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Hermes: Italy and Europe – the integration dilemma

While Italy’s short-term economic outlook includes some positive elements, material downside risks loom amid high policy uncertainty. In her latest Ahead of the Curve, Silvia Dall’Angelo, Senior Economist at Hermes Investment Management, argues the Italian situation is a symptom of deep-rooted malaise and requires a credible and concerted response.

 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.

While the situation has normalised, the landscape in Italy remains fragile. 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.

Effects of the crisis

Italy’s double-dip recession – 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. The typically short-lived political cycle – with 65 administrations at the helm since World War II – has 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.

Today, Italy is still feeling the effects of the double-dip: Italian real GDP is 5% below the levels that prevailed before the 2008 crisis (see chart). The unemployment rate has declined, but at 11%, it is still high. Additionally, youth unemployment is elevated at about 30%.

Since the double-dip recession, real GDP has recovered in major Eurozone countries, with the exception of Italy 

Short-term positives and challenges

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. However, this is still below the growth rates that are currently prevailing in the rest of the Eurozone.

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, but the quality of jobs has deteriorated.

While the European Central Bank’s accommodative monetary policy has also contributed to Italy’s recovery in recent years, 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 have declined to 3% of GDP from a peak of more than 5% of GDP in 2015-16.

 Domestic politics and policies

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.

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. Public debt amounts to about €2.3tn and 70% of it is held domestically. In general, Italy has a solid net external international position – with net international liabilities amounting to only around 7% of GDP in Q4 2017. Therefore, it makes little sense for the country to exit the euro and renege on its external debt.

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. 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.

 Advancing European integration

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 would 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.

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.

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.