How long will Italy's miraculous growth last?

The Italian government will have to hit the brakes in the coming years to adhere to the re-instated and reformed EU budget rules. Last year, Italy posted a public budget deficit of 7.2% of GDP, compared to the limit of 3%, and a public debt ratio of 137.3% (reference level 60%).

Although the new budget rules are less strict than the old ones and offer more wiggle room for strategic investments, they require Italy to significantly tighten fiscal policy over the coming years – partly because the major costs of the Superbonus tax credit scheme will continue to haunt public finances (see box 1). Based on recent calculations supplemented with new data, the primary balance, which excludes interest payments, should average about +1.5% from 2024 to 2027, to adhere to the budget rules (see figure 1).[1]

[1] Calculations in a recent publication that were finalized on 26 February showed a required surplus of 1.2%. However, two major data realizations have taken place since: (i) Estimations for total accrued yet unclaimed tax credits have risen from about EUR 100bn to about EUR 140bn / EUR 150bn. (ii) At the same time, nominal GDP has been revised upward by some EUR 50bn. Updated calculations show that the negative impact of higher tax credit costs outweigh the positive impact of higher GDP, pushing up the required primary surplus.

The phasing out of the Superbonus tax credit scheme should help the government bring down its (primary) deficit considerably this year. In fact, barring any new tax credit surprises,[2] the planned primary deficit of -0.2% in 2024 is not out of reach. But it will require firm commitment and likely some discretionary tightening beyond what is already planned, especially since we think the government’s economic growth projection of 1.4% for this year is too optimistic (more on this later). More tightening will also be necessary to comply with the EU budget rules.

As shown in figure 1, the primary balance is expected to improve over the coming years, but insufficiently to fully adhere to the budget rules. Our projections (based on the methodology explained in this report) show that debt and deficit ratios should move in the right direction, but not enough, unless the government changes fiscal course (see figures 2 and 3). As such, the European Commission will likely ask Italy to up its game.

At the same time, however, a major conflict with Brussels seems unlikely. Ratios are moving in the right direction and Italy can and will opt for leniency as it is to invest in defense and other strategic sectors, and to implement reforms in line with its National Recovery and Resilience Plan. Moreover, it will try to convince the European Commission of its good intentions. Both prime minister Giorgia Meloni and Minister of Economy and Finance Giancarlo Giorgetti have presented themselves as supporters of prudent fiscal policy, aware of the importance to keep financial markets calm. While they are likely to test the budget rules’ limits if deemed favorable for Italy’s economic performance, they are likely to smooth things over rather than picking a fight with Brussels; contrary to some of their predecessors.

[2] Without diving into the nitty gritty details here, the accounting rules for tax credits accrued in past years could change, which is beyond the control of the government. This would lower past deficits, yet could substantially lift deficits as of this year. Furthermore, if construction tax credits were to continue to be wildly popular this year, this would also hamper deficit reduction.

The Superbonus has helped the Italian economy to recover rather quickly after the pandemic. In fact, the Italian economy has performed better than many of its peers over the past years. End 2023, GDP volume was 4.2% larger than pre-pandemic, whereas the total Eurozone economy was 3.5% larger and the German economy just 0.1%. In the past year, growth has slowed, however, and recent survey-based evidence suggests that the Italian economy has continued to muddle through at the start of 2024. There are some signs that activity in the service sector is increasing and that weakness in manufacturing is bottoming out. Yet, according to recent PMIs, new orders and production in the manufacturing sector are still in decline, and backlogs are shrinking rapidly. Meanwhile, service providers comment that order books are moderately improving, but a rapid expansion is not yet in the cards. Businesses are hopeful that the economic environment will improve over the coming year. So are we. But we think it will only happen gradually.

We forecast economic growth to slow from an annual average of 1% in 2023 to 0.8% in 2024, and to accelerate somewhat to 1.2% in 2025; versus respectively 0.5% and 1.4% for the Eurozone. Our projection for 2024 is quite a bit lower than the 1.4% the government has penciled in, but pretty much in line with consensus and the view of other official institutions.

We project consumption growth to recover in the coming quarters from its dip late last year (-1.4% quarter-on-quarter in Q4 2023), but to remain relatively subdued.

Consumption should be supported by increasing household purchasing power, partly due to higher real wage growth. Real wage growth turned positive at the end of last year, owing to a significant drop in inflation and a major pay raise for civil servants (see figure 6). Due to some peculiarities related to the latter, recorded wage growth (year on year) could have fallen back somewhat at the start of this year, but not to below inflation. More wage agreements are expected to be renewed over the coming months, with more than 50% of employees currently awaiting renewal. Given that they have already been waiting for 30 months on average, and considering that the labor market is still very tight with few signs of easing (see figures 7 and 8), we expect workers to experience higher wage growth going forward.

Although we forecast inflation to increase again over the course of the year, from 0.8% in February to average 1.8% in 2024, and 2.2% in 2025, wage growth is expected to continue to outpace inflation in the coming quarters. In addition to higher wage growth, job security should also support consumption, as it lowers the need for precautionary savings.

The flip side of a tight labor market, however, is that the potential for further employment growth is limited. Note that employment growth is often a more important driver of consumption growth than wages. If the participation rate continues to trend upward, this could provide some relief to the labor market tightness. Yet, a rapidly shrinking working age population effectively reduces the number of people potentially available to work (see figure 9). Raising the retirement age could soften the aging impact, but just like its predecessors, the government faces opposition to do so.

Meanwhile, households’ potential to spend from savings has come down significantly, while high rates of return also lock money into financial assets. Indeed, consumer surveys show that Italian households think it’s a very good time to set money aside. Finally, tight fiscal policy will act as a headwind. At the very least, it is highly questionable if the government can extend temporary measures such as the cut in the tax wedge and support for families with children and working mothers, beyond this year.

Investments have positively surprised since interest rates started to rise. Investment growth has remained strong, owing to businesses’ large self-financing capacity, grants from the EU Recovery and Resilience Facility, and construction-related tax credits. The latter have fueled a construction boom. For reference, housing investments have contributed three percentage points to GDP growth since end-2019, compared to zero in the four years preceding the pandemic (see figure 10). Going forward, investment growth is projected to slow, but to remain rather strong.

Survey and credit data suggest there is still weakness in the pipeline. Internal financing capacity has shrunk significantly (see figure 11). In fact, surplus buffers seem to have been mostly depleted. Moreover, housing investments will bear the brunt of the impact of the fading Superbonus, while the Italian government will have to tighten its belt to adhere to the budget rules.

EU funds set to drive investment

That being said, a decline of more than 120 basis points (bp) in long-term interest rates since October last year, increasing real disposable income, and RRF funds will support investment in the coming year(s). Italy is one of the main beneficiaries of the EU pandemic recovery fund. It is entitled to EUR 72bn in non-repayable grants (16.3% of GFCF and 3.4% of GDP in 2023). So far, Italy has met more milestones and targets than its peers and has already received more than half of what it is entitled to. But it can still prescribe to some EUR 31bn (7% of GFCF in 2023). Moreover, part of what has been transferred already, has not been effectively spent yet. Estimates vary, but based on government estimations end-2023, some EUR 21bn in transferred grants (4.8% of GFCF and 1% of GDP in 2023) and EUR 36bn in transferred loans is still waiting to flow into the economy.

As expected, reform and investment progress is slower than initially planned and it seems unlikely that Italy will be able to meet all reform milestones and investment targets before the mid-2026 deadline. Moreover, even if it were to be able to call all funds, it would likely lead to crowding out of other spending, as we argued before; and as also noticed by the EC in its mid-year review. But, according to both the government and the independent Parliamentary Budget Office, investment spending should accelerate in the coming months, as the planning and administrative phase is well advanced. Given the amounts involved, the RRF will certainly be a supportive factor in the coming years.

In the short term, Italy is expected to perform pretty much in line with the Eurozone average. Even though this means the era of outperformance is over, this is still quite impressive for a country that had been lagging behind for a long, long time prior to the pandemic. Meanwhile, public finances are improving, with debt and deficit ratios substantially down from their pandemic peak, and the prime minister presents herself as a believer in prudent fiscal policy. Combined with strong appetite among domestic retail investors for high yielding Italian government bonds and the expected start of the ECB’s cutting cycle near, this has sent “lo spread” down to a 28-month low. The spread between 10-year Italian and German government bonds has bounced somewhat from its recent low of 121bp at 13 March, but is still very small and substantially down from 253bp in September 2022, when Meloni won the elections, and 287 in May 2019, when the Five Star Movement and Lega showed plans that would completely derail public finances.

The fact that fundamentals are actually quite poor – with very low growth once the RRF comes to an end in combination with very high debt – does not seem to bother investors much at this point. According to our Rates Strategists, investors currently seem willing to hold onto Italian debt to enjoy the carry until things are really about to break.