Italy’s economy enters choppy waters
Italy faces a triple threat of a gas squeeze, higher
interest rates and looming elections.
BY PAOLA
TAMMA
June 27,
2022 3:25 pm
https://www.politico.eu/article/italys-economy-interest-rates-inflation-enters-choppy-waters/
Italy’s
smooth sailing is about to come to an end.
A
combination of factors — the "Super Mario" brand of its prime
minister, negative interest rates and the chance to spend nearly €200 billion
in EU recovery funds — meant that the EU’s third largest economy was heading
into strong growth this year after getting clobbered during the pandemic.
Those hopes
are now dashed. War, inflation and looming elections mean a perfect storm is
brewing, one that threatens to buffet the economy on multiple fronts.
Prime Minister
Mario Draghi was upfront with reporters after a summit of EU leaders in
Brussels on Friday on shifting expectations.
"In
the euro area, mainly due to energy prices and inflation in general, the
forecast for the economy is for a slowdown somewhat in all countries," he
said. Italy's economy is still doing "relatively well," particularly
thanks to a boom in tourism, Draghi said, but he added that it'll be important
to sustain citizens' purchasing power to maintain "social peace."
Gas woes
After Italy's
output fell nearly 9 percent during 2020, it rebounded by over 7 percent last
year and was poised for above-average growth this year, carried by pent-up
demand. But war, squeezed supply chains and energy price spikes changed that
outlook drastically, slashing forecasts for 2022 GDP growth to 2.4 percent,
according to the Commission, down from the 4.1 percent previously expected.
The economy
could contract further if Russia, after reducing gas supply by 40 percent,
decides to close the tap altogether.
Italy still
depends on Russia for around a quarter of its gas needs. While this is down
from 40 percent last year, Italy remains the second biggest European gas buyer
after Germany. So a total halt in supply could trigger shutdowns and layoffs.
“The number
one risk that currently exists in the European and Italian economy, in
particular, is the risk that we get the full disruption of supply in natural
gas,” said Filippo Taddei, chief economist for Southern Europe at Goldman
Sachs.
Under that
scenario, GDP would drop by 2 percentage points in the eurozone on average,
with the most gas-reliant countries — Germany and Italy — shrinking further
into negative territory, he said.
"Investment
drops, consumption drops, and as a consequence you get into a recession,"
he added.
That fear
is widespread in Italy. Confindustria, the top business lobby, similarly
projects that a halt to gas supplies would mean a 2 percentage point hit to GDP
in both 2022 and 2023.
That
scenario is why the government in Rome is now scrambling to find alternatives,
pursuing gas deals with other countries, including Qatar, Angola and Algeria.
It's also maximizing the use of its coal plants to save gas in a bid to ensure
energy security in case of a full Russian shut-off.
The
country’s gas storage is just over half full, but if Russia keeps reducing
flows, Italy may struggle to reach its objective of 90 percent capacity by
November, in time for the winter.
There's
also the inherent risk of worsening energy-price inflation: The more supply
shrinks, the more energy prices spike.
Italian
inflation rose to nearly 7 percent in May, the highest level in over two decades
— largely driven by energy prices. In an effort to mitigate eye-watering
utility bills, Rome wants to impose a price cap on Russian gas imports — but
the idea has yet to win over other EU capitals, who fear it could cause even
more retaliatory action by Moscow.
Draghi's
retort is that Russia is already slashing supplies to Europe, sending gas
prices higher and resulting in a situation where Russian President Vladimir
Putin "cashes in more or less the same, and Europe is having immense
difficulties," he said Friday.
That
tightening feeling
Rome is
also nervously eyeing the European Central Bank, which is expected to tighten
monetary policy to counter the eurozone's red-hot inflation. The bank is ending
its net bond buys — which it ramped up during the pandemic to keep interest
rates low and borrowing easy — and is set to increase interest rates in July,
followed by a second hike in September that may be even bigger.
These plans
have set off market turmoil, with stock indices plunging and bond yields rising
on expectations of higher rates. Italian debt has been specially hard hit. The
difference between yields on Italian 10-year government bond and its German
equivalent, the ultra-safe bund, has risen to levels unseen since 2020,
prompting concerns in Rome that the famous "spread" that commanded
Italian headlines during the sovereign debt crisis is back.
The
European Central Bank is expected to tighten monetary policy to counter the
eurozone's red-hot inflation
After the ECB
called an ad-hoc meeting last week and announced that it's developing a new
tool to limit the divergence in eurozone borrowing costs, that difference in
German and Italian yields narrowed, as concerns over Italy's creditworthiness
eased. But markets will watch carefully as the ECB unveils its rate hike in
July and more details on the tool itself.
"I
don't think markets are testing Italy right now," said Taddei.
"They’re testing the commitment of the ECB."
Even if the
ECB hikes further and the financing conditions of the eurozone's most
heavily-indebted countries worsen, yields aren't likely to rise to the point of
calling into question Italy’s ability to pay its debts, many economists concur.
That’s
because Italy's current GDP growth rate is still strong enough to whittle away
at its large debt-to-output ratio — at 150 percent in 2021 — even if it runs a
budget deficit. Much of that debt is financed at very low interest rates and at
long maturities, with an average of seven years. Taken together, all this buys
Rome time.
"One
should be very clear about the timeframe," said Klaus Regling, the managing
director of the European Stability Mechanism, at a recent event in Brussels.
"To expect any debt crisis in two, three, five years because interest
rates go up — it’s just totally unrealistic."
But top
Italian officials remain uneasy regarding rising financing costs, with Bank of
Italy Governor Ignazio Visco calling current yield spikes
"unjustified."
It seems
that the famous "Draghi put" that kept Italy’s bond market quiet for
over a year is wearing off.
All eyes on
2023
In his time
as prime minister, Draghi’s main job has been to make good on commitments that
Italy undertook under the EU’s recovery fund, which disburses billions in
return for structural reforms.
But that
task is becoming more and more challenging ahead of next spring, when Italians
go to the polls. Those election results will have direct consequences on the
country’s long-term growth prospects and on the willingness of any future
government to steer the country’s finances to healthier territory.
Signs of
electoral posturing are already apparent. Last week, the largest party in
parliament, the populist 5Star Movement, split over providing weapons to
Ukraine. These stunts will only increase as elections approach and parties vie
for votes, and Draghi might find it difficult to keep his supporting majority
focused on the reform agenda.
“If these
frictions affect the degree of implementation of the recovery fund, they could
turn out to be more material,” said Taddei.
At this
point, a coalition of right-wing, eurosceptic parties — Brothers of Italy and
the League — are polling at nearly 40 percent, giving them a lead over a
leftwing alliance of the Democratic Party and the 5Star Movement, according to
POLITICO's Poll of Polls. An EU-bashing government is unlikely to willingly
conform to Brussels’ demands for fiscal self-control, which could spell further
trouble for the economy.
"[If]
you have a stable government that will push through the reforms and has the
support of the broader public, then ... a reasonable government can prevent a
debt crisis," said Stefan Kooths, vice president of the Kiel Institute for
the World Economy. "But if the message goes the other way around, and
there is a very weak government or the populist parties win the next elections,
making things even worse, then it becomes critical," he added.
"It's
completely in the hands of Italian voters."
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