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Why is the Italian recovery so slow?

THE ESSENTIAL

Compared to the majority of other eurozone countries, the Italian economic recovery is particularly weak. While the immediate political and financial context is not conducive, the Italian economy is suffering from many structural problems, and the dysfunction in its domestic markets has long affected its external competitiveness.

Still, we can just make out a few signs of improvement, specifically on jobs, as the 2014 Job Act starts to have an effect. However, it is hard to imagine the recovery truly accelerating without additional reforms, again of the labour market as well as in other directions. In this sense, a No victory in December's referendum would be a very unhappy event. Despite these obstacles and risks, we still believe that the Italian recovery will continue and show some modest improvement in 2017.

 

 

 

 

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Although in 2015 the eurozone's real GDP returned to its pre-crisis peak of Q1 2008, the delay in the Italian recovery is flagrant: Italy's GDP has only regained a very small part of the ground lost since 2008 (Graph 1). Today it is still close to its level at the start of the millennium. This stagnation is in contrast with an increase of about 20% since 2000 for France and Germany, and about 26% for Spain, which was also hard hit by the crisis in recent years but which, unlike Italy, has been in a strong recovery since 2013.1

Two well-identified culprits: The banks and politics

Two factors explaining this underperformance in the last 3 years emerge immediately, if only because they clearly distinguish Italy's situation from Spain's:

  • The delay in the banking system's return to operability, in particular because Italy did not call on international aid, unlike the other so-called "peripheral" countries, and so did not feel the pressure from European and international institutions as intensely to restructure its banks. Indeed, even though there has been a notable improvement in credit suppy (interest rates on loans to SMEs have declined very substantially, while the ECB’s quarterly Bank Lending Survey shows a regular decline in the rejection rate of loan applications, at least until Q2 2016), the stress caused by the situation of the banking sector is weighing on general business confidence.
  • Political uncertainty and a fragile government, recurring problems in the country that have persisted in recent quarters, and which have very likely played negatively on confidence and the investment recovery (whereas Spain's government could count on a solid government majority in the critical period between the 2012 and 2015 elections). These two brakes continue to exert their pressure, quite clearly illustrated against the current backdrop, where mounting uncertainty over which way the constitutional referendum (mostly on cutting the Senate's powers, slated for 4 December) will go, and over the procedures for restructuring the weakest Italian banks, are feeding each other.

Low rates has been very costly to Italian households

On top of this, despite an overall favourable review, the effect on the Italian economy of ECB easing was probably less unanimously positive than the impact on the other struggling economies in the eurozone's periphery, for two reasons: 1/ The Italian private sector (businesses and households) is less deeply in debt than that of other peripheral countries, so the decline in interest rates has not had as spectacular an effect there in terms of reducing the liquidity constraints exercised by debt inventories. 2/ Conversely, while assuredly beneficial for public finances, lower interest rates did drag down interest income for households that are, on average, fairly well supplied with savings products. In terms of figures, between Q3 2008 and Q4 2015, the fall in interest earnings cost Italian households nearly 5% of their gross disposable income while the lower interest payments only saved them 2%, whereas this same net effect has been broadly balanced in Germany and France and very positive in Spain (See the ECB’s Economic Bulletin, Issue N°4/2016, June 2016).

The ills of the Italian economy are much deeper-rooted

Yet it would be highly reductive to blame the bulk of the delay in Italian growth to the political and banking vicissitudes of recent years, or to a lesser impact of monetary policy. The Italian crisis is different from that of the other peripheral countries and harks back to long-term difficulties. Indeed, while the weakness of the cyclical rebound since late 2012 is striking, the country's economic underperformance dates back to well before the crisis (annual average growth around 1.5% for the 1990-2007 period, versus 2% for France and Germany), to say the least. Where does it long term underperformance come from? There is no shortage of studies on the subject: for years, European institutions have unflaggingly pointed out many dysfunctions in both the public and private sectors: The most recurrent themes are intertwined: lack of transparency, lack of competition, and multiple rigidities of the labour market as well as the goods and services market (see box below).

 

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  • The main consequences of these problems are identified as stagnant productivity compared with those in comparable countries (see graph 3), and deficient price and wage setting mechanisms, resulting in loss of external competitiveness, whereas euro membership no longer offers the devaluation facility (see export price graph). Italian growth potential, which, in addition to these factors, is penalised very weak demographic, is now considered virtually nil by the European Commission (0.1% in 2017, vs 0.7% for Spain, 1.1% for France and 1.6% for Germany), which has also revised its output gap estimates sharply downward: in other words, the current quasi-surplus, far from being a disagreeable transitional phase, would be closer to a new normal, one that is here to stay. Remember, among others, this prospect of virtual stagnation also poses the problem of the sustainability of the very large public debt inventories inherited from the past (public debt totals more than 130% of GDP, a still growing ratio despite the primary surplus generated almost every year for decades) and therefore the country's dependency with regard to the ECB's action to preserve the markets' confidence. 

The bright spot: A recent improvement in jobs clearer than the improvement in GDP

The very disappointing picture of the recovery as a whole should not result in neglecting the few positive signs that have appeared over the past few quarters. In addition to recent positive news on industrial production, the main sign of improvement is on employment, which is recovering more quickly than GDP, (unemployment fell from 13.1% to 11.4% between late 2014 and August 2015; the number of people in work rebounded by 2.1% or 360,000 in volume terms, with just under half of these jobs being full-time, since the low point of early 2014) (See graph 6). In addition, at the aggregate level, wage moderation is taking hold, allowing the Italian economy to break with a very long term trend of wages rising above productivity, and stop the loss in competitiveness compared with Germany and France. 

There are probably more positive impacts of the 2014 Job Act on the way

Increase in jobs and wage moderation were clearly among the targets of the labour market reform (Job Act), Prime Minister Renzi's flagship measure in 2014. Drawing on the "flexi-security" principle, this reform combined the introduction of a new full-time employment contract that would gradually become more secure, elimination of more precarious contracts, a decline in payroll costs paid by employers, and an improvement in unemployment insurance. In light of the time usually required for this type of reform to have an effect, it is understandable that they only became visible recently, and very likely that there will be more to come. As such, one of the reasons for the delay in the Italian recovery is very likely the recent nature of this new regulatory framework (remember that Spain carried out a major reform of its labour market in 2012).

The work to restore competitiveness has only just begun 

Yet the expectation of additional effects of the Job Act is no guarantee that the Italian recovery is poised to pick up, let alone remain sustainably brisk: 

  • First, the Job Act came with temporary tax incentives for hiring, and that probably explains part (although not all) of the improvement in jobs. 
  • Next, productivity is not improving. Yet this is necessary to avoid restoring Italy's cost competitiveness at the price of wage deflation only, which would be politically difficult to support over the long term. 
  • Finally, generally speaking, going by the analyses of a majority of international organisations, fixing the country's massive competitiveness problems will require new stages of labour market reform, as well as efforts in other directions, specifically to reduce obstacles to competition on the products and services market and improve the way the administration and judicial system work. Until now, resistance to reform plans (specifically the attempts of former Prime Minister Monti) in these areas, has been especially strong. Yet it is significant that the referendum on 4 December should also ratify an overhaul of local governments, which play a role in price-setting mechanisms in a number of sectors.

Nonetheless, the little progress that has been made should allow slightly positive growth 

Two years after its labour reform, and despite modest growth levels, Italy has at least begun to break away from the long-standing plight of wages rising systematically higher than productivity, which is unsuited to the eurozone as a fixed exchange system. That is a significant achievement, with a few effects already observed on jobs, but it cannot lead to a lasting improvement of productivity, and therefore potential growth, unless other reforms follow. In this regard, a No victory in the referendum on 4 December would have very problematic consequences, both in preserving the Senate's ability to block new initiatives and weakening the current government, which initially carried the hope of significant transformations to the economy. 

Still, sticking with the 2017-2018 scenario, we do think that the combination of an improving job market and the halt of loss in competitiveness should persist and retroact positively, although moderately, on the economy, via consumption, exports, and the effect of expected demand on investment. Yet fiscal policy, which was already eased in 2015, will not be able to provide strong additional support as long as it remains constrained by the country’s commitments to Brussels. The risks are balanced; the banks' restructuring efforts may play positively on available credit, while new political and financial spasms (starting with a No victory in the referendum) would slow down the investment recovery. All in all, we are maintaining a scenario of slight improvement, with projected growth for 2017 just above 1% (vs. 0.8% in 2016), likely to be adjusted slightly in accordance with the people's verdict on 4 December, but still lower than that of the eurozone's other major countries.

 

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1Note, however, that due to higher inflation since 2000, the underperformance by Italian GDP appears less than when it is measured in current euro: a 32% increase compared with more than 40% for France and Germany and more than 60% for Spain.

The Italian economy's
under performance
pre-dates the crisis

 

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Cross Asset of October 2016 in English

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PERRIER Tristan , CFA, Strategy and Economic Research at Amundi
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