Against the tide: Is Italy turning?

Italy’s economic track record has been pretty woeful in recent years. The economy has been dogged by high and rising sovereign debt; a stagnant labour market that seems to have all but abandoned younger workers; and terrible productivity. This drove trend growth rates down to zero. Politics was in an equally sticky quagmire. It is the key obstacle to addressing all of the above.

But things may be changing at last. Reforms of Italy’s labour and product markets are beginning to look more forceful than markets were crediting.

Much needs to be done to get Italy back on track. Sovereign debt to GDP is above 130%, unemployment remains above 12% and youth unemployment an even more intolerable 41%. Unit labour costs are prohibitively expensive, while the quality of state services is poor and getting poorer. It is no wonder productivity is falling.

However, there are foundations on which to build recovery. External debt is low and the government has been successful in running persistent large primary surpluses, something the other peripheral economies have so far failed to achieve. Italy also has a vibrant small and medium-sized enterprise sector, especially in the north, which has more in common with Germany’s industrial heartlands than it does with its own southern boot.

The government of prime minister Matteo Renzi has implemented a number of economic reforms since coming to power, including measures to improve access to credit for small firms and a reduction in the regional tax on company turnover. Labour market reforms enshrined in a Jobs Act have gone even further. Reforming traditional job safeguards unlocks a pool of talent that employers were previously loathe to touch. It has made the hiring of temporary staff more attractive by allowing contracts to be rolled over more easily. Renzi followed this up with a tax cut for low-paid workers – a meaningful reduction in the tax-wedge that contributes to Italy’s uncompetitive labour costs. The OECD estimates that reforms made since 2012 – including those implemented by Renzi – will boost growth by 0.7% a year over the next five years, a cumulative 6.2% points to GDP over the next decade.

The reforms complement other, favourable external factors. The economy is benefitting from a weaker euro, which has helped lift exports; the income effect of lower oil prices is helping consumption; and the onset of ECB sovereign QE is leading to lower interest rates. Together, these have been enough to nudge Italy back to growth.

Industrial production is also expanding again. And with capacity utilisation already back at pre-crisis levels, businesses will have to expand capital spending if they are to raise production levels, a potentially virtuous combination for growth. There are already some signs of this coming through. There has been a jump in the import of investment goods.

The financial sector remains pressured, but there are some promising signs. Banks are better capitalised, though they continue to struggle with non-performing loans. The IMF estimates that NPLs make up 18% of the total stock and have yet to hit their peak. This has been restricting the flow of credit into the real economy, a particular problem for the SMEs that are too small to tap bond markets for funding.

Bad bank

There are growing calls for the establishment of a bad bank to dump these toxic assets into, which would allow the banks to return to their core business of lending. Although it is unlikely the state would stump up capital, it may support other measures; for example, it might make additional state guarantees on securitized portfolios of impaired loans, helping expand the distressed debt market. Even though interest rates have been falling, real loan rates still remain elevated, both by historical standards and when compared to other eurozone states, including Spain (where the banking sector has clearly benefited from cleansed balance sheets). There is more of the ECB’s monetary dividend to pass through.

The improving growth story is positive, but not yet transformative. After all, real GDP is still back at 2000 levels and GDP per capita is languishing at 1998 levels. Even with reform raising growth rates, the economy looks unlikely to reach its pre-crisis size until the early 2020s. This maintains pressure on the government to continue structural reforms. The bottom line is that both debt sustainability and voter support for reform depend on Renzi producing the growth dividend.