Euler Hermes Economic Economic Research Insight

Italy: The show must go on December 05, 2016 Executive summary

voted No to constitutional reform in a Ana Boata, Economist referendum (59.1%) and Prime Minister Renzi resigned. [email protected] In 2017, political uncertainty can cause a mild confidence crisis. If there are no spillovers to banks or Benedetta Scotti, Junior Economist the bond market as the baseline scenario suggests, the [email protected] downturn may shave off -0.3pp of Italian GDP. In this case, the economy should grow by a mere +0.6%.  A knee-jerk reaction is inevitable. But a 2011-12 style financial stress, which would cost -0.7pp in GDP growth and push close to zero growth (+0.2%), should be avoided. This time around Italy benefits from stopgaps, courtesy of Europe, such as the ECB’s QE program and the ESM 2.0. Add to that the country’s structural strengths: fiscal surplus and debt ring fencing. The Italian banking sector should feel the pinch.  Italian companies will bear the brunt of a confidence shock, albeit mild. Slight divestment from abroad and tougher financing conditions mean that investment will stay flat. +2% growth was previously expected for 2017.

Italians said No to Constitutional reform and Figure 1: The Italian Constitutional Reform referendum results Renzi resigned. No panic needed, but by region confidence will take a hit

On December 4, 65% of Italian voters cast their ballots. The results – 59.1% voted to reject a Trentino South Tyrol proposed constitutional reform – were anticipated 53.9% by pollsters. The almost 20 point gap was not. The Aosta Valley 61% 56.8% results signified widespread defiance of Prime 55.5% Minister Renzi, who was asking for the people’s 61.9% In total direct support for the first time since taking office. 56.5% 65.47% turnout Emilia-Romagna As a consequence, Renzi announced his 50.4% Yes – 40.9% resignation, opening yet another period of political 60.1% No – 59.1% uncertainty in Italy. 55.1% This year, Italian GDP performance has 52.5% 51.2% disappointed time and again. Growth should reach 64.4% +0.9% in 2016, a lackluster performance compared to the +1.6% Eurozone average. 63.3% 60.8% Moreover, Italy’s fragilities, and its banking 67.2% sector’s precarious position, have taken center 68.5% stage following the Brexit vote and US election. The economy’s prospects are once more linked to 72.2% 65.9% confidence – or lack thereof. This is evident both domestically and abroad. 67% The President may appoint a Grand Coalition or a Technocrat government to serve in the run-up to the next elections. These are due in the first half of 2018, or in late 2017, if most pundits are to be believed. 71.6%

Latest polls show the ruling Democratic Party (social democrats) in a neck to neck race with the Sources: Ministero dell’Interno, Euler Hermes anti-establishment Five Star Movement (M5S). This adds to the uncertainty surrounding Italian policy-making and its safeguarding role.

Moreover, the unresolved status of the two houses Figure 2: The impact of confidence crisis on Italian GDP growth of parliament will continue to hinder forward- looking reforms. As a result, markets might test Impact from a confidence crisis with economic spillovers the resilience of Italian banks and public debt. Realized/expected growth in a confidence crisis with economic spillovers Investors’ confidence will be weaker, to the detriment of companies and banks. Economic Impact from a confidence crisis without economic spillovers reforms could come to a standstill, exposing more Expected GDP growth in a mild confidence crisis (baseline scenario) of Italy’s structural weak points. 0.9% Our baseline scenario suggests that Italy will avoid 0.6% a 2011-12 style confidence crisis with significant 0.2% economic spillovers. Sovereign bonds are backed by ECB’s QE purchases and the European -0.3pp institutional framework has been reinforced. If the -0.7pp political transition is carried out in a swift and transparent manner, negative shocks should remain contained. In this scenario, we expect GDP -1.7pp -1.7% growth to reach +0.6% in 2017. That is -0.3pp -2.1pp lower compared to our previous forecast. Yet, if a confidence crisis were to hit banks and/or -2.9% the bond market with spillovers similar to 2011-12, ... the impact could be significant. -0.7pp could be 12 13 16e 17f shaved off growth in 2017, pushing GDP to +0.2% Sources: IHS, policyuncertainty .com, Euler Hermes estimates (Figure 2).

Fearing the spread? Do not expect a 2011- Figure 3: Portfolio investments in Italian government bonds vs. 12 rerun ECB’s purchases of public debt securities EUR bn, cumulative 12M Compared to political transitions in the past, Italy benefits from a number of stopgaps. 200 (i) The ECB. It will remain the savior as it will 150 continue to purchase Italian bonds through its QE 100 program, perhaps until late 2017. Since March 2015, the net monthly purchases of Italian public 50 debt securities by the ECB reached EUR10bn on average. The scheme amounts to EUR188.5bn in 0 total, 10% of the total Italian bond market. This rate of purchase, constrained by the capital key -50 rules of the ECB, would be enough to compensate -100 for a sell-off reminiscent of 2011-12. Still, punctual shocks are possible (Figure 3); -150

(ii) Stronger European institutions. The Banking -200 Union and bail-in rules provide a clearer 11 12 13 14 15 16 17 18 framework for bank resolution excluding public Portfolio investment in Italian securities intervention. The European Stability Mechanism (ESM) is also a source of stability and would allow Expected portfolio investment in Italian government debt securities - political crisis the ECB to purchase even more Italian sovereign ECB purchases of Italian public debt securities bonds in the secondary market if a Memorandum Forecasted ECB purchases of Italian public debt securities at current rate of Understanding is signed;

(iii) The primary balance surplus stood at +1.4% Sources: Bloomberg, , Euler Hermes estimates in 2015. It should strengthen going further and reach +2% in 2018. Thus there should be some room for manoeuver to face higher interest Figure 4: Gross bad debts (sofferenze) held by Italian banks expenditures for 1-year or so. The average (EUR bn) interest rate on the debt currently stands at around 200 3% and allowed the Italian government to save 180 EUR20bn over the past years; and 160 (iv) The ring fencing of Italian debt: 65% remains held by Italian residents which will mean 140 that contagion effect to the other eurozone 120 countries should remain limited. 100 The restructuring of Italian banks is a matter 80 of confidence 60 The stress tests conducted by the European Banking Authority this summer have reassured 40 investors fretting about the resilience of major 20 Italian banks. The local banking system remains fragile for three main reasons: (i) the high stock of 0 non-performing loans, notably sofferenze, i.e. non- 08 09 10 11 12 13 14 15 16 recoverable loans, equal to 12% of GDP Sofferenze rest of the economy (Figure 4); (ii) low profitability; and (iii) undercapitalization, especially of small-medium Sofferenze non-financial corporations sized banks. Sources: Bank of Italy, Euler Hermes

Euler Hermes Economic Research 2

This is the case of Monte Paschi di Siena, which is Figure 5: The number of M&A deals by foreign investors going through an arduous EUR5bn recapitalization in Italy (cumulative 12m) process. Other regional banks, such as Banca 300 80% Popolare di Vicenza and Veneto Banca are also Political crisis begins bearing the brunt. This affects many local 60% enterprises. 250

With a number of M&A deals pending - Banco 40% Popolare and Banco Popolare di Milano are 200 prominent examples - further restructuring and 20% consolidation efforts are to follow in the upcoming 150 months. Privately-funded and government- 0% sponsored solutions, such as the Atlas Fund which is supported by the Italian Treasury’s guarantee 100 schemes (GACS), are already in place. But -20% investors’ confidence, which depends on political 50 stability and economic prospects, will play the -40% pivotal role. 0 -60% 07 08 09 10 11 12 13 14 15 16 Italian companies could stray from recovery Number of M&A deals by foreign firms in Italy, 12m - lhs Italy’s firms are in a recovery mood: turnovers 12m/12m % - rhs increase and profits are up. At the same time, Sources: Bloomberg, Euler Hermes companies are moderately indebted and hold high amounts of cash. Figure 6: Average GDP growth 2016-2017 (x-axis) vs Yet business confidence remains fragile and might Average GDP growth 2008-2015 (y-axis) be impacted by a period of political transition 1,0% through several channels. Germany (i) Investments from abroad will likely take a hit if political turmoil intensifies. In 2012, foreign Belgium acquisitions of Italian companies have dropped by Austria more than 30% compared to 2011 (Figure 5). 0,5% France Netherlands

(ii) Increasing pressure on banks would lead to EU average deterioration in financing conditions for Italian firms. These rely on banks to cover 60% of their financing needs. This will make Italian companies, 0,0% particularly SMEs, even less competitive than their European counterparts and could hurt profitability. Denmark (iii) Higher financing costs and negative confidence effects could hamper SMEs’ growth in Spain -0,5% 2017. As confidence remains brittle we estimate Finland that if political turmoil resembles 2011-12 investment growth could stall instead of growth Portugal by close to +2%.

-1,0% Italy Keeping the eye on the ball as far as 0% 1% 2% reforms are concerned will reassure EUaverage Productivity is critical to restore growth and make public debt sustainable Sources: IHS, Euler Hermes estimates

Notwithstanding spending review efforts, the stock of Italian public debt has peaked to EUR2,255bn Figure 7: Labour Productivity Index in July 2016. It is expected to reach 133% of GDP (Real GDP per hour worked) in 2016. As both primary surplus and low interest 105 rates are still in place, the main problem remains sluggish GDP growth. It stood at +0.6% on average over the past 3 years and negative on average since 2008 (Figure 6). Although the 100 expected return of inflation should help, Italy still needs to tackle the structural weakness, i.e. low productivity.

Reforms to boost Italian firms’ competitiveness are 95 even more urgent given the sluggish growth of global trade and adjustment efforts made by European countries such as Spain and Ireland. This limits the potential of the mighty Italian 90 exports machine.

Worse still, Italian labor productivity has barely increased in the last fifteen years (Figure 7). It 85 2000 2005 2010 2015 grew at an average rate of +0.3% far below the eurozone average of +1.1%. The gap is explained EU (28 countries) Germany France Italy only in part by Italy’s specialization in low to medium value-added sectors. Sources: Eurostat, Euler Hermes

Euler Hermes Economic Research 3

In fact, the country continues to suffer, inter alia, Figure 8: Net creation of new contracts from high labor costs, a dysfunctional training Permanent Temporary system, and low innovation. The shrinking labor force and a historically low fertility rate of 1.37 400 are additional important structural drags. Budgetary Laws 300 R&D investments are needed to revitalize firms’ competitiveness: Industria 4.0 is a positive step but implementation risks remain 200 In order to boost innovation, the government has launched a 3-year industrial plan in September 100 2016. Industria 4.0, inspired by a German initiative, designed to boost research and 0 development expenditures. These represent only 1.3% of Italian GDP while the average euro area is 2.1%. -100 Jobs Act The plan aims at increasing private investments in R&D by EUR24bn by 2020, and the -200 government has already committed EUR13bn to

cover tax cuts on investments that will be -300 realized in 2017. It also announced its intention 01/14 07/14 01/15 07/15 01/16 07/16 to allocate additional EUR6.7bn for maximizing firms’ access to ultra-broadband and strengthen Sources: ISTAT, Euler Hermes its support to soft-loan schemes meant to boost machinery upgrades. Public efforts are in place. Yet as in the case of banks’ restructuring the key success factor will be investors’ confidence.

The Jobs Act is delivering, but labor costs are still to be reduced

The Jobs Act which entered into force in March 2015 has introduced some flexibility into a relatively rigid labor market. It contributed to the creation of more than 3.5 million jobs over the last 12 months or +56%, 12m/12m (Figure 8). The effort has been accompanied by the education system reform. La Buona Scuola should help academic institutions become more responsive to labour market demands, through the strengthening of on-the-job training programs. According to the Italian Treasury, it will contribute mostly to long-run growth, adding +2.4% to baseline GDP. Yet, reforms are still needed to tackle the high cost of labor. With a tax wedge of 47.9%, Italy remains well above the OECD average of 35.9%. Although the fiscal incentives included in the two last Budgetary Laws (the so-called decontribuzioni) have pushed down labor costs by 4% y/y in Q2 2016 (excluding wages and salaries), these remain one-off solutions.

DISCLAIMER These assessments are, as always, subject to the disclaimer provided below.

This material is published by Euler Hermes SA, a Company of Allianz, for information purposes only and should not be regarded as providing any specific advice. Recipients should make their own independent evaluation of this information and no action should be taken, solely relying on it. This material should not be reproduced or disclosed without our consent. It is not intended for distribution in any jurisdiction in which this would be prohibited. Whilst this information is believed to be reliable, it has not been independently verified by Euler Hermes and Euler Hermes makes no representation or warranty (express or implied) of any kind, as regards the accuracy or completeness of this information, nor does it accept any responsibility or liability for any loss or damage arising in any way from any use made of or reliance placed on, this information. Unless otherwise stated, any views, forecasts, or estimates are solely those of the Euler Hermes Economics Department, as of this date and are subject to change without notice. Euler Hermes SA is authorised and regulated by the Financial Markets Authority of France.

© Copyright 2016. Euler Hermes. All rights reserved.

View all Euler Hermes Economic Contact Euler Hermes Publication Director and Chief 4 Research online Economic Research Team Economist http://www.eulerhermes.com/economic- [email protected] Ludovic Subran research [email protected]