated, but domestic demand has performed worse than expected. The exact breakdown of expenditure components is not yet known. Based on available data we think that investment growth significantly slowed from the 2.7 percent Q-o-Q in the previous quarter or even contracted, and that inventories were ran down. Consumption growth expectedly remained quite stable but still weak at close to 0. Consumer confidence has held up rather well in Q3, but producer confidence, especially in the industry sector, has substantially deteriorated over the past months (figure 1 and 2). This is likely partly related to uncertainty stemming from the political situation, but also to weak assessments of export order books.

In our view Italy’s economic outlook remains poor. The economy has been losing steam since the beginning of the year, almost before it actually gathered speed, and the positive impact of expansionary budget measures next year will expectedly be largely (or even completely) nullified by higher interest rates and uncertainty over the economic outlook on the back of increased risks surrounding government finances. That said, ongoing improvement at the labour market, even though it is slowing, and in household finances, should support the economy also next year.

We expect economic growth to come in at 1 percent this year and below 1 percent next year. This compares to a 1.5 percent growth forecast for 2019 by the Italian government.

Figure 1: Deteriorating producer sentiment clouds outlook
Figure 1: Deteriorating producer sentiment clouds outlookSource: Macrobond, Rabobank calculations
Figure 2: Manufacturing sector contracts according to PMI
Figure 2: Manufacturing sector contracts according to PMINote: Purchasing Managers’ Index. If the index is above 50, this generally points to growth. If the index drops below 50, this generally implies a contraction.
Source: Macrobond, Rabobank calculations

Outlook is poor: despite or because of government spending plans?

In its budget draft 2019, the government presented a wide range of measures that should support economic growth in the short run. Think about lower taxes, tax incentives for investment and hiring, more public investment and increasing welfare benefits for the poor via the so-called citizen’s income. The income is intended to be made conditional upon job search and spending, to prevent freeriding and saving. At the same time, though, the budget draft includes measures that increase government spending, but are unlikely to improve the economic outlook. Such as a lower retirement age for certain workers. The government reasons that earlier retirement frees jobs for unemployed youth. Yet against the backdrop of rising uncertainty and worsening sentiment, it is very unlikely that all retirees will be replaced with currently unemployed. Several institutions have estimated long-term costs of the pension reform at over 10 percent of GDP.  

Despite some supporting measures we think that the 2019 budget will not be able to substantially support economic growth next year. The three main reasons are: (i) elevated government bond yields (ii) increased uncertainty over future policy and the economic outlook (iii) implementation difficulties that are likely to delay the actual implementation of the proposed expansionary measures.

Given the already high debt burden, the high costs involved in the programme and uncertain benefits, the government’s creditworthiness has worsened and borrowing costs for the Italian government have risen (figure 3). Usually a rise in government bond yields translates into higher interest rates on corporate bank loans and corporate bonds as well. According to surveys conducted by the Bank of Italy and the statistics agency Istat, credit has already become less accessible for businesses in the second and third quarter of this year, for the first time since the beginning of 2015. We expect credit accessibility to deteriorate further going forward as Italian banks’ balance sheets have worsened and funding costs have risen given their high exposure to government bonds. Based on past form this hampers investment growth.

Figure 3: Investors are concerned (2018)
Figure 3: Investors are concerned (2018)Source: Macrobond
Figure 4: Order books bode ill for investment
Figure 4: Order books bode ill for investmentSource: Macrobond

Already worsening producer sentiment due to higher uncertainty, deteriorating (export) orders (figure 4), and declining capacity utilisation rates do not help either. In fact, the stagnation in the third quarter supports our view that the government’s plans can have a negative impact on economic growth, especially as long as the expansionary measures have not yet come into force.

In this respect, it is important to note that the implementation of certain parts of the budget 2019, such as the citizen’s income scheme and selecting the right projects for public investment will likely be (very) time consuming. In fact, while Di Maio has managed to secure the funds with Tria, there is no thought-out plan yet on how to implement the citizen’s income. It is rather unlikely that the scheme will be up and running in the first half of the year and the same holds for additional public investments. While this would limit next year’s spending, it also means that the economy would have to bear rising uncertainty and interest rates at a time when it is not yet benefitting from additional spending. The government could choose to increase existing unemployment benefits and pensions of low-income households, instead of fully implementing the new scheme, but that might not go down well with a certain part of its voter base. And moreover the impact on the economy would likely be smaller, as households could choose to save the money instead of spend it.

Against this backdrop, it is very difficult to estimate the exact impact of the 2019 budget. And let’s not forget, it is still not completely certain how the final 2019 budget will look like as the final draft is not yet approved by parliament. This has to be done by year-end. Yet all in all, we are rather pessimistic about the economic outlook for 2019.

Market volatility isn’t going anywhere

Financial markets clearly do not like the government’s plans and they were also not too happy with the weak growth figure (figure 3). But at this point, market pressure seems insufficient to force the government to alter its course. In particular because support for the government is high (figure 5). As such, it is unlikely that the Italian government will please Brussels by significantly changing its budget draft before the 13 November deadline. Minor tweaks might keep the door for negotiations open. But a further worsening of the relationship with Brussels lies ahead. All in all, investors’ concerns and market volatility are not going anywhere soon. And while an all-out debt crisis is not imminent, under the current government Italy is becoming more vulnerable to shocks.

Government break-up not likely at this moment

Figure 5: Government enjoys strong support
Figure 5: Government enjoys strong supportSource: Macrobond, Rabobank calculations

Which brings us to the point: is the current government here to stay? We have argued before that it is very unlikely the government will survive its term given the many interest groups it is looking to please, very little governing experience, and limited fiscal space which makes it difficult to give all groups what they want – although the government is trying to stretch that space. In the near term, a government break-up is unlikely, though, as neither party would benefit from early elections. Five Star has been losing some ground in the polls, while for the League it would be a big gamble as well (figure 5). Furthermore, both are very keen to get their current 2019 budget draft approved before year-end. Failing to do so would mean that the 2018 budget remains in place, i.e. a budget excluding both party’s expansionary election promises and including the harshly criticized VAT hike. This would likely cost them voters in the European elections in May. And gaining bigtime in the European elections seems to be one of the main goals of especially League leader Salvini: to try and change the EU from within. So we think the coalition will at least survive until the European elections. Cracks will likely become more visible from the second half of 2019. Underperforming economic growth and a lack of progress on election promises will at some point cause voter support to fall, budget talks over the 2020 budget will prove significantly more difficult than over the 2019 one, and ignorance will lead to more and more coalition infighting.

Euro area membership not at risk

Figure 6: Majority of Italians in favour of the euro, but they are closing ranks
Figure 6: Majority of Italians in favour of the euro, but they are closing ranksSource: Macrobond, Eurobarometer

Although the League and Five Star are Eurosceptic and want to defy Europe’s budget rules, we think it is highly unlikely that the current government would intentionally give up Italy’s membership of the euro. The government has repeatedly stated that it does not intend to take Italy out of the Eurozone. It wants to change the EU from within. Furthermore, the majority of the Italian population (about 60 percent) is also still in favour of the euro (figure 6). While not too enthusiastic when compared too other Eurozone citizens, it is the highest share in more than six years.

In a recent publication, we nevertheless presented a thought experiment in which Italy could unintentionally fall out of the Eurozone as a result of a sequence of unwise decisions by Italian policymakers. It appears that it would take quite a few large policy errors and incorrect estimates for things to reach that point due to which the risk that this will happen is extremely low.


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