By Pedro Sousa
The Italian economy
The one government that has been battling Germany for the recalibration of the Eurozone towards growth and shared prosperity has been the Italian government, under the guidance of Finance Minister Pier Carlo Padoan. Padoan is the strongest voice within the Eurogroup against further austerity measures and with strong rhetoric in criticising the EU’s fiscal rules, which many Italians blame for their chronically stagnant economy. It is vital that both the Italian population and the decision makers in Brussels – and in Germany – follow Padoan’s lead. Under Padoan’s watch, Italy emerged from a record-long, double-dip recession. GDP growth is estimated to be 0.8% in 2016, and is projected to reach 1% by 2018. The budget deficit has declined to 2.4% of GDP in 2016 from 2.6% in 2015. The government was targeting 2% but had to add spending worth 0.4pp of GDP for extraordinary measures to tackle earthquake reconstruction in central Italy and the migrant crisis. Unemployment rate remains stuck at 11.7%, above the EU average. According to the latest OECD data, the economy will grow by 0.9% in 2017 and 1% in 2018.
The challenges ahead are well known: productivity performance, which has been rather poor since the early 1990s; debt-to-GDP ratio – 133% of GDP for 2016; and Italy’s bad loan burden of €360bn, which are a reflection of its non-performing economy. Some hindrance factors are corruption and slow-moving bureaucracy. Italy’s weak growth, in line with the sluggish growth experienced globally, leaves little scope for any material reduction in the country’s very high debt burden over coming years. What Renzi’s government managed to achieve is to set Italy back in motion. Renzi, who began his watch in 2014, managed to bring back some growth to the Italian economy, and pushed investment by public and private sectors in key drivers of productivity: education, research, human capital formation and innovation. Renzi performed a major reform of Italy’s labour laws in 2015, which has been accompanied by rising employment. The international environment is unfavourable and it is worsening, both in terms of slower growth perspectives globally and in Europe. The euro’s appreciation this year is also not helping. Private consumption continues to be the main driver of the recovery. Investment is turning around, providing some support to domestic demand, but constraints on the availability of bank credit still impede a faster investment recovery. Sluggish external demand has been holding back export growth, while robust private consumption has been sustaining import growth.
Renzi’s government has made progress on structural reforms, including active labour market policies, the public administration and the school system. The latest step of this plan to enhance political and economic governance was the planned constitutional reform. It was subject to a referendum in December, and the Italian population chose to deny this step. Renzi made the mistake of putting his job on the line with the referendum – mistake that he has paid for. Political instability in Italy is something that has been somewhat of an unwanted but unavoidable continuous feature. Italy has seen 63 different governments since World War II. Renzi was Italy’s third unelected premier in a row with Mario Monti and Enrico Letta as his predecessors. The 2013 general election was yet another illustration of this problem. Renzi managed to establish the most stable government Italy had seen in a decade and the most reform-minded administration since the introduction of the euro.
With the constitutional reform, Renzi was aiming to achieve an overhaul of the Italian constitution designed to make the political system more efficient. The cornerstone of the plan is an end to what is known as “bicameralismo perfetto” — or the perfectly bicameral system, which means any law, needs to be approved by both the Chamber of Deputies and the Senate of the Italian parliament, with the same text. Reform supporters said the back and forth of legislation between the two chambers leads to big delays, gridlock and instability. Renzi’s solution was to disempower the Senate, by reducing the number of lawmakers in the upper chamber from 315 to 100, and they wouldn’t be directly elected but selected among regional representatives and mayors. All the power would be in the Chamber of Deputies. Economic reforms would be easier and faster to get through parliament. Political stability — a rare commodity in Italy — would become the norm. Critics defended that this reform would concentrate too much power in the hands of the sitting government. It would remove a vital check on executive power, which could become even more important in the event of a populist electoral victory. In a country that has seen rulers like Benito Mussolini and Silvio Berlusconi, this easily creates opposition.
The “No” campaign was comprised of politicians across the spectrum of Italian politics but was dominated by anti-establishment parties. At the forefront was the Five Star Movement. The movement, founded in 2009 and led by the comedian Beppe Grillo, supports holding a referendum on Eurozone membership, and has demanded an immediate general election. The anti-immigrant separatist Northern League led by Matteo Salvini, has also questioned Italy’s membership of the euro. These parties have railed against establishment politicians, and are hoping to use Renzi’s defeat as a springboard to power at the next national elections, due at the latest in early 2018. As well as Salvini and Grillo, opposing Renzi’s reforms was the centre-right party Forza Italia, Silvio Berlusconi’s party, which has turned rabidly anti-euro. This is worrying: Italy has three opposition parties, all of which favour exiting the euro. The Five Star Movement is gaining strength in opinion polls. A significant concern is a new electoral law that came into force in July known as Italicum. It is designed to ensure that the winning party can gain an absolute majority. Under this electoral law, if Five Star Movement wins a certain share of votes, it could form a majority single-party government, which frightens Italy’s political establishment. Italicum appealed to Renzi who depended on a fragmented coalition to govern. However, now Renzi’s Democratic party is expected to negotiate a change in the electoral law aimed at reducing the chances that Grillo’s party could take power.
It was a politically ambitious reform to try to pass in Italy. A reform Renzi promised right from the start. When it was proposed, it was seen as a much-needed reform to change the old ways of Italy. A win for the Prime Minister seemed certain. However, with Renzi taking a wholly unnecessary risk in putting his own political future on the line, the “No” gained momentum. Renzi turned the vote into a referendum on his premiership for many Italians, just as his personal popularity was declining and anti-establishment populists movement were feeling emboldened – Brexit and Donald Trump’s election providing that boost. In the end, Italian voters rejected the constitutional reform. The “No” side won 59% of the vote. This led Renzi to resign, dealing another blow to a crisis-ridden European Union.
To replace Renzi, Italian president Sergio Mattarrella appointed previous foreign minister and Renzi loyalist, Paolo Gentiloni. The outgoing premier will remain leader of the Democratic Party. The selection of Paolo Gentiloni has a lot to do with the fact that the foreign minister is very familiar with the workings of the EU. Gentiloni pushed European partners to share the burden of migrants crossing the Mediterranean from North Africa. An experienced diplomat, Gentiloni will have to be strong in Europe and will have to solve the domestic urgencies that are in his table, that is to say, the troubled banking system. No doubt, Gentiloni will rely, like everyone else, on Pier Carlo Padoan, Minister of Economy and Finance, who agreed to remain in the government.
The banking sector
Italy’s banking challenges are proving to be daunting. The economy needs stronger growth and in order to achieve this, the banking system needs to be fixed through a proper restructuring of banks. The banking system is under one of Europe’s largest bad loan burdens, made worse by the long stagnation. The large stock of non-performing loans – €360bn – and the uncertain recovery keep hampering banks’ loan volumes, hindering the recovery of investment. Not only that, there are renewed worries of capital flight, with depositors taking money out of Italian banks, and sending them to banks elsewhere. The banks need substantial amounts of extra capital to shore up confidence in their balance sheets. The most stricken bank with €28bn in bad loans is Monte dei Paschi di Siena (MPS), country’s third largest bank and the oldest in the world, founded in 1472. Several Italian governments, across the political spectrum, failed to tackle MPS’s problems, due to fears of a loss of votes. MPS shares fell 86% in the 2016, while Italian banks on average have halved in value. Renzi’s defeat in the referendum brought down the likelihood of the JPMorgan-led €5bn private sector recapitalisation plan to happen, as it affected the ability to secure an anchor investor due to political instability in Rome. A crucial part of the plan was the debt-for-equity swap, which bankers said was on track to raise only €1.7bn.
After Renzi’s resignation, the Single Supervisory Mechanism, the ECB unit charged with banking regulation, rejected a request from Rome to delay a private sector-led rescue for MPS. The ECB feared this wouldn’t resolve the bank’s problems and could spread across Italy’s banking system. Bankers and politicians had wanted to avoid forcing losses on debt holders as required under new EU rules on government bailouts because of the toxic political ramifications. Under European banking rules set in January of 2016, governments can only bail out lenders with taxpayer money if they also impose losses on stakeholders. These could hit small-scale retail investors who purchased MPS bonds. The government feared undermining confidence in the banking system and giving political ammo to populist opposition parties. Now, this state bailout with burden sharing – a bail in – is pretty much certain to happen. Other midsized banks in Veneto and Genoa – Popolare di Vicenza and Veneto Banca, Genoan bank Carige – are in need of capital amid expectations they will also fail to find private support.
In late December, the government asked parliament to increase the public borrowing limit by as much as €20bn to ensure liquidity and to reinforce capital for Italian banks. Support for the bank bailout bill also came from members of the centre-right opposition. The Five Star Movement opposed the measure, calling for a full nationalisation of struggling banks. Italian officials and bankers consider €20bn to be sufficient to stem concerns. In addition, Padoan insisted that apart from a few critical situations, Italy’s banking system was solid and healthy. The government-backed recapitalisation would be conditional on the willingness of banks to put forth restructuring plans allowing them “to travel on their own legs, be profitable, and finance the economy”, according to Padoan. The government will attempt to limit the fallout of the burden sharing, seeking to iron out with Brussels details of a compensation plan for as many as 40,000 retail bondholders. Italy might have to mimic Spain’s example, which cleaned up its banks in 2012, and set up a government-backed fund, bail in junior debt as new rules require and refund retail investors.
Italy and Europe
Italy is the third-largest economy in the Eurozone, thus it has a strong impact in the future of the common currency. For Italy to remain in the Euro, its representatives have to warn Germany and the other northern European countries that the Eurozone is set on a path of self-destruction unless there is a recalibration. A crucial mistake was made when the EU failed to construct a proper economic and banking union after the Eurozone crisis of 2010-2012 and imposed austerity instead. The next German chancellor has to understand that the only way forward is a political and fiscal union, with commonly-backed Eurozone bonds, a strengthened European Stability Mechanism, etc. Otherwise, the risks of Italexit and Frexit and more will turn into reality. The resentment against the EU and Germany could prove unsustainable. Mario Draghi has warned European leaders that the combination of rising global interest rates and explosive politics could expose the euro area’s underlying weaknesses, even if there are signs of a moderate recovery. Despite the pick-up in investment and consumption supported by the ECB’s monetary policy, rising interest rates could send public debt soaring again. Draghi himself has been keeping the Euro’s hopes alive throughout the recent years by overcoming and out-maneuvering the current German conservatism and dogmatism. European action is needed to de-risk financial systems and build defences against volatile capital flows.
The massive post-crisis divergences in economic performance combined with weak aggregate demand, is creating warning signs. The immediate solution for the Eurozone is a shift away from the politics of austerity. If there’s a lesson to be taken from 2016 is this: there is a need for policy to ensure that the gains from trade and growth are widely shared. Tax and transfer plans haven’t been capable of adjusting market income to a more equal household disposable income. In its most recent Economic Outlook, the OECD made a plea for growth-supporting fiscal expansion. Low interest rates have opened a window of opportunity by reducing governments’ debt service costs and increasing fiscal space. It is a window that may not remain open for long, so the opportunity should be seized. Collective action enables greater gains at lower political cost. The main target of this message: German government. Germany’s surplus is very high, above allowed thresholds and the rules must be symmetrical, both the deficit and the surplus must be adjusted. If the Eurozone continues to fail to deliver widely shared prosperity, it will be vulnerable to political and economic shocks. Generating economic divergence among members rather than convergence is the true issue at hand for Eurozone leaders.
Padoan – a former official at the IMF and former chief-economist of the OECD – has elaborated a 2017 budget that will appropriately support growth, and a further fiscal easing is assumed in 2018. With the accommodative ECB monetary conditions, this will support the country’s moderate recovery. Lower interest payments and the moderate expansion will help keep the headline budget deficit stable at 2.4% of GDP in 2017. The budget has investments to enhance targeted programmes to raise labour market participation and encourage innovation. It also lowers the corporate income tax rate from 27.5 to 24%, raises spending on low pensions, and plans for a fiscal leeway amounting to about 0.4% of GDP due to the 2016 earthquake, the refugee crisis and infrastructure investment. The self-reinforcing cycle of higher employment, household income and private consumption that began in early 2015 due to the Jobs Act, social security contribution exemptions and fiscal easing, cannot fall to the uncertainty that the Eurozone austerity dogma, the December referendum result, and the banking crisis might bring.
The risk of disintegration is such that the EU needs to send a strong and clear message of revamping and unity. As Padoan stated earlier in June: “Deep dissatisfaction over immigration, security and slow economic growth could combine for a further push toward disintegration of the EU bloc. Italy has been pushing for more EU action to encourage economic growth.” There is a need for institutional progress. Member countries need to be willing to share and mutualise some common targets. Insufficient mutual trust amongst countries has been prevents positive outcomes. Risk sharing is a fundamental component to a successful Eurozone, especially in economic times where some countries are under tight fiscal constraints. A macroeconomic stabilisation mechanism is needed in order to smooth negative cycles and deal with asymmetric shocks. This means common funds to deal with economic and financial issues. Risk sharing must be enshrined in European treaties in order to incentivise mutual confidence. In addition to this, there needs to be someone in charge of European public goods and fiscal policy coordination. Padoan has proposed a European Finance Minister and financial integration through the banking union and capital markets union. Handling and delivering European public goods has a very large financial dimension, so the Eurozone needs a systemic way of raising and allocating resources. This would help, for instance, with the implementation of a common unemployment benefit to cope with asymmetric shocks and help in building the necessary trust. This European Finance Minister would manage common resources to ensure financial stability and would coordinating economic policies to avoid imbalances among members.
Due to all of the above, the work that the Italian government has been doing should be recognised. It has allowed Italy to encourage the EU to focus its economic strategy more on investment and growth. As Padoan stated, “the EU is the only road possible but it must change, Italy has done many things to change the EU agenda with this government and the results can be seen”. It breathes new life into the ideals of the EU, especially after Brexit. Padoan’s vocal stance on European matters and strategy to set the agenda of growth and shared prosperity should be applauded in difficult times that breed nationalism and protectionism. The worrying factor is that this Italian government might be the last hope for setting and delivering the growth-enhancing agenda needed to secure Italy’s long-term future in the Eurozone.