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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.”
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.
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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.
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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