RaboResearch - Economic Research

Italy climbs out of recession, but economic situation remains dire

Economic Comment

  • GDP growth in the first quarter of 2019 is revised downwards to 0.1%. The most important positive contribution comes from a substantial decline in imports
  • Tensions between Brussels and Rome look set to increase again this autumn when the new Commission needs to approve the Italian budget for 2020
  • Coalition is expected to stay together in 2019, but the probability of a split-up will increase after January 1
  • Growth is expected to decelerate in the rest of year as policy uncertainty and tension between Rome and Brussels weigh on private sector confidence
  • We still forecast growth to be 0,0% in 2019, while we expect growth to pick up a little in 2020

Italy climbs out of recession

As was made clear by the flash estimates on April 30, Italy climbed out of recession during the first quarter of this year. The exact breakdown of the GDP figures (released on May 31) revealed a downward revision of GDP growth to 0.1% q-o-q. Private consumption and investments both increased by respectively 0.2% and 0.6% and therefore contributed positively to growth in Q1. Nevertheless, Figure 1 shows that the most important positive contribution comes from net exports. This sounds more positive than it actually is, as the positive contribution mostly came from a 1.5% decrease in imports (compared to a meagre 0.2% rise in exports). The most important drag on growth was the decline in inventories. Production companies may still be anticipating a slowdown in activity and therefore see less need in keeping inventories. However, we are not reading too much into this, given the statistical issues related to the inventory figure.

Sentiment remains subdued in second quarter of 2019

Monthly survey data released in April signal that the Italian economy experienced a rough start of the second quarter. After consistently increasing throughout the first quarter, the Composite Purchasing Managers’ Index (PMI) slid during the first month of Q2 and currently stands at 49.5 (Figure 1). This is usually consistent with a small contraction in output. As opposed to Q1, the domestically-oriented services sector was the driving force behind the decline in the Composite PMI which suggests that domestic demand slowed at the start of Q2. On the other hand, the Economic Sentiment Indicator (ESI) increased in May for the first time since June 2018. Nevertheless, it stands far below the level observed in the second half of 2018 when Italy was in recession. Moreover, it barely rebounded to the level observed at the end of Q1. Add to this that growth was positive in Q1 mainly due to a large drop in imports and we are not seeing much reason to expect that growth will pick up going forward.

Figure 1: Net exports drive Italy’s return to growth
Figure 1: Net exports drive Italy’s return to growthSource: Macrobond, Rabobank calculations
Figure 2: PMI’s are still looking bleak
Figure 2: PMI’s are still looking bleakNote: If the PMI is above 50, this generally points towards economic growth, whereas if the index is below 50, this generally implies a contraction.
Source: Macrobond

Tensions between Rome and Brussels likely to flare up again in second half of 2019

What’s more is that tensions between Rome and Brussels look set to increase this autumn. The European Commission (EC) forecasts a nominal deficit of 2.5% of GDP in 2019. This means Italy will fail to achieve the target of 2.0 percent of GDP agreed on last December after a heated row between Rome and Brussels. EC forecasts also show that Italy is set to breach the EU fiscal rules next year, as the deficit is expected to increase to 3.5 percent of GDP in 2020. Debt is expected to increase to 135 percent of GDP in 2020 on the back of weak economic growth and expansionary fiscal measures. Therefore, the question seems not whether Italy will breach fiscal targets, but by how much and how the Commission is going to respond.

The Commission will publish a fresh assessment of the Italian fiscal situation on June 5th in which it may recommend an ‘Excessive Deficit Procedure’ (EDP). Nevertheless, we do not expect the Commission to recommend an EDP yet. The (projected) dismal performance of the Italian economy in 2019 and 2020 is definitely considered, but the main basis for an Excessive Deficit Procedure would be Italy’s fiscal performance in 2018. The budget deficit decreased in 2018, whereas the total debt increased only slightly throughout 2018 (Figure 3). We do not expect that the EU sees this as a sufficiently large breach to justify a decision of such consequence. Additionally, the current Commission nears the end of its term, while the next few months will be used to appoint new European leaders. Therefore, tensions between Brussels and Rome are more likely to flare up again this autumn, when the new Commission takes office.

Here we go again!

A lot will depend on the Italian government’s intentions while designing its budget for 2020 this autumn. The coalition needs to come up with alternative measures to reduce the budget deficit, since it has repeatedly stated it has no intention of letting an automatic value-added tax (VAT) hike kick in.

Figure 3: Debt figures in 2018 unlikely to be the trigger of an EDP
Figure 3: Debt figures in 2018 unlikely to be the trigger of an EDPSource: Macrobond

Nevertheless, the projected revenues of alternative measures proposed by the government, such as the sale of public assets, are considered optimistic. Therefore, we expect that the government will at least use some deficit spending to compensate the cancellation of the VAT hike. Furthermore, the coalition is unlikely to roll back the expansionary fiscal measures and, due to his win during the European elections, Salvini feels empowered to push ahead with his plans to cut taxes. All in all, we foresee that a new row between Rome and Brussels seems inevitable. This will likely inflate government bond yields, tighten private sector financing conditions and decrease private sector spending as policy uncertainty weighs on confidence. The willingness of the coalition to comply to European demands will hinge on the severity of financial market pressure. Based on past form, serious damage will already be inflicted before a compromise with Brussels is reached.

Coalition split-up remains a possibility

Besides the uncertainty stemming from its policy-making, there still exists a probability that the current government splits up in the near term. A split-up will probably be followed by snap elections, as the only alternative coalition between Five Star and the Democratic Party is ruled out by the leader of the latter party. The probability of a split-up has increased following the European elections, which Lega won by a landslide and in which it is substantially outperformed Five Star. This may tempt Salvini to solidify Lega’s position at home by means of a snap election.

Coalition not expected to split in 2019, but probability looks set to increase in 2020

Nevertheless, we do not expect the coalition to split up any time soon. In case the current coalition does split up and new elections are held, a right-wing coalition, consisting of Lega, Forza Italia and the Brothers of Italy, would be the most likely successor. We do not see any reason why this would be more preferable for Salvini. Lega is clearly dominating Five Star in the current coalition, which has been successful for Salvini so far. If anything, the strong election result increases Salvini’s ability to set the government agenda. Moreover, Berlusconi could prove to be a liability, as he is a seasoned politician with a controversial reputation at best. Also, the timing looks to be a delicate issue. Elections are traditionally not held during the summer as it risks a low turnout. This autumn could be a possibility, but walking away from the painful budget drafting process is unlikely to do both parties any favours. What’s more, an automatic increase in the value-added tax (VAT) rate kicks in when Italy lacks a government at January 1st. This would reflect badly on both parties and may be especially hard to digest for Salvini, whose plan to revamp economic growth centres around personal and corporate tax breaks.

It remains to be seen, however, if the coalition finishes its entire term, given the major ideological differences that constantly cause friction. We expect the probability of a government split-up to increase in 2020, as the timing issues are out of the way. Moreover, it is not unthinkable that both parties start to lose ground in the polls if the dire economic situation carries on into 2020.

Looking ahead

All in all, we expect Italian growth to slow during the rest of the year as political and financial market turbulence will once more weigh on private sector confidence. Nevertheless, we do expect a small but positive impact of the expansionary measures on private consumption during the second half of 2019. Overall, we still forecast growth to be 0.0% y-o-y in 2019, while we expect growth to pick up a little in 2020 to 0.3% y-o-y.

Michiel van der Veen
RaboResearch RaboResearch Netherlands, Economics and Sustainability Rabobank KEO
+31 6 8313 4616

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