Italy: Draghi from lender to leader of last resort

As do many European countries, Italy is trying to find the right balance between measures to keep the virus and its more contagious mutations in check (figure 1) and providing wiggle room to the economy and its people. Where epidemiologists ask for tougher measures, several politicians are demanding more freedom. At the same time, the government is trying to find the right balance between supporting the economy’s recovery from last year’s 8.9% contraction and winding down support in order to not keep insolvable firms and unviable jobs alive forever – with a myriad of views among labor unions, employer’s organizations and economists. Last but not least, the new Draghi government is tasked with formulating and implementing a comprehensive investment and reform plan, to improve the economic outlook and debt sustainability of an ageing country that has failed to overcome the previous two crises and show material growth since the start the century (figure 2). At least nobody disagrees with the necessity of the latter, but, clearly, views differ on how to do so, with large political fragmentation, vested interest and public sector inefficiency severely complicating this task. Like they have over the past decades.

Despite this major task and multiple challenges, we argue that Mario Draghi could very well again become Italy’s savior. At the very least his arrival has brightened Italy’s future and improved the chances of an adequate absorption of EU recovery money. Of course fragmentation has not disappeared all of a sudden. But the fact that Draghi has been able to muster a government of national unity comprising parties from the far left and to the far right is an achievement that couldn’t have been foreseen only a few weeks ago (figure 3). And, therefore, this should not be neglected.

Furthermore, while weak institutional quality cannot be tackled in a day (figure 4), according to insiders Draghi has the managerial and intellectual skills required for the job; he enjoys respect among the Italian people and politicians for his role in saving Italy during Europe’s debt crisis; and he is supported by high-profile technocrats at the most delicate ministerial posts, while political heavyweights of all but one large party (FdI, radical right) are invested in the government. Hence Italy’s Recovery and Resilience plan will be drafted by qualified officials with the support of a very broad range of government parties. The latter complicates the task in the short run, but might reduce the risk that reforms will be (substantially) reversed once the next government takes over in at most two years[1]. Furthermore, at least in the beginning, oversight of implementation is in the hands of qualified officials - on paper that is. Finally, Draghi is here to spend and not to cut like many of his predecessors. Reform will be awarded. At least one of the above elements has been missing in the governments’ policies of the past decades.[2]

Against this background we argue that the policy outlook and hence the medium-term economic prospects for Italy have improved upon the change in government.

[1] To some extent this is what has happened with for example the pension reform the Monti government and the labour market reform the Renzi government implemented.

[2] This is measured by the World Governance Indicators’ index of the World Bank. It comprises six categories: Voice and Accountability, Political Stability and absence of Violence/ Terrorism, Government Effectiveness, Regulatory Quality, Rule of Law, and Control of Corruption.

The short-term outlook, on the other hand, remains very much clouded by the development of the virus and its mutations, the necessary containment measures to keep the situation under control and the subdued vaccination campaign. So far 5% of the population has been inoculated – 2.4% with the required two shots – implying about two thirds of the delivered doses is still waiting in the freezer. According to the government’s forecast of vaccine deliveries, Italy should have received sufficient vaccines to inoculate 60% of its population – with two shots, if necessary - by the end of Q2 and 100% over the course of Q3.

In our baseline, we expect the government to gradually loosen the reigns over Q2 and to return to last summer’s level of ‘strictness’ by the end of next quarter. In the second half of this year a more substantial return to normal would then be possible. In our economic projections we pencil in another, albeit mild, economic contraction in the current quarter (figure 5 and 6), subdued growth in the next, followed by substantial recovery in the second half of the year. We project Italy’s economy to grow with 4% this year and 3.5% next year. Only by mid-2023 the economy will again reach its pre-crisis level. Especially international tourism will likely require several years to recover, while weakened balance sheets, precautionary savings and subdued employment growth will temper domestic demand after the initial phase of the recovery. According to our preliminary estimate, the impulse from EU Recovery and Resilience facility will be limited this year, but will gain importance thereafter, lifting the GDP level by 1.1% by 2023.

So far, the setup of the EU crisis recovery fund has already supported the Italian economy by pulling down government bond yields. Even before actual money has started to flow. Clearly, ECB policy has played a major role as well, but the setup of the fund has helped as markets interpreted it as a confirmation the euro is here to stay. Moreover, it could also be argued that the willingness among member states to share the burden of the crisis and support the weaker ones, has given the ECB the pretext to go further than it would otherwise have done without facing resistance. .

Back to the fund. In the coming years Italy could receive about EUR 70bn (4.3% of 2020 GDP) in investment subsidies from the EU’s Recovery and Resilience Facility. Commitments will be based on investment plans that the Italian government presents to the European Commission. Yet apart from pre-financing of maximum about 13% this year, disbursements will depend on spending and reform milestones. Payouts should then run from 2021 to 2026.

The total impact on GDP depends on:

1. Whether a decent goal for the money can be found and approved investments actually take place;
2. Reform implementation;
3. The multipliers of public investment and reforms, which also depends on potential bottle necks on the supply side as well as the type of projects chosen.

While the plans are still on the drawing table, making thorough calculations difficult, we have made a first attempt to include the use of the grants component of the EU Recovery and Resilience facility in our forecast.

Absorption is a challenge, but there are some silver linings

Italy is rather slow in spending money from European Structural and Investment Funds (ESIF) and has a weak track record in implementing reforms. By 4 March 2021, it had consumed only 53% of the available funds under the multiannual EU budget 2014-2020, ranked 22nd among all member states. Without going too much into detail as to why, Italy’s weak scores on governance indicators such as government effectiveness[3] should help to make a case in point (figure 4). Furthermore, with the fund we’re talking big money. It is more than 1.5 times the funds available under the old ESIF. It is also 1.7 times the stock of government investment in 2019 and comes on top of money still to be spent from the old budget and the ESIF of the 2021-2027 budget.

That said, the major output gap and possibilities (need) to put the funds to good use support the uptake in our view. For Italy, the distance to frontier scores in several important pillars of the RRF – specifically those related to digitalization (figure 7) – are large, while the EU’s green deal requires significant steps on energy and climate in all countries[4]. Moreover, the government change has improved Italy’s prospects of absorption of funds. Skills and know-how at the ministries most important for the formulation and implementation of investment plans and necessary reforms have significantly increased. Meanwhile the prospect that bottlenecks that have withheld efficient (public) investment spending in the past are being tackled have improved. But even when we abstain from the fragmentation in parliament, there will be no easy fixes for Draghi and his government to absorb the available RRF funds.

[3] Government effectiveness “Reflects perceptions of the quality of public services, the quality of the civil service and the degree of its independence from political pressures, the quality of policy formulation and implementation, and the credibility of the government's commitment to such policies”.

[4] For sustainability and energy indicators, another important pillar of the RRF, Italy’s performance is mixed, but better than the EU average when looking at the aggregate picture. That said, to reach the EU’s climate goals as presented in the green deal, all EU countries have to make great efforts.

Multiplier another big unknown for now

Meanwhile, the multiplier clearly depends a great deal on what projects the money is spent on, whether it concerns additional projects or not, and what kind of reforms are implemented. Besides the direct demand impulse stemming from the subsidies, investments could fuel growth even more in the longer term. After all, investment in for example new technologies and human skills could increase the productive capacity of the economy. At the same time, already planned investments now paid for with EU subsidies instead of with ‘own money’ should not be fully seen as additional – an example being plans for certain high-speed train trajectories. Furthermore, investments to support the green transition are probably accompanied by less or even divestment in grey facilities. And in the short term, investment in for example reform of the public administration and (re)training will likely mainly run via more salary payouts to those who have to organize the changes and trainings, not leading to an equal demand impulse as a share of that additional income will likely be saved. Finally, reforms take time to bear fruit. But we should not forget that, especially in Italy, they could have a major impact (as underscored by the distance to frontier at a broad range of institutional indicators, figure 4 and 8). According to the OECD, a full-fledged reform package could increase trend growth in ten years by 1%-point a year. According to the IMF, a package could raise Italian GDP by as much as 12% in ten years’ time. This would lower debt to GDP by some 15%, just through the numerator.

A preliminary estimate

All in all, awaiting further information, in our preliminary projections we assume that Italy will have absorbed about 30% of total grants it is entitled to by 2023. In these early years we assume that the multiplier is 0.9. This brings us to the aforementioned GDP impulse of 1.1% by 2023. Italy can also request a low rate loan through the RRF worth almost EUR 125bn, but we’ve left that out of the calculations. For one because they come with strings attached and at this moment market finance is very cheap, lowering the necessity to make use of these loans. Second, if Italy would make use of these loans, the overall investment impulse would likely be limited, given the aforementioned absorption problem and the fact they need to be repaid at some point. So either EU loans would be used to finance projects that would otherwise be financed with market funding or investments made with these loans cannibalize on other projects. Of course the interest rate argument could change if market sentiment changes. But for now, even if Italy would make use of the loans, the additional GDP impact would likely boil down to a negligible benefit stemming from the minor interest rate differential.

In 2012, ECB President Mario Draghi saved Italy and the Eurozone, with his famous words “Whatever it takes”. The big question is whether he can pull this off again, but now as the Prime Minister. Indeed with Italy being the third country in the Eurozone, its growth and debt outlook are of significant importance to the entire union. Moreover, the EU needs the heavily debated Recovery and Resilience facility to be a success in severely hit high-debt countries such as Italy. Should this fail to materialize, this could very well put a severe limit on burden sharing in the future – if needed – and Eurozone integration. At the same time, if it will be a success, it could lay the foundation of the reform of the stability and growth pact, currently under debate. All that being said, a change of course is clearly most important for Italy itself.

So will it happen? Draghi awaits the major task to navigate the country through the corona minefield and implement a powerful recovery plan, amidst a highly fragmented political landscape. All that in a country with a weak track record, tons of bureaucracy, an inefficient public administration and certain political heavyweights eying to take over his position at some point. Possibly already next year, but early 2023 at the latest. It will be no ride in the park, as underscored by the difficulties last week to appoint the deputy ministers and expressed irritancies from Lega’s corner over current and discussed containment measures – leading to its abstention in the Senate vote over the new COVID decree.

Still, for the reasons laid out in the piece, we argue the Draghi government could make decent progress and definitely more than any other at this moment. The challenge is gigantic, but never before the reward was this large. It could be exactly the push Italy needs – if experience in Spain and Portugal after the previous crises is of any guide. And if this doesn’t work, what will?