Italy faces moderate growth and fiscal tightening

Mid-June, the European Commission proposed to put Italy in an excessive deficit procedure (EDP). The announcement came as no surprise, given that Italy ran a deficit of 7.4% in 2023. The commission projects a deficit of 4.4% in 2024 based on expected policy and 4.7% in 2025 based on a no-policy change. These deficits clearly surpass the 3%-threshold and cannot be deemed temporary. In early April, Minister of Economy and Finance Giancarlo Giorgetti told Italian parliament to expect an EDP, and that policy would have to be line with certain requirements – that is, a structural reduction of the deficit of at least 0.5% of GDP per year. After the commission’s announcement in June, Giorgetti was quick to reiterate that “the deficit goals are those we have indicated in our budget path, which we intend to respect.”

The government’s projections indeed show sufficient improvement in the budget deficit to fulfil the requirements of an EDP: the deficit is projected to drop to 4.3% in 2024 and to 3.7% in 2025. Initially, the reduction is supported by the phasing out of the Superbonus scheme. But more measures are planned to cut back the deficit. Last year the Parliamentary Budget Office stressed that the government would likely have to take additional discretionary action to meet its targets in the coming years. This will be all the more true given that the government wishes to extend the cut in the tax wedge for low and middle income households into next year, and considering the fiscal challenge posed by the aging population and Europe’s strategic agenda.

The European Central Bank (ECB) recently posted its calculations for additional strategic investment needs. In short, in total, the EU would require EUR 5.4 trillion or about 5% additional investments in the coming six years, of which between 0.6% and 1% would need to come from public sources, on top of EU money already available through e.g. the EU budget and the Recovery and Resilience Facility. Imagine the difficulty for the Italian government to get its house in order, if we were to simply add this percentage to Italy’s structural primary balance of about 5% currently. Unsurprisingly, the article indirectly concluded that this is not an option for some countries – but still.

Moreover, Italy currently spends only 1.3% of GDP on defence, quite a bit below the 2% required by NATO agreement. Raising defence expenditure, as is talk of the town in the EU these days, to 2% of GDP would bring quite a challenge. Finally, critics (among which the European Commission) argue that the recently approved autonomy law, which gives local governments more say in how tax revenues raised in their region are being spent, risks fiscal slippage and less cohesion.

At the moment, we still believe that the Italian government will be able to comply with the requirements that come with an excessive deficit procedure, at least enough to avert fines within the EU governance framework. Especially because EDP countries won’t need to compensate for the budgetary impact of projected increases in interest payments (as a percentage of GDP) until 2027. The discretionary fiscal effort “only” needs to be 0.5% of GDP per year, even if this means the structural deficit is actually being cut back by less than that 0.5%, due to an increase in interest costs. Still, the trajectory is certainly not without risks of fiscal slippage and, despite the funds from the EU Recovery and Resilience Facility, it will likely lead to a contractionary fiscal stance and difficulties to take full part in the EU’s strategic agenda.

The opening of an excessive deficit procedure also means that Italian government debt is ineligible for the ECB’s TPI – at least, on paper. This is not currently an issue, but if the TPI were necessary things could get more tense. If necessary, the Italian government could apply for a precautionary credit line at the European Stability Mechanism (ESM) or an official support package, which would also make it eligible for the so far never used Outright Monetary Transactions (OMT), another tool the ECB could use to suppress yields. But the ESM is highly contested in Italy as it would come with strings attached, and in their opinion, such a program would fuel rather than temper financial market unrest. Prime Minister Meloni has vowed never to apply. We doubt that Meloni will stick to that promise if push comes to shove, but this would likely require significant market pressure beforehand.

The IMF has recently warned that Italy’s growth would plummet to close to zero by 2026, as the construction-related tax credit scheme known as the Superbonus comes to an end, and the boost from the National Recovery and Resilience Plan is to fade. We sympathize with the line of reasoning that the end of the very generous tax credit scheme will weigh on growth, but we are a bit more optimistic in the short to medium term. We think Italy will manage to post moderate growth figures of around 1% over the coming three-year period, pretty much in line with the eurozone average. We expect a drop to around 0.5%, as of 2027, when the Recovery and Resilience Facility comes to an end and aging will increasingly start to weigh on growth.

In the short term, growth will be held back by very weak housing investment, as well as rather subdued global demand, ongoing tight financing conditions, tighter fiscal policy, and an underperforming manufacturing sector, with industrial production on a downward trend for months already. But the outlook remains quite good, owing to the recovery in purchasing power, support from EU RRF funds until 2026, and a strong labor market – although slower employment growth will put a lid on consumption growth. Inflation is projected to drop massively this year to just above 1%, from 5.9% in 2023, before it is expected to move back up to 2% in 2025 and 2.1% in 2026, owing to base effects and higher trade tariffs under a Trump presidency, as explained in our previous monthly. Finally, lower (long-term) interest rates and input cost pressures should also support some investment growth later this year and next year.