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Sunday, December 24, 2006

Italy: Flickers of Light


Vladimir Pillonca | London

For the first time in a decade, there are positive signs of change, and a medium-term improvement of Italy’s macro performance is becoming a more concrete possibility. We are finally witnessing two crucial changes from Italy’s policymakers: 1) acknowledgement that Italy has serious long-term economic problems; and 2) willingness to tackle these problems. For example, the government has reduced the huge debt burden and liberalized key sectors of the economy, ranging from banking to the retail sector, as outlined in the recently made effective Bersani Decree.

Provided the current government coalition holds, the next few years could provide the foundation for higher future economic growth. The beginning of the legislature is the ideal time to push on with reforms, some of which will be painful in the near term. This will likely diminish popular support for the government in the short term, raising political uncertainty. But not only will supply-side reforms be instrumental in raising Italy’s sustainable longer-term growth, they will also make the reduction of Italy’s enormous debt burden a more manageable task, increasing the longer-term attractiveness of investing in Italy.

Flickers — not sparks

Italy’s economic growth has been strong this year, following a decade of chronic macro underperformance: GDP growth averaged just 1.4%Y in 1995-2005, compared with 2.1% in the euro area and 2.8% in the UK. Reversing Italy’s persistently negative growth differential will take time — but an improvement relative to its own recent history is becoming a more concrete possibility. The government’s initiative to liberalize services is an essential step toward strengthening the services sector, while encouraging competition. Encouraging competition in the services sector should help to reduce Italy’s exposure to the internationally competitive and volatile manufacturing sector. This is also an important step toward boosting potential growth, and one of the reasons why we are positive on Italy — provided the reform effort intensifies.

Clever consumers avert recessions

Next year marks an important test for the Italian economy: a significant degree of fiscal tightening takes place domestically, while a VAT hike becomes effective in Germany, a key export market for Italian firms. In principle, next year’s fiscal tightening could trigger a recession and could have a particularly adverse effect on consumption. However, we expect consumers to behave in a forward-looking rational way, and to look through the temporary phase of higher fiscal pressure, and lower economic growth in 2007, in anticipation of higher economic growth in 2008 and beyond. The expectation of higher growth in the future could strengthen if the reform effort gathers pace, underpinning confidence. Consumers don’t typically allow their consumption to fluctuate as much as their income; instead, they smooth their consumption expenditure over their life cycle, even when their income falls temporarily. It is the longer-term expectation of the future stream of income that tends to dictate consumption patterns. This explains why the volatility of consumption is normally much lower than that of consumers’ disposable income. Hence consumer spending could hold up relatively well next year, while the savings ratio falls slightly, though admittedly there are downside risks to our central consumption forecasts. Besides, the payroll tax wedge will be cut by five percentage points next year, which should help to insulate consumers’ take-home pay from income tax increases, which will mostly affect higher-earning individuals and holders of financial assets. Finally, we expect annual CPI inflation to decline to 1.7% in 2007, while nominal wage growth is unlikely to edge much lower than 3.0%Y, implying approximately a 1% gain in real wages.

Credit deepening and corporate awakening

Households’ access to credit has improved in recent years, and loan-to-value (LTV) ratios have risen. Italy’s mortgage debt/GDP ratio has increased from 10% in 2000 to 17.2% by the end of 2005. But even so, consumers’ mortgage debt/GDP ratio remains relatively low at 17% in Italy, compared with 52% in Germany and 80% in the UK. Rising interest rates might slow credit deepening in the near term, but we think this process has further to go in Italy over the medium term. On the corporate side, our tentative impression is that the restructuring process is at a barely nascent stage, and is more likely to start with the larger corporates. We expect fixed investments to rise in line with GDP growth in 2007, and to pick up appreciably in 2008. M&A activity has the potential to extend beyond the banking sector, but stringent labour protection laws suggest that the restructuring process is likely to be a slow-moving phenomenon. If reforms do progress, the corporate environment should improve, and the room for improvement is large.

Bumpy outlook ahead — but no crashes in sight

A sharper US or global slowdown than we expect would imply downside risks to our central euro area forecasts. In our central case, GDP growth in the euro area slows from 2.6%Y this year to 1.9%Y in 2007, before picking up again in 2008. Next year’s slowdown also reflects fiscal tightening in Germany and Italy, the lagged effects of higher interest rates and a strong euro. In Italy, we forecast GDP growth to slow to 1.1%Y in 2007 from 1.8%Y this year. This projected slowdown would amount to a robust performance by Italian standards, especially given the significant degree of domestic fiscal tightening, while Germany’s VAT hike will likely curb demand for Italian exports. So, we expect net exports to be neutral on growth next year, after adding to GDP growth in 2006. While fiscal tightening should be enough to push the budget deficit down to 3.0% of GDP next year, it won’t be enough to position Italy’s massive stock of debt on a lasting downward path. For this reason, fiscal policy is likely to remain tight beyond 2007.

Risks and alternative scenarios

While the above discussion focused on a central scenario, there are two representative alternative scenarios worth highlighting:

i) Negative scenario: Fiscal hangover cracks fragile recovery

Under this scenario, consumption growth slows in 2007, reflecting the impact of an effective increase in tax pressure. The VAT hike in Germany in 2007 reduces demand for Italian exports in 2007, while a strong euro has an adverse effect on many Italian firms’ fragile competitive position. Any combination of these factors could advance Italy into yet another phase of low growth or even an outright recession.

ii) Optimistic scenario — a low probability event

Under this scenario, a series of coincidences would have to materialize simultaneously: i) GDP growth remains significantly above trend across the euro area, particularly in Germany, despite the VAT hike, while global and US growth defy expectations of a slowdown; ii) much lower energy prices result in significantly lower inflation, underpinning households’ purchasing power much more markedly than in our central case; and iii) a sharp drop in consumers’ savings ratio, as consumers significantly increase their debt levels. The probability of these events occurring concurrently is very low, in our view.

Distribution and assessment of risks: Our central GDP growth forecast is closer to the positive case than the negative scenario, but there are many risks on the horizon, coming from multiple directions. Political instability could thwart the reform effort, fiscal policy could have more of a restrictive impact than we anticipate, and a persistently strong euro could undermine the fragile competitive position of many Italian firms, especially in the manufacturing sector. Overall, we feel risks are skewed to the downside of our central forecast for economic growth.

A more in-depth report on Italy’s outlook is available: See “Flickers of Light at the End of the Tunnel,” December 2006.