Italy: Durable solution to the political instability looks beyond reach

Italy was unable to shake off concerns about its ailing economy during the second quarter of 2019 as GDP growth was flat at 0.0% q/q (down from 0.1% q/q in the first quarter). This adds to a recent series of weak growth data which, taken together, indicate that Italy’s economy has been stuck in stagnation since the second half of 2018 (Figure 1). Istat provided little information about the drivers of the second quarter growth figure, but disclosed that industry contracted whilst services expanded. Despite the weak growth figure, we do observe an improving labour market as Italy’s economy added jobs at a steady pace while the size of the labour force remained more or less stagnant throughout the second quarter (Figure 2). As a result, the unemployment rate moved towards 9.7% in June, its lowest level since February 2012. Although it ticked up to 9.9% in July, the trend has been broadly positive in the past few years. Together with the implementation of recent policy measures and the slide in inflation during recent months, this suggests that private consumption grew. Given the prevailing political uncertainty and gloomy global economic outlook, private investment growth was likely weak.

Political uncertainty has increased sharply in recent weeks following Salvini’s decision to pull the plug on the Five Star-Lega coalition which prompted prime minister Conte to offer his resignation. On Wednesday evening the Democratic Party (PD) and Five Star gave their official support to Conte-II to which President Mattarella responded by giving Conte an official mandate to form a government without returning to the polls. A PD – Five Star tie-up would enjoy a comfortable majority in the lower house (Figure 3), but would require the backing of some unaligned senators in the upper chamber (Figure 4).

What the policy agenda of a potential PD-Five Star government would look like is not entirely clear at this moment, but we can expect this government to be less hostile towards Europe. Given PD’s pro-Europe stance, the risk of a euro-exit or a parallel currency being introduced will be virtually non-existent. Because of the lower hostility towards Europe, we would also expect this government to show greater awareness of Italy’s fiscal situation. This being said, Five Star is still likely to opt for deficit spending to boost welfare in Italy’s south, while PD’s policy reforms that must attract investments are unlikely to be free of charge either.

There are still some hurdles that need to be overcome before Conte-II can actually take office. Five Star leader di Maio intends to put the final decision to a vote through Five Star’s online platform on which plenty of voters are expected to oppose a tie-up, while Five Star also wants technocrats on important ministerial positions rather than PD’s preferred option of politicians. Moreover, both parties are divided on several issues such as the high-speed railway to France and the Five Star-Lega migration laws, which suggests that talks can still break down in the coming days. Nevertheless, one thing PD and Five Star have in common is their willingness to avoid elections since this would relegate them into opposition while Five Star would incur a substantial loss of seats.

Indeed, if talks between PD and Five Star break down, Italy will almost certainly return to the polls in late October or the beginning of November. Given its current polling strength, Salvini’s Lega will almost certainly emerge as the winner of these elections (Figure 5). How Mattarella intends to deal with an election and the design of the 2020 budget is uncertain, but he will most likely appoint a market-friendly caretaker government which should guide Italy through the budgetary process.

Whichever path is taken, one of the first challenges of any new government will be to submit a proposal for its 2020 budget to Brussels by mid-October. This will come only four months after Italy escaped an ‘Excessive Deficit Procedure’ (EDP) through a mid-year budgetary correction, which should reduce its 2019 fiscal deficit to the previously agreed 2.04% of GDP. This correction is brought about by unanticipated revenues and lower than projected costs from, for example, the citizen’s income. However, this may do little to reduce Italy’s projected deficit in 2020, which the Commission estimates at 3.5% under the assumption that an automatic value-added tax hike would be scrapped without counteracting measures. Therefore, a new government should focus on finding budget cuts that would stave off both a violation of EU fiscal rules and a tax hike which has the potential to tip Italy’s economy into recession.

How the situation surrounding Italy’s budget plays out in the near future depends heavily on how the political situation unfolds. Given PD’s desire for Italy to become a loyal EU-member, we expect a Five Star – PD government to be willing to make concessions towards Brussels. The European Commission is also likely to be more lenient towards a constructive government and may therefore grant some budgetary flexibility. Another option to shore up funds would be to undo the pension changes championed by Lega.

However, if Italy heads to the polls in the coming months, we can expect tensions between Brussels and Rome to re-emerge next year. Admittedly, a caretaker government will likely be market-friendly and therefore steer clear of any expansionary measures that may upset Brussels and financial markets in the near term. On the other hand, after a potential election win, Salvini will be sure to push ahead with his tax cuts next year. He would not even need an outright majority as other far-right parties, such as the Brothers of Italy, share his anti-Europe rhetoric and are ready to support his tax reforms. The Commission could then threaten with an EDP again, but a Lega-led government is unlikely to be very responsive if such a procedure is not accompanied by a fresh bout of market pressure.

Finally, there is also the issue of whether a Five Star-PD coalition is here to stay. Historically, there has been a lot of bad blood between both parties mainly because Five Star was designed to take on parties such as PD, which has frequently been on the receiving end of Five Star’s anti-establishment narrative. For now, differences on the aforementioned policy issues may be overcome with some patchwork, but fact is that several important people inside both parties are no fan of this potential tie-up. This legacy of historical differences and hatred could cool relations in the first instance in which the coalitions’ cohesion is put to the test. Therefore, a Five Star – PD government is almost certain to have an expiration date while we can be sure that Salvini will be armed and ready when the time comes.

The conclusion is then that the split-up of the Lega-Five Star government is unlikely to bring the political stability needed to solve Italy’s deep-rooted problems (Figure 6). Its economy is troubled by poor quality institutions, low productivity growth and a shrinking population, while Italy’s electorate shifted towards populist parties as they blame the mainstream parties for failing to address Italy’s problems. Given this current political landscape, it is hard to see any government coming in which can effectively address the institutional problems and spur a lasting sustainable rise in productivity growth. So far, Five Star and PD have been more concerned about how ministerial posts are divided instead of agreeing on a shared policy agenda. Whether this can be agreed upon is uncertain anyway, since it looks like this government is not based on shared values and only created to prevent elections, which does not bode well for its capacity to get things done. The most likely alternative to a Five Star-PD tie-up, a Salvini-led far-right government, will be unpredictable, full of populist rhetoric and is certain to clash with Brussels over its fiscal stimulus plans. As the previous populist coalition made painfully clear, populists usually prefer short-term expansionary policies that put money in the pockets of its voter bases, but so far these policies have done little to revamp Italy’s growth, let alone solve its structural problems. All in all, as long as Italy’s political landscape is crowded with populists, it seems that little will be done about its structural problems. Therefore, we remain deeply concerned about Italy’s long-term growth outlook.

In the short run, we do not see a quick rebound to growth on the Italian peninsula either. The Economic Sentiment Indicator’s various components show that sentiment in all but retail trade deteriorated in the first seven months of 2019, while July’s confidence figures stood lower than in the second half of last year when Italy was in recession (Figure 7). What’s more weakness in industry is likely to persist given that order-book levels and the amount of new orders have been in decline for a while (Figure 8). Given that US-China trade tensions are bound to escalate further, we expect the resulting global slowdown to further weigh on demand for Italian (industrial) production. Italy’s most important trade partner Germany is already experiencing a pronounced slowdown, which may also find its way to Italy in the coming period. Also, private sector confidence is unlikely to improve going forward given that the uncertain government policy outlook is expected to persist.

All in all, we expect the economic stagnation to continue and forecast growth to be 0.0% y/y in 2019 and 0.1% y/y in 2020.