Italy will choose their next government in 2018. Under the circumstances, the country is subject to the same four issues present in many Eurozone member states, but with greater intensity: low growth (with productivity gains gone AWOL before the Global Financial Crisis), high public debt, a weak banking sector and political fragility, according to AXA IM. The experts highlight that improvements on all four fronts have characterized 2017. In fact, GDP growth accelerated to +1.5%, public debt remained sustainable despite (reasonable) stress, non- performing loans (NPLs) have peaked and progress was made to tackle the weakness of the Italian banking system. In addition, recent reform in the electoral law supports their view of reduced political risk for 2018. Nevertheless, Italy needs reforms to address its structural problems.
Weak growth: don’t blame the euro
In the short term, Italy is benefiting from improved domestic dynamics supported by household consumption and resilient investment. Italian GDP grew by +0.4qoq in Q2 2017, mostly thanks to domestic demand. Recent economic data were rather positive; business confidence is high and Purchasing Managers Index ( PMI ) remains on the positive side. Consumer confidence is also strong and unemployment rate decreased to 11.2% in August (from 11.8% in January). We forecast GDP growth of +1.5% and +1.3% for 2017 and 2018 respectively, below Euro area averages and reflecting Italy’s lower potential growth.
Indeed, with 0% GDP growth per capita on average since the adoption of the single currency (in 1999), the Italian economy has been almost systematically underperforming its Eurozone partners. GDP growth per capita has ranged from 0.85% in France to 1.1% in Spain and 1.25% in Germany. However, this underperformance pre- dates 1999 and there is no apparent break coinciding with the euro introduction. Instead, growth actually increased in the two years following the euro’s introduction and unemployment went down before 2008. One might even argue that the euro may have shielded Italy against its own political risk, reducing the impact of negative events in terms of financial tightening. Something that the Lira failed to do between 1973 and 1999. Instead, a number of structural factors have played a key role in disappointing Italian growth figures, including poor administration, low education levels, poor corporate governance, globalisation and China’s low production costs and strict labour market laws. As AXA IM analysts explain:
Despite the implementation of some reforms by Renzi’s government, so far economic recovery has been hampered by structural factors (rapidly aging population) as well as increasing unit labour costs in the aftermath of the recession, and wage growth outstripping productivity gains. Boosting growth and competitiveness requires a comprehensive policy response and a package of reforms. In terms of fiscal adjustments, a less-distortionary tax system could have a number of benefits. A policy -mix with a decrease of labour tax wedge by 1.5% of GDP, a reduction of VAT gaps for 1% of GDP, downsized benefits and reduced spending on goods and services of 1.25% of GDP each, could increase output by about 2 percent and lower debt -to- GDP ratio by around 13 percentage points in the long- run. The decentralisation of wage bargaining could help job creation. Latest analysis from the IMF also recommends a reinforcement of active labour market policies, an increase in childcare spending (to boost female participation) and a broadening of the social safety net, with neutral spending reallocation.
Easing regulatory barriers for trade, professionals, roads, transport services and other areas could also support potential growth. Increasing public administration efficiency in all 103 Italian provinces could also expand output for average firm by up to 3%. Altogether, such a reform package could increase output by 6 to 13% above baseline and largely depreciate Real Effective Exchange Rate ( RE ER ) without notable short -term output losses due to fiscal consolidation.
A limited risk of a rates -led fiscal crisis
Very low growth has had a negative impact on Italy recently. Meanwhile, the rest of the Eurozone is recovering which will likely raise interest rates. The lag in Italian growth compared to European growth casts the doubt on the sustainability of Italian debt and thus opens the door to wider spreads. Yet a rates- led fiscal crisis scenario seems highly unlikely. AXA IM strategists believe that even if Italy’s growth failed to catch up with the Euro area average and investors were to lose confidence, the European Stability Mechanism along with the IMF would launch an adjustment program and pave the way for unlimited intervention from the European Central Bank.
The required adjustments of primary fiscal balance to stabilise the debt ratio are much smaller for Italy than those required for Japan or Greece in 2010. Even with a 3% real borrowing cost, the fiscal adjustments required would only reach 1.5% of Italian GDP thanks to the 1.4% of GDP primary surplus achieved in 2016. Requirement for Japan and Greece stood at 4% and 10% of their deficit, respectively. Nevertheless this scenario implies full governmental cooperation, and a populist wave could indeed create an unmanageable situation if combined with high debt, rising interest rates and low growth.
The fragmented banking sector leaves place for consolidation
The Italian banking sector has suffered from record levels of NPLs (21% of GDP for 2016) as well as a high heterogeneity level of fragmentation. Indeed, in Q2 2016 the Italian banking system consisted of 635 credit institutions. Current cyclical recovery levels and high operating costs (2% of banks assets) are unlikely to restore bank’s healthy profitability or to reduce their vulnerability to shocks. To address these issues, three targets need to be implemented : aligning cost -to- income ratios to best performers ensuring NPLs are reduced in compliance with the new guidance, together with concrete sales plan and reduced operational costs. The resent sale of liquidity by Monte dei Paschi and two Venetian banks should help reducing the weight of NPLs . According to analysts the low level of concentration in the Italian banking system “leaves scope for improved performance”, namely through efficiency -driven M&A operations leading to downsizing and economies of scales both on a domestic and cross -border scale.
Measures should include supervisory encouragement for every structure to meet capital adequacy requirements, reach sufficient income generating capacity, cent ralise and rationalise risk management and IT, and set up robust and independent governance procedures. Despite the rigidity of the Italian labour market, banks should benefit from the flexibility introduced by the recent Jobs Act as well as the €500 million that the government allocated to early retirement schemes.
Furthermore, reforms should aim to resolve outstanding governance issues by fighting collusion between politicians and loan officers. They should also attempt to close the gap with EU rules on m anagement requirements. Policies at EU level will need to facilitate cross -border consolidation, particularly by reducing explicit political and regulatory integration barriers at national levels.
Rosatellum 2 : no game -changer
The Italian government recently approved the Rosatellum law that changes the electoral system in Italy. According to the new law, 64% of seats will now be attributed via proportional elections and 36% via elected lawmakers (collegi uninominali ). The Rosatellum law also aims to guarantee post -election governability by allowing the formation of multi -party coalitions before the ballots.
Entry voting thresholds are now set at the national level: 3% for parties joining a coalition and 10% for single parties. Despite the attempt to reduce the 5SM party’s strength, in our view this law will have little impact on the potential outcome of the next elections and the overall political landscape in Italy. The current consensus is for the Parliament to split into three blocks (centre- right, centre- left and 5SM).
In opinion of AXA IM, there is a very low chance for an anti -establishment coalition between 5SM, Northern League and Brothers of Italy to be formed and to reach absolute majority in the Lower House. Hence, they foresee a “hung parliament” or a grand coalition should Renzi’s Partito Democratico and Berlusconi’s Forza Italia come to an agreement.
In both cases, we expect the status quo to prevail with limited appetite for economic and structural reforms.