Italy’s recent political imbroglio reignited the debate over the European Union’s (EU) future and the viability of the European single currency within its current institutional framework.
The March 4 election produced a hung parliament, with the anti-establishment 5-Star Movement emerging as the largest single party. The longest political stalemate in Italian postwar history ensued and in late May, the 5-Star Movement and the far-right League, in an attempt to form a coalition government, put forward well-known euro-sceptic candidate, Paolo Savona, for the delicate role of finance minister. Their candidate of choice sent shockwaves through financial markets and triggered the return of ‘redenomination risk’ – i.e. a higher perceived risk that Italy might exit the euro. A new populist government was subsequently sworn in on 1 June after President Sergio Mattarella agreed a revised slate of ministers.
Since then, the situation has normalised: the new populist government avowed that a plan to leave the euro has never been discussed, and other risks – most notably, concerning international trade tensions – have become more relevant for financial markets.
However, the situation in Italy remains fragile. Moreover, it is emblematic of the challenges the eurozone is facing in a new political era. This new political backdrop emphasises national sovereignty, has an inward looking approach and favours centrifugal forces, posing hurdles to European integration.
The new political landscape in Italy is hardly surprising, as it springs from the convergence of both global tendencies and idiosyncratic factors.
From a general perspective, populist parties have gained support in developed countries in reaction to some long-term trends, which have been exacerbated by the global financial crisis. Two such trends stand out in recent decades: there has been a steady decline in productivity growth and a fall in labour’s share of income in developed countries. Slower productivity growth means that living standards have continued to improve, but at a slower pace. At the same time, the distribution of growth benefits has become more uneven within developed countries, probably due to globalisation and automation, which is squeezing labour’s bargaining power and, in turn, labour’s share of income. The global financial crisis – the deepest recession since the great depression – and an ensuing slow and uneven recovery unleashed an already brewing broad-based malaise.
Italy’s double-dip recession – i.e. the global financial crisis in 2008, followed by the European Sovereign Debt Crisis in 2012/13 – was particularly severe, as the country was ill-equipped to deal with it in the first place. Italy had lost competitiveness since the early ‘90s, when productivity growth started its descent. At the same time, the international economic backdrop became more challenging for Italian exporters, as new actors such as China emerged. Domestic policies did not respond to these new challenges: they were the hostage of a typically short-lived political cycle (65 administrations have taken the helm since World War II, each one lasting for a little more than a year1), which favoured wasteful public spending and quick fixes rather than long-sighted structural reforms. In this context, public debt grew quickly, thereby reducing the fiscal space available at times of crisis. The devaluation lever was systematically and unsustainably deployed to provide a temporary boost to competitiveness, but it disappeared with the adoption of the euro.
Today, Italy is still feeling the effects of the double-dip recession: Italian real GDP is 5% below the levels that prevailed before the 2008 crisis (see chart 1). The unemployment rate has declined in the last few years, but at 11%, it is still high (see chart 2). Additionally, youth unemployment is elevated at about 30%.
Chart 1: Since the double-dip recession, real GDP has recovered in major eurozone countries, with the exception of Italy
Source: Reuters Datastream, based on national sources, as at Q1 2018
Chart 2: Unemployment rates have fallen since the 2008 crisis, but they are still high in the periphery
Source: Reuters Datastream, based on national sources, as at May 2018
Going forward, the short-term economic outlook includes some positive elements, but material downside risks loom amid high policy uncertainty, both domestically and externally.
In the last couple of years, the recovery has accelerated somewhat: annual GDP growth came in at 1.5% in 2017, which, by recent Italian standards, is a decent number (see chart 3). However, this is still below the growth rates that are currently prevailing in the rest of the eurozone (the bloc grew by 2.4% in aggregate last year).
Chart 3: The Italian recovery has accelerated in recent years
Source: The Italian National Institute of Statistics (ISTAT) and the European Commission as at June 2018
The pick-up in activity has mainly relied on the synchronised upturn in global demand that started at the end of 2016 (see chart 4). As the Italian cycle is at an earlier stage of the business cycle, there is room for the recovery to continue. That said, as global growth has plateaued and become less synchronised, the Italian economy is expected to deliver a slightly softer performance this year. Importantly, increased uncertainty over international trade policies implies downside risk. As the US administration has ramped up its protectionist stance ahead of the upcoming November mid-term elections, there is a high likelihood of accidents that could disrupt international trade. An escalation of trade tensions would likely have a negative impact (initially via the confidence channel) on an export-oriented country – and Italian exports account for more than 30% of GDP.
Chart 4: Business investment and net exports have been the main drivers of faster growth in the last year and a half, reflecting the lift from a synchronised upswing in global demand
Source: ISTAT as at Q1 2018
The sustainability of Italy’s recovery seems limited should support from external demand falter. Indeed, the fundamentals for domestic demand are mixed. Real disposable income has improved slightly, reflecting improvements in the labour market and contained consumer inflation. Yet, the labour market is still weak. Employment has improved in recent years and it is edging back towards levels that prevailed before the crisis. However, the quality of jobs has deteriorated (job creation has been concentrated in part-time work, implying that the total number of hours worked in the economy is still about 5% off its pre-crisis levels). Furthermore, wage dynamics have been anaemic: nominal wage growth has remained at about 1% on an annual basis, a record low for the series. In real terms, annual wage growth has averaged 0.2% in the last ten years (nominal wage growth has averaged 1.6%, while consumer inflation has averaged 1.4%). More recently, the increase in energy prices is also set to weigh on real incomes. And although the sentiment around the new government is positive, there is still uncertainty about future prospects.
The European Central Bank’s (ECB’s) accommodative monetary policy has also contributed to Italy’s recovery in recent years. According to our estimates, the ECB’s Asset Purchase Programme has compressed Italian government yields across different maturities by between 70 and 80 basis points on average. In June, the ECB announced its plans to wind up its QE programme at the end of the year. Yet, the continuation of its reinvestment policy of maturing securities and a stronger forward guidance on rates – which states that rates will stay at their current levels through summer 2019, at least – implies that conditions will remain accommodative, thereby helping credit conditions.
Today, the main hurdle to credit expansion in Italy is the condition of the banking system, which is still burdened by a high amount of non-performing loans. The situation has improved in the last couple of years: net non-performing loans (correcting for provisions) have declined to €51bn (3% of GDP) from a peak of almost €90bn (more than 5% of GDP) in 2015-16.
The main risks for the Italian situation stem from domestic politics and policies. The new coalition populist government is inherently fragile. Its main political components are rooted in two parties that have different approaches, different goals, and a different electoral base. This could lead to inconsistent and ineffective government action and, more importantly, tensions within the coalition that could compromise the tenure of the government. In this respect, the risk of new elections sometime next year leading to renewed political instability is significant.
There are two main areas which could prove challenging for the current government: the relationship with European institutions, and, partially related to that, fiscal slippage (thereby, compromising the long-term sustainability of the country’s large public debt). Difficulties in dealing with these issues could become a source of tension within the coalition and trigger a crisis, particularly if opinion polls continue to signal a change in the balance of power within the coalition, with consensus shifting to the League at the expense of the Five Star Movement.
The new government is likely to have a more strained relationship with European institutions, compared to its predecessors. Indeed, leaders of the populist parties that now hold top positions in the government have stuck to their anti-establishment rhetoric in order to secure – or even strengthen – their support. However, the appointment of technicians to key roles in the government, namely the finance minister and the foreign minister, should act as a mitigating factor. Indeed, these appointments have already reassured financial markets about the intentions of the new government.
Importantly, initial rumblings about Italy’s euro membership have quickly dissipated and high-level government officials have stressed the country’s commitment to the single currency. This position makes sense in light of the ever-prevalent public support for the euro: according to recent polls, including the Eurobarometer, it stands at about 60%. This probably reflects the fact that households hold assets amounting to about €9.6tn, which makes a redenomination to the lira unpalatable. Public debt amounts to about €2.3tn and 70% of it is held domestically. In general, Italy has a solid net external international position (net international liabilities amounted to only around 7% of GDP in Q4 2017) (see chart 5). Therefore, it makes little sense for the country to exit the euro and renege on its external debt.
Chart 5: Italy’s net international investment position has improved in recent years
Source: Eurostat, Bank of Italy, and ISTAT as at Q1 2018
That said, the evolution of Italian public finances will probably put pressure on the relationship between the government and European institutions. While it is unlikely that all of the fiscal measures promised by the coalition will come to pass in the upcoming budget, even a partial inclusion would lead to fiscal slippage. The main proposals of the coalition agreement point to higher spending or lower revenues: the universal guaranteed income, the introduction of a flat tax, the partial reversal of the pension reform introduced by the Monti government in 2011, and the avoidance of the VAT increase due in January 2019, which are jointly worth more than €100bn or 6% of GDP. In other words, fiscal slippage is likely, but it will probably be limited, due to European rules (there is a 3% GDP limit for fiscal deficit) and, more importantly, the pressure from financial markets.
Financial markets have already demanded greater compensation for holding Italian debt since the bumpy government formation a month ago, as they now perceive it as riskier. Indeed, Italy is running a high public debt of more than 130% of GDP and the path to sustainability is a very narrow one. We ran some simulations in order to get a sense of the sensitivity of debt sustainability. They suggest that under reasonable assumptions for nominal growth and the primary surplus (largely implying a continuation of recent trends), debt sustainability relies on the marginal borrowing rate staying below 3-3.5%. They also show that small changes in the key parameters could compromise the picture. While pressures from financial markets should limit the extent of fiscal slippage in the short term (the next budget is due in mid-October), the large debt overhang will continue to cast its shadow on medium- to long-term prospects given its fragile sustainability.
The main challenge for Italy is boosting its growth prospects, which are currently depressed by low productivity gains, low investment and a negative demographic profile.
Weak productivity is probably the main challenge for the country. While declining productivity growth has been a feature of developed markets across the board in the last two decades, the trend began earlier in Italy. Labour productivity growth has been on a descending trajectory since the early ‘90s. The global financial crisis in 2008 amplified this pre-existing trend: labour productivity has largely stalled over the last ten years.
In recent years, Italy has managed to improve its competitiveness within the eurozone, but this reflects adjustments in wages and prices (i.e. internal devaluation) rather than productivity gains. In turn, the current account balance has improved, reflecting both the increased attractiveness of Italian exports and weaker domestic demand on the back of softer income growth (see chart 6).
Chart 6: Evolution of Italy’s competitiveness, 1992-2019
Source: Hermes Investment, based on OECD data, as at May 2018. Note: RULC represents Relative Unit Labour Costs.
In Europe, Spain deserves special consideration as it stands out for the progress it has made in recent years. Its economy has staged an outstanding recovery, and its democracy has displayed some rare vibrancy.
Spanish real GDP growth has topped the developed markets’ league in the last few years, ticking in at above 3% on an annual basis since 2015. What’s more, having contracted by 10% peak-to-trough between 2008 and 2013, Spanish real GDP has recovered in recent years and it is now running about 3% above its pre-crisis levels (see chart 1). The labour market has also improved significantly: the unemployment rate has declined at a sustained pace in recent years and it is now running at 15.9% – a high level, but well below the 26% peak that it touched in May-August 2013 (see chart 2).
The reason for Spain’s success lies in the radical and relatively early moves that the country took to tackle the double-dip recession in 2008-2013. The 2008 recession in Spain heavily affected its banking sector as it featured the bust of a housing bubble. In 2012, the Spanish government mopped up its banking system with an EU bailout at a time when European rules allowed for it. In addition, policymakers managed to push through a set of structural reforms targeting the labour and product markets. They also pursued a gradual fiscal adjustment. This contributed to a boost in competitiveness through the nominal channel and allowed for some improvement in productivity growth (see chart 7).
Chart 7: Evolution of Spain’s competitiveness, 1992-2019
Source: Hermes Investment, based on OECD data, as of May 2018. Note: RULC represents Relative Unit Labour Costs.
The Italian situation is a symptom of deep-rooted malaise: it requires serious consideration and a credible and concerted response from both domestic and European politicians.
Domestically, a combination of limited and targeted fiscal stimulus and structural reforms woauld be helpful. There are quite a few low-hanging fruit: the new government could make the judiciary system more efficient, simplify the tax system, and favour business creation and competitiveness in several sectors, services notably. Fiscal space should be used to lower taxes on labour and to spur investment in innovation, education and infrastructure. However, it is unclear whether the current Italian government has the political capital and the vision needed to pursue structural reform and targeted fiscal stimulus by implementing reforms that are unlikely to pay off in the short term. Indeed, the populist parties’ programme mainly emphasises spending rather than structural reforms. European institutions will probably adopt a somewhat more flexible approach towards Italy, allowing for a limited and temporary fiscal slippage and, possibly, offering a plan on immigration. However, it may just be too little, too late.
In general, despite making some progress since 2009, the gap between core and periphery countries within the eurozone has persisted – and significant convergence is still far away. This implies that the next crisis is likely to have a disparate impact across different member countries, thereby acting as an asymmetric shock. At present, there is no mechanism in place that can respond effectively to shocks hitting different countries unevenly.
This requires a concerted response: the European integration process needs to advance. European leaders will have to work to fix the shortcomings of the European project, providing a stronger political and fiscal underpinning to the single currency.
The general political backdrop in Europe looks challenging and much less supportive than it was only a few years ago. Populism and Euroscepticism are widespread. In Germany, Chancellor Angela Merkel is not only facing opposition in parliament from the far-right party Alternative for Germany (AfG), her already precarious coalition is also wavering as the Christian Democratic Union’s Bavarian sister party, the Christian Social Union, is now joining the AfG in a race to the bottom on anti-immigration policies.
Disillusion about European institutions and a focus on migration issues have prevented Italy – the third-largest economy in the eurozone and a founding member of the European project – from making its contribution to the debate on deeper eurozone integration – a loss for both Italy and Europe.
That said, historically, the European integration process has leaped forward at times of crisis. Therefore, the materialisation of the populist threat may act as the catalyst this time. The presence of anti-establishment forces in the Italian government should be a reminder that the general malaise and disillusion should be taken seriously.
This was the backdrop against which the EU Council Summit took place at the end of June. The ambitious agenda included several items, most notably including advancing a roadmap for deepening the European Monetary Union. During the event, the migration issue, which is the focus of the populist debate in Europe and beyond, overshadowed more pressing decisions on further eurozone integration – a necessary development to deal with the next crisis, when it hits.
Following months of debate, which primarily involved French and German policymakers, the Council produced only limited and at times vague commitments concerning the completion of the banking union and the strengthening of the European Stability Mechanism. By contrast, there was no mention about the issue of a common fiscal capacity, and controversial decisions concerning the banking union (notably, with respect to a common deposit guarantee) were kicked down the road into an indefinite future. The Euro Summit statement was brief, it lacked details and it postponed further discussion until the December 2018 meeting.
In sum, the outcome of the two-day meeting lacked detail and it kicked controversial choices down the road. Yet, there is one overarching positive takeaway from the summit: against today’s complex political backdrop, there is still significant political capital backing the European project.