Italy Faces Lower Growth, Higher Inflation Than Euro-area Peers; EU Funding Should Help Avert Stagflation

The prolonged Russia-Ukraine war will adversely affect all countries dependent on Russian oil and gas. Economies with large international manufacturing sectors are also exposed to disruption of global supply chains from China’s continued zero-Covid strategy. In Europe, Italy (rated BBB+/Stable) is among the most vulnerable, alongside Germany.

Given Italy’s energy dependence on Russia – with Russia accounting for 50% of Italian coal, 40% of gas and 17% of oil consumption during 2020 – the EU’s increasingly tough sanctions of Russia, set to incorporate oil by the end of the year and possibly gas medium run, dim prospects for growth and stable price evolution over years 2022-24.

Effects of EU sanctions of Russia will prove far from temporary for Italy

Regardless of government efforts to substitute Russian oil and gas near term, which would only partially offset immediate impact of an embargo, absence of cheap and available substitutes currently at required scale will necessarily result in higher inflation and lower output over coming years. We believe the impact of the EU’s sanctions of Russia for Italy will prove far from temporary.

As such, Scope Ratings has revised downward growth forecasts for Italy for 2022 to around 2.0%-2.5% from about 4% before the war. For 2023, we expect growth of around 1.5%-2.0%. As a result, Italy will reach pre-pandemic output only by Q4 of this year.

Figure 1. Weakening growth and inflation outlooks
Average 2022-26, %

A growth baseline for this year of 2.0%-2.5% implies average quarterly growth of 0% for the remainder of this year. After Italian real output contraction of -0.2% during Q1 this year, zero growth for remaining quarters would presently result in 2.2% annual growth given favourable base effects.

Baseline projections assume no gas shortages

Critically, our baseline economic projections assume no gas shortages. Should these materialise in line with Banca d’Italia’s adverse macro-economic scenario, the economy would contract by 0.5%-1.0% in 2022 and 2023, while inflation would increase to circa 8% in 2022.

Under such a stressed economic scenario, assuming annual growth of around 1% and inflation of around 3% for 2023-26, broadly in line with latest IMF forecasts, Italy would experience the most adverse combination of low growth and high inflation dynamics among large, advanced economies – a reflection of near-term vulnerabilities to surging energy prices and weak medium-run growth prospects.

Italy’s inflation rate in April stood at 6.2% YoY, down from 6.5% in March, pointing to early signs of peaking of price pressure. Still, even under a very unlikely scenario of convergence towards a 2% inflation rate by year-end, Italy’s annual inflation rate would average about 4.5% for the 2022 calendar year. The energy price index component rose about 70% YoY over a past three months.

We estimate medium-run growth potential of about 0.8%, supported by EU funding

Looking at the medium-run economic outlook, we estimate Italy’s medium-term growth potential at about 0.8%, incorporating declining working-age population projections and modest productivity improvement. This compares with the IMF’s medium-term growth estimate of only 0.5%, significantly below the government’s own forecasts for medium-term growth of around 1.4%.

Italy’s growth prospects would be even worse, with stagflation over 2022-23 a more likely outcome, were it not for the EU’s significant, and now very timely, recovery financing. The EU is set to disburse about EUR 70bn, or about 4% of 2021 GDP, for Italy over 2022-24 under Next Generation EU, equivalent to an annual boost of output of around 0.5% of GDP.

In addition to direct EU stimulus, associated reforms of Italy’s tax system, judiciary, public administration and competition ought to gradually bolster the economic growth outlook, potentially adding more than 10pps to real output over a long run, according to government estimates.

Still, despite frontloading of targets related to reforms under the Mario Draghi government, implementation of growth-friendly reforms after 2023 might falter ahead of next year’s elections, particularly given Italy’s fragmented political environment, which weighs on the medium-run growth outlook and informs our conservative growth estimates.

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Alvise Lennkh is the Deputy Head of Sovereign and Public Sector ratings at Scope Ratings GmbH. Giulia Branz, Analyst at Scope Ratings, contributed to writing this commentary.