Italy: the worst case scenario

Robert Sierra - 26 July 2017

Much has been written about Italy’s economic woes in recent weeks. The prospect of tighter monetary policy, in particular, could damage Italy’s shaky debt sustainability dynamics while the rise of anti-euro parties in next year’s general election could yet trigger a new euro wide crisis. How worried should we be?

On purely economic grounds, the situation is less worrisome that it first appears, for two reasons. Firstly, it is likely that cyclical growth in Italy will catch up with the euro area average given the country’s still sizeable output gap. More importantly, with recent progress in cleaning up its banking system - a major impediment to growth over the past decade - Italy’s growth outlook has become more benign.

Secondly, even in an extreme scenario, Italy would still be able to manage its debt position. If investors did lose confidence and Italy lost access to the markets, the European Stability Mechanism (ESM), in conjunction with the EC and perhaps the IMF, could in principle provide Rome with an adjustment programme. That programme, in turn, would clear the way for Outright Monetary Transactions allowing the ECB to intervene directly in the Italian bond market.

Italy is not Greece and the fiscal adjustment that would be needed to stabilise the former would be a fraction of what was required from the latter in 2010. Assuming real government borrowing rates of 1,2 and 3 per cent (equivalent to long run nominal yields of close to 3,4 and 5 per cent), figure 1 compares the adjustment in the primary fiscal balance for Italy today with what was requested from Greece seven years ago. If we assume, as the IMF does, that Italy has a potential growth rate of 0.85 per cent then for a real rate of 2 per cent, Italy would need to adjust by close to zero to stabilise its debt. With a real rate of 3 per cent (or 5 per cent nominal) the fiscal adjustment needed would be 1.5 per cent of GDP; last year’s surplus was 1.4 per cent.

That’s fine from a technical viewpoint, but could a populist party disrupt the structural reform and fiscal adjustment of recent years? Three of the four largest political parties are critical of the EU in general and of the Eurozone in particular. But disliking the euro doesn’t necessarily translate into wanting to abolish it. Surveys continue to show that Italians who oppose the single currency are also concerned about the financial and economic implication that would follow if the euro was abolished. And it is this dilemma which puts Italy’s Eurosceptic parties in a quandary.

Criticising the euro is an important part of their populist agenda but they also know that the prospect of leaving the eurozone scares away many voters. While the Five Star Movement talks of holding a referendum they have shied away from including such a policy in their manifesto. Moreover, the Italian Constitution does not allow binding referendums on international treaties. For Italy to leave the eurozone it would first have to amend its constitution but given the fractious state of its politics it would seem unlikely that the government that assumes power early next year could secure enough support in Parliament for a constitutional change.

In short, on economic grounds alone, Italy’s high public debt, rising interest rates and low growth are not an unmanageable problem but it is the prospect of populism that could throw a spanner in the works. So far the populists’ bark has proved to be worse than its bite.

Figure 1

Data source: IMF

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