Italy: Strong Rebound is Underway; EU Funds to Help Raise Medium-Run Growth Potential

We forecast a robust Italian rebound this year and next, with the rating agency I represent raising a 2021 growth estimate to 6.1% from an already above-consensus estimate of 5.6% we had forecasted previously since December 2020, while we kept for the present an estimate of growth in 2022 of 3.8%. The Italian economy shrank by 8.9% in 2020.

However, the medium-run growth potential of Italy as the EU’s third biggest economy remains modest given domestic bottlenecks in part relating to an ageing population, tepid productivity growth alongside risk that sizeable EU funding is absorbed only incompletely or ineffectively.

Here, we see after 2022 a gentle moderation of Italy’s annual growth in direction of a potential rate of around 0.8%, the latter revised modestly up from an estimate of the economy’s medium-run growth potential of 0.7% we had held prior to the Covid-19 crisis.

Public investment and economic adaptation to the virus support economic growth potential

The expected growth-enhancing effects of extra public investment post-crisis and economic adaptation to coexisting with the SARS-CoV-2 virus, curtailing some associated longer-term economic scarring effects, support the more optimistic assessment of the economy’s medium-run potential.

But any more significant increase in Italy’s growth potential might hinge upon Prime Minister Mario Draghi maintaining current momentum in deep-rooted structural reforms – in competition policies, enhancing fiscal and social safety nets, labour market reform, after a first set of judicial reform was achieved. Maintaining the cohesion of this government of national unity remains crucial after such actions had for decades eluded policy makers amid frequent changes in government.

Continued robust growth expected over the second half of this year although risks have settled on the horizon

We should see continued robust growth over the second half of this year if Italian households continue spending some of the forced savings accrued during successive lockdowns, further progress is achieved with vaccination of residents and investment stimulus from the Next Generation EU recovery programme begins flowing in over coming months.

However, we also acknowledge that there are downside risks to the economic outlook moving ahead as Covid-19 cases have climbed due to transmission of the Delta variant, potentially restricting some economic activities, plus the possibility of a harsher winter flu season.

Nonetheless, Italy’s Q2 GDP came in at double consensus estimates at an elevated 2.7% on quarter, largely in line, however, with our estimate for the quarter.

A large beneficiary of EU funds

For the medium-run outlook, Italy is one the largest beneficiaries from the Next Generation EU plan, particularly important given low levels of investment since the global financial crisis.

Inflation is another factor. Italy’s inflation rate, at 0.9% YoY in July, is running well under the euro area’s (2.2%) and is likely to continue underperformance even though we might consider much of current low inflation of Italy to associate with transitory factors and Italy’s inflation medium run is likely to rest above a 0.7% pre-crisis rate.

Higher but still comparatively modest levels of medium-run nominal growth

Higher real and nominal growth for Italy is anticipated as compared with rates from before the Covid-19 crisis, but the nominal medium-term trend will nonetheless remain comparatively modest at around 2%, representing an ongoing constraint for debt sustainability.

After all, real growth averaged only 0.3% over a 2010-19 decade (with nominal growth of 1.3% on average over this period), while an expected 0.5% annual decline in the working-age population over 2021-26 remains a significant economic headwind.

Italy’s 10-year yield level trades currently near its historic lows, at below 0.6%, helped by ECB support, despite the significant increase in the country’s government debt by the equivalent of nearly 25% of GDP since the crisis started.

The next review of Scope Ratings’ BBB+/Negative Outlook sovereign ratings of Italy is on 20 August.

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Dennis Shen is a Director in Sovereign and Public Sector ratings at Scope Ratings GmbH. Giulia Branz, Analyst at Scope Ratings, contributed to writing this commentary.