Fixing Italy’s growth problem
Italy’s growth trajectory, at around 1.5%, may look modest in comparison to the 2.3% growth that UniCredit is projecting for the eurozone as a whole in 2018 and 2019 but by Italian standards, it represents an encouraging advance, given that the root cause of so many of Italy’s problems is its chronic lack of growth. Philip Moore reports.
The robust performance of the Italian economy over the last 12-18 months has come as a positive surprise to a number of analysts. As recently as April, the IMF was forecasting growth in 2017 of just 0.8%. With the economic recovery across the eurozone gathering momentum, in July the IMF increased its forecast for 2017 to 1.3%, slightly below the 1.4% pencilled in by the Bank of Italy in the summer.
Bank economists are hopeful of slightly faster growth than these revised projections suggest. Paola Monperrus-Veroni, chief European economist at Crédit Agricole in Paris, is expecting Italy to grow at 1.6% in 2017 and 2018. UniCredit’s economic preview for 2018 forecasts growth of 1.6% in 2017 and 1.5% in 2018. BNP Paribas, meanwhile, anticipates growth rates of 1.5% in 2018 and 1.1% in 2019.
This growth trajectory may look modest in comparison to the 2.3% growth that UniCredit is projecting for the eurozone as a whole in 2018 and 2019. But by Italian standards, it represents an encouraging advance, given that the “root cause” of Italy’s problems, in the words of a recent Robeco research note, is its “chronic lack of growth”.
Marco Valli, chief European economist at UniCredit in Milan, says that one of the main drivers of the improved outlook for the Italian economy has been the acceleration in global economic growth. But he adds that an encouraging feature of Italy’s accelerated growth is that the economy has been firing on a number of cylinders. “2017 was finally a year when we saw a broadly-based recovery, with consumption, exports and investment all contributing solidly to growth,” he says. “My expectation is that we will see a broadly similar picture in 2018.”
Others agree. As Moody’s comments in its most recent assessment, “importantly, the broad-based nature of the recovery provides some assurance that growth can be sustained over the near term; in contrast to the past two years the recovery is no longer driven solely by private consumption.”
Perhaps the most welcome news — and the longest overdue — has been the strengthening of investment, which fell sharply during and immediately after the financial crisis. According to the European Commission’s 2017 Country Report on Italy, in 2007 Italian investment reached 21.6% of GDP, which was broadly in line with the Euro area average of 23.2%. “With the crisis,” notes the EC, investment fell to 16.6% of GDP in 2015, around three percentage points below the euro area average. In real terms, this means that total investment is around 30% lower than in 2007, at its lowest level since the mid-1990s.”
A notable recent pick-up in investment, estimated to have grown by 3% in 2017, has gone some way towards closing this gap. The most recent Bank of Italy/Il Sole 24 Ore report points to “a marked acceleration of investment expenditure in the second half of 2017, especially in industry excluding construction and for the largest firms.”
More positive still, this uptick in investment is expected to gather momentum in 2018, according to the Bank of Italy survey. This reports that the number of companies in the manufacturing and services sectors planning to increase investment expenditure outstrips the share of those intending to cut back by 34.2 percentage points.
This rise has been driven in large part by a range of measures introduced by the government to boost investment. Specifically, the 2017 Budget Law introduces very generous depreciation allowances on investment, including a so-called “hyper-depreciation” 250% amortisation rate for digital investments as part of Italy’s new Industry 4.0 strategy.
At Crédit Agricole, Monperrus-Veroni says that the pick-up in investment came slightly later than she originally expected, but that has not diminished the importance of its contribution to Italy’s economic revival. “The government’s measures for supporting investment initially benefited the transport equipment sector, because in the early phases of the cycle companies focus on investment in logistics,” she says.
“In 2017, however, there was a very strong improvement in investment in machinery, equipment and innovation,” she adds. “This has important implications, because private consumption appears to have peaked after four years of growth and Italy needed another more sustainable source of growth.”
There are a number of other reasons for analysts to be more upbeat about the prospects for the Italian economy. Uppermost among these is the much improved financial profile of Italian companies, which is supporting a rise in business confidence. “In the corporate sector, profits and margins are rising,” says Monperrus-Veroni. “Bankruptcies are also now back to their pre-crisis level, which is a clear indication that the crisis is over.”
That may be. But the challenges that remain are as familiar to students of the history of the Italian economy as they are formidable. Foremost among these is public debt, which has stabilised but remains high. “Italy’s key credit weakness is the elevated public debt, which at 132% of GDP is among the highest of the sovereigns we rate and which implies a high vulnerability to economic and financial shocks,” notes Moody’s.
Another longstanding vulnerability is unemployment in general, and youth unemployment in particular, which at just over 35% in August 2017 remains stubbornly high. That is lower than in Greece and Spain, but is still well above the average for the euro area of 18.9%. Perhaps even more disturbing, the youth unemployment rate has been much slower to fall in recent years than it has in Spain.
A third weakness is the state of the Italian banking industry, where asset quality, capital and profitability have all been under intense pressure. As the IMF comments in its latest report, non-performing loans (NPLs) in the Italian banking system have declined marginally, but at about 21% of GDP are still among the highest in the EU.
A fourth vulnerability for the Italian economy is weak productivity and its poor infrastructure, with the European Commission commenting that “transport infrastructure quality is below the EU average, with significant regional variation.”
Repairing the damage
Notable progress is being made in all these traditional areas of weakness for the Italian economy. The government is expecting to achieve a balanced budget by 2020, with the debt to GDP ratio falling to 123.9%. According to the Bank of Italy: “Simulation exercises confirm that a reduction in the debt-to-GDP ratio is possible in the medium term, based on realistic assumptions about the future growth of the Italian economy and financial conditions, and provided that primary surpluses are adequate.”
Economists support this view. “Thanks to QE and the extension of its average life to about seven years, the cost of the government’s debt has fallen,” says Valli. At current interest rates, a nominal growth rate of below 2% is enough to stabilise the debt to GDP ratio, which has started to decline.”
Monperrus-Veroni is also optimistic about the outlook for Italy’s public debt. “We have been forecasting a fall in the debt ratio for the last two years, which did not materialise because subdued inflation prevented the denominator from rising,” she says. “However, we expect to see the ratio decline in 2018, which will send out a very strong message to investors and ratings agencies.”
The outlook for the labour market is also brightening. “There has been a drive towards reduced taxation of labour which is making it less expensive for companies to hire people,” says Valli. “Some of the tax incentives aimed at promoting permanent employment have now expired. But companies’ overall tax wedge has been reduced over recent years which has improved their competitiveness, and surveys of hiring intentions for 2018 are generally constructive.”
Positive momentum in the labour market is reflected in analysts’ forecasts for employment, which the EC expects to increase by 0.9% in 2018 and 0.6% in 2019. This will help the unemployment rate gradually recede from 11.3% in 2017 to 10.5% in 2019, according to the EC’s forecasts.
A continued pick-up in investment and employment in Italy in 2018 is expected to mirror a strengthening in several economic indicators across the eurozone. Luigi Speranza, head of European market economics at BNP Paribas in London, recently revised his forecast for eurozone growth up to 2.4% in 2018, underpinned by monetary policy remaining loose for longer than previously expected, and global growth buttressing rising eurozone exports. His preview of the eurozone economy also points to a “promising” outlook for investment and a further improvement in labour market conditions.
Banking on recovery
In Italy, reform of the banking sector is another source of support for accelerated economic recovery. The OECD comments in its most recent analysis that “the government’s strategy to deal with weak banks is bearing fruit and NPLs have started to decline.” For the time being, this may not be feeding through into a palpable increase in credit to the corporate sector, says Monperrus-Veroni. “There has been a strong rebound in consumer and residential housing lending. Growth in bank lending to businesses has been flat or slightly down, but we think this is a function of demand for credit rather than supply, because companies’ liquidity position and self-financing ratios are much stronger.”
More broadly, however, economists say that improved sentiment in financial markets is providing companies with a much wider and more flexible range of funding options. “Prior to the crisis, Italian companies were highly dependent on bank credit,” says Valli. “Today, we are seeing more mid-sized companies accessing debt as well as equity financing, which is positive because it helps to strengthen balance sheets and diversify funding sources in the corporate sector.”
Infrastructure and the other indicators on doing business remain an Achilles heel for the Italian economy. But although it still ranks behind countries like Belarus, Rwanda and Moldova in the World Bank Doing Business rankings, Italy has been inching up the league table in recent years. In the 2018 report, it wins a special mention for making it easier to get electricity and pay taxes, and is 46th in the overall ranking, up 10 places since 2015.
While the potential of politics to upset the apple cart should never be underestimated in a country now under its 65th government since the end of the Second World War, economists appear to be sanguine about the likely economic impact of Italy’s general election in the first week of March. “The main challenge for 2018 will be the election, although we have a reasonably constructive view of the outlook for Italian politics,” says Valli at UniCredit. “With the populists unlikely to win power, we don’t think that any political uncertainty in the run-up to and possibly after the election will be enough to derail the economic recovery. We believe that in 2018 economic fundamentals in Italy will prevail over political concerns.”