COVID-19 has a devastating impact on Italy’s economy
- We think that Italy’s GDP volume contracted by close to 17% y-o-y in the second quarter
- In the second half of the year there is room for a ‘technical’ recovery, but we believe the economy will not have fully recovered before 2025
- We project the economy to contract by 11.5% this year and to grow by 7% next year
- We do not expect an outright banking crisis, but bank balance sheets will deteriorate and the overall picture remains rather gloomy
- Government finances are set to deteriorate significantly
- Government bond yields are close to historic lows, but this is mainly due to ECB support
- Early elections are unlikely for now. But as things stand, the probability that the next elections, whether early or in 2023 as planned, deliver a far-right euroskeptic government is large
The Italian economy has suffered massively
The Italian economy is facing one of its darkest hours in modern history. After shrinking by 5.4% y-o-y in the first quarter, it is set for a much larger contraction in Q2. We will have to wait until the end of this month for the first official GDP estimate, but the available data leaves little to one’s imagination: in April, arrivals at tourist accommodations were down 99% compared to last year, car sales contracted by 98% y-o-y, retail sales by 29%, industrial production with 47% and construction production by 68%. And while scarcely available data suggests that May and June have been less bad –which makes sense as non-essential production sites and stores were allowed to reopen, albeit with restrictions– the figures were still very weak (figures 1, 2 and 3). Industrial production shrank by 31% compared to the same quarter last year and car sales by 57%.
We think that GDP volume contracted by close to 17% y-o-y in the second quarter.
Starting from the second half of this year, there is room for a ‘technical’ recovery. The simple fact that stores and restaurants have reopened, and people are again able to spend as opposed to being confined to their homes, for example, will lead to more spending. Moreover, the fact that since 3 June, the country again welcomes foreign tourists from the EU, Schengen and the UK, is likely to lead to at least some tourist inflow, as opposed to close to zero during the largest part of the spring. But many factors, related to both demand and supply side shocks are holding back the recovery (see below).
All in all, we project the economy to contract by 11.5% this year and to grow by 7% next year (figure 4). We believe the economy will not have recovered losses before 2025, the end of our forecast horizon. This forecast is based on the assumption that a COVID-19 vaccine will not be available before the second half of next year, implying social distancing rules will remain in place until then.
Room for recovery, although limited
The Italian economy will likely grow rapidly in the third quarter, on the back of the economy opening up (figure 5). Yet if we look passed this so-called technical recovery, the Italian recovery faces many hurdles.
For starters, the economy was already performing very weakly by the end of last year: it contracted by 0.3% q-o-q in the final quarter. Second, while many containment measures have been lifted, social distancing rules continue to persist. This has an impact on a broad range of activities, for example in the hospitality sector. We have estimated that about 17% of Italian jobs cannot be done from home or while maintaining a 6 foot distance. Moreover, even when on paper jobs can be done from home, weak digital advancement hampers that possibility, at least partially. Third, despite that the country is again welcoming desperately needed tourism, international tourism is expected to remain muted. Which is very troublesome for the economy, given that half of its tourists are foreign (figure 6), the high season is coming and tourism contributes to 13% of GDP (figure 7).
Fourth, the major contraction in the first half of this year brings along a large domestic demand shock despite large fiscal support measures. So far, the government has approved fiscal support packages worth around EUR80 billion (4.6% of GDP), including health care investment, short-time work-schemes, income transfers, tax deferrals, and moratoriums on loan repayments and utility bills. On top of this, the government is issuing guarantees on loans to a broad range of businesses covering at maximum between EUR700 and EUR750 billion loans. According to the European Commission, the contingent liability for the government arising from these guarantees would, at maximum, be EUR430 billion euro.
Labor market outlook
Despite government support via short-time work-schemes and a ban on lay-offs, employment heavily contracted in April (-2.2% y-o-y) and May (-2.6% y-o-y). This outpaces the monthly rate at which employment was reduced in the worst month of the Eurozone debt crisis. Not surprisingly, the self-employed and people on a temporary contract are bearing the brunt. In May, employment for latter group dropped by 19% compared to May last year. The sharp fall in employment has been accompanied by a sharp contraction of the labor force (figure 8).
All these figures exclude the number of workers admitted to the short-time work schemes. With companies struggling to survive and large uncertainties going forward, employment will inevitably fall when the ban on layoffs is lifted by the end of August and the crisis related expansion of short-time work schemes ends in October. Employment expectations in all sectors except the construction sector are weak, especially in the services sector. In Q1, the job vacancy rate already dropped by as much as in the 2008/09 financial crisis (figure 9). For which likely only March was to blame. This suggests the job vacancy rate has dropped by much more in Q2.
Government support will also not be able to prevent a rise in corporate defaults. Several indicators, for example higher earnings to debt payment obligations (figure 10), suggest firms are now better able to withstand a shock to income than back in 2008 and 2010 and that a massive liquidity crisis could be prevented. According to estimates by Banca d’Italia, gross operating income of firms would need to fall by over fifty percent in 2020 to return to the peak of loan repayment difficulties seen during the global financial crisis. In the first quarter, operating income fell by just 5 percent compared to the same period last year.
Still, while firms seem to have better finances than when the financial crisis stroke, a wave of defaults is likely, due to different reasons. Regarding government support, non-eligibility or delays in receiving support could still lead to liquidity-induced defaults. Especially among small firms, in the real estate, construction and the hospitality sector. Furthermore, in hard-hit sectors such as hospitality, in which limitations to capacity will continue to persist, anecdotal evidence suggests margins are too small to cope with a sustained fall in revenue and remain profitable, while uncertainty over the future will likely induce especially small and already less profitable firms to shut down, instead of taking on more debt.
Weak public balance sheet
Finally, weak public balances imply the government has to strike a difficult balance between supporting the economy and preserving debt sustainability. Italy entered the crisis with a very high public debt ratio of 134.8% of GDP, the second highest in the Eurozone (figure 11). So far it has mainly focused on supporting the economy. Clearly the massive ECBs bond buying program and EU credit support lines help to keep interest costs manageable, but until what point? In any case, the government has less financial wiggle room than its Northern Eurozone partners. And it is likely that it will need to consolidate its finances before the economy has fully recouped crisis losses.
So conditional upon no significant flare up of coronavirus infections and subsequent containment measures, we can expect a technical recovery starting in the second half of this year. Yet many factors are holding back a v-shaped recovery and suggest that Italy’s recovery will be weaker than in the Northern Eurozone.
Worrying about a banking crisis?
An increase in corporate bankruptcies and payment difficulties will have an impact on bank balance sheets. While crisis-related regulatory changes by the ECB will help to limit the increase in loans classified as non-performing (NPL) and ease provision needs for the time being, bank balance sheets are set to deteriorate. All in all, the Italian banking sector is weaker than its Eurozone peers and the entire picture for the banking sector remains gloomy, but on average it should be able to withstand a rather substantial increase in non-performing loans without running into an outright banking crisis.
While still less capitalized than most of its Eurozone peers, Italian banks have significantly increased capital ratios since the financial crisis in 2008 (figure 12). The tier 1 ratio, for example, improved from 6.9% end 2007 to 15% end 2019 (16% in the euro area) and the capital to asset ratio from 123% to 185% (272% in Spain and 525% in Germany). From this point of view Italian banks should be more resilient to a large influx of non-performing assets then back in 2008, but less than their peers.
That said, although Italian banks have significantly reduced their non-performing loan book in recent years, with the NPL ratio standing at 6.7% end 2019 (EBA) from its peak at 17% end 2015, the NPL ratio is still a touch higher than end 2007 (5.8%) and more than double the Eurozone average (2.7%). The same holds for the ratio of NPLs net of provisions to capital, an indication of capital adequacy: it stood at 37% mid-2019, compared to its peak of 93.5% in 2015 and its low of 23.5% end-2017. Finally, profitability is very weak, with interest margins to income and return on equity lower than in 2008 and non-interest expenses to income higher. Increased provisioning needs for the rise in NPL would further strain profitability. So, even though the banking sector in general seems to be able to withstand the crisis, the overall picture remains gloomy.
Holdings of public debt
Next to the size of the NPL increase stemming from the private sector, the valuation of Italian public debt is of great importance to the strength of the Italian banking sector. Italian banks, excluding the central bank, hold EUR 673bn, i.e. 26.5 percent of total government debt (figure 13). That amounts to 18% of their total balance sheet. Public debt securities amount to 184% of own funds (capital), while loans to the government make up for about 15% of total loans. Hence Italian banks’ balance sheets are very vulnerable to falls in the creditworthiness of the government.
A sovereign debt crisis?
So should we worry about a sovereign debt crisis? This question is inherently difficult to answer as it depends on a great variety of factors, both in and outside of the control of the government – with ECB policy being an example of the latter.
In 2019, public debt stood at 134.8% of GDP. Based on the several fiscal support packages and our growth forecast for this year, we expect Italian public debt to rise to over 160% of GDP this year. While estimations differ among economists, the government and official institutions, it is clear that debt-to-GDP is set to rise massively and that large gross financing needs (GFN) this and next year will test the government’s access to financial markets – in its spring forecast the European Commission (EC) estimated Italy’s GFN to total 31.7% of GDP this year and 26.5% next year. With GDP forecasts downgraded in the summer forecast, these ratios are likely to have risen. Usually, the EC and IMF agree that gross financing needs should ideally remain below 15% of GDP and should rise to 20% of GDP at most, for debt to remain financeable and hence sustainable.
Still, currently, government bond yields are nowhere close to levels to be expected in times of large doubts over debt sustainability. In fact bond yields on Italian debt are rather close to historic lows, far below levels seen during the Eurozone sovereign debt crisis of 2010/2012, and even far below levels seen back in 2018, when the 5-Star-Lega government threatened Italy’s euro area membership (figure 14).
To a great extent the low yields are the result of ECB support through, its public sector purchase program and more recently through its pandemic emergency purchase program, launched in March. Under the umbrella of the ECBs different asset purchase programs over the past years, Banca d’Italia has significantly increased the amount of Italian government bonds on its balance sheet. In April, it possessed close to EUR 450bn euro of Italian debt (figure 13), 18% of the total. As long as the ECB continues to buy sufficient bonds in the secondary market under its asset purchase programs, it can help to suppress bond yields and prevent the Italian public debt situation from spiraling out of control. The big question then is, up until what point and for how long is the ECB willing and able – based on the different treaties - to step in. If the ECB lowers its game or does not raise it sufficiently to keep up with increasing Italian financing needs, yields on Italian government bonds will start to rise.
Next to ECB support, the Italian government can draw loans with very low interest rates from several instruments drawn up by the EU, to fight the corona crisis: such as SURE – for labor market related support schemes - and unconditional ESM pandemic credit lines for financing needs directly related to health sector costs. While in Italy it is very much disputed whether or not to make use of these instruments, we think that when push comes to shove, the current Italian government will get approval from parliament to tap the different EU support lines currently available. This would help lower interest rate costs, even though it would only cover financing of at maximum 3.5% of GDP. Note that these lifelines are time-limited.
All that being said, it is still hard to see how, absent policy changes, the very large public debt stock would not increase debt sustainability risks at some point. Especially given the fact that Italy’s longer-term real growth potential was already close to 0% prior to the crisis and potentially long-lasting negative effects from the corona crisis are unlikely going to make the outlook any better. Moreover the higher the debt load, the lower interest rates need to be to prevent the debt ratio from rising, let alone to bring it down, when holding nominal growth and the primary balance constant. Interest rates also need to stay low to prevent the Italian government’s interest burden to rise, to make sure sufficient money remains available to spend on policies benefitting welfare and growth without the need to resort to austerity, which could reach the opposite and have large repercussions for the debt-to-GDP ratio.
It is impossible to say at what ratio debt would still be sustainable and at what ratio it would spiral out of control, but it is clear the situation is very precarious.
The recovery fund
The EU recovery fund could help, both in the short and long run, and both in terms of the grants provided to Italy and the signaling effect of such a big step forward in EU fiscal coherence. The latter could help to suppress bond yields. Based on the proposal and a suggested distribution key, the European Commission has forecasted the fund could raise the EU27 GDP level with 1.5-2.25% by 2024, depending on assumptions made on the take-up rate for the loans. For the country group that includes Italy, the estimate ranges from 2.8% to 4.2%. But its size, composition – loans and grants – and timing is still up for debate and will matter substantially for the overall impact. European leaders hope to agree on the fund in an extraordinary summit 17 and 18 July. From the Italian perspective, they could agree with receiving support based on reform conditions, as long as it is up to them to make the proposal and they remain in charge, but only in exchange for grants, not loans. The latter holds for as long as push does not come to shove, which could very well change attitudes, although it might require a change in government.
A government crisis?
So far, Italians are not that fond of the EU’s handling of the crisis. To give some examples: in the Eurobarometer of June, 81% of Italians indicated that solidarity among EU member states has been insufficient. On average, 57% of EU citizens concluded the same. In the barometer of July 58% of respondents said to have become more negative about the EU. And finally in June, 47,7% of respondents in a survey by Termopolitico indicated that they would agree with leaving the Eurozone and EU, or one of the two, compared to 48.5% indicating they would rather stay (figure 15).
Still, so far, the right-wing euroskeptic opposition has not been able to gain ground (figure 16). Although the even more anti-immigrant and conservative Brothers of Italy, headed by Georgia Meloni, has gained at the expense of Lega, headed by Mateo Salvini. The right’s inability to benefit from the EU’s mishandling of the crisis is related to, amongst other things, to widespread approval of the Italian government’s handling of the crisis - even among voters of far-right opposition forces. That said, general election polls also give no indication that the current government would stand to gain from new elections. On the contrary, the right-wing opposition would still likely win. So all in all, early elections remain unlikely for now. Yet, there are many frictions within the government and these are only set to increase once the height of the crisis is over and the total economic damage becomes clear. Especially if at some point European budget rules get back into play. For now, a government reshuffle, or replacing Conte as PM would still seem a more likely option in that event than early elections. But in any case, absent a magical economic rebound, the probability that the next elections, whether early or in 2023 as planned, deliver a far-right euroskeptic government is still large, complicating EU-policymaking any further.