Italy’s new Prime Minister Draghi has made it clear that his government will be reformist and pro-European. In his remarks to Parliament when seeking a vote of confidence he laid out his government’s intention to focus on the structural issues that have dogged Italy’s economy over the last two decades.
So far, Draghi’s agenda has been short on specifics. But education, the gender gap, environmental issues, corruption, institutional reforms, and tax reform have all emerged as target areas. While this list comes as no surprise, it is a good starting point for a country that has failed to produce a truly reformist government for 20 years and whose economy is expected to return to 2008 GDP levels only after 2025. What is more, Italy’s economic activity has consistently trailed that of the eurozone for years, with Italian structural stagnation and its high public debt regularly cited as one of the main worries for the stability of the monetary union (Figure 1).
Our baseline won't change immediately
Draghi’s goal of charting an ambitious reform course for Italy will face plenty of obstacles over the coming years and will require future governments stick to the path to have any chance of success. But in the immediate future, the two main constraints are how long this government will last and if it will be able to maintain strong political support over the next few months. Our view remains that at some point the reality of Italian politics will resurface. In fact, itis not difficult to envisage a scenario in which – after vaccinations are rolled out and the economy is firmly on a recovery path – some political parties () withdraw their support and ask for new elections.
This could happen as early as next spring after the appointment of Italy’s next President, which admittedly could be Draghi himself. The history of Italy’s other technocrat governments (such as those led by Mr Ciampi and Mr Monti) shows that one year is the likely limit for this type. While some may hope that a government led by Mario Draghi would last until the end of the current legislature in 2023, we are not sure this time will be different.
Furthermore, the short-term outlook for the Italian economy remains clearly tied to two developments: the unfolding health situation and accessing the EU’s fiscal support fund. While a Draghi administration could stray from the previous government’s line on both, itis difficult to see Italy changing course in the middle of a pandemic. In the short term, we also do not expect a government of national unity to drastically alter fiscal policy, which we expect to remain accommodative in 2021. In his speech, Draghi stated the need to be selective to avoid propping up failing ‘zombie’ firms, but still committed to further stimulus to protect firms and employees.
For these reasons, we do not plan to adjust our outlook on Italy in the baseline forecast. Still, itis important to recognise the potential for an upside scenario if a Draghi government is able to set the stage for institutional and economic reforms that are subsequently built on in the next few years.
Upside scenario: economic and structural reforms in Italy
Using our Global Economic Model, we have developed an illustrative upside scenario for Italy. The main underlying theme of this scenario is that Draghi is able to set Italy on a path of structural reform that subsequent governments follow. The main assumptions are summarised in Figure 2 below and listed in the appendix.
Fonte: Oxford Economics
- Investor sentiment improves. Under this assumption, the Italian 10-year government bond yield spread versus the German bund broadly remains at low level (90bps) this year, before increasing only marginally in 2022 to 100bps, versus our baseline that sees the spread rising steadily to around 200bps. Yields on Italy’s bonds would be in line with what we expect for Spain, with investors assessing the two countries’ risk premia as broadly similar. We also assume that Italy’s redenomination risk premium will decrease substantially. Indeed, some parties (such as Lega) which have been advocates for a euro exit are now supporting this pro-European government. We assume they would continue to do so in the coming years.
- Faster implementation of the EU Recovery Fund. Previously, wehave noted that Italy has had persistent difficulties in spending European resources and it lacks institutional preparedness, indicated by persistently poor public sector performance and institutional quality indicators. Particularly For these reasons, our current baseline assumes a much slower absorption of the funds than the government projects, at least for the first few years. But in the upside scenario, we assume that reformist governments in Italy will be able to solve these issues, with a better target for the recovery fund and a much quicker absorption than in our baseline, with the government able to spend all the money by the end of 2025.
- The gender gap is reduced. In Italy, the number of women in the labour force remains low due to a combination of cultural and structural factors. Even though there are no significant differences in the level of education between men and women, the lack of family-friendly policies, low career expectations, subdued growth, and high pay gaps drag heavily on female participation. The female participation rate, at 56% in 2019, is 20ppts lower than that for males (Figure 3). In our upside scenario, we assume that Italy follows the example of other countries in Europe, such as Spain in the early 2000s, gradually reducing this gap to around 10ppts over 10 years. Despite the improvement, the overall participation rate in the scenario would still be lower than our baseline estimates for other large eurozone economies (Figure 4).
- The quality of institutions is improved. Italy has long been seen as a laggard because of its poor institutional quality. While difficult to measure directly, some proxies can help gauge the distance between Italian institutions and those of its European peers. The World Bank’s governance indicators show that the quality of Italy’s institutions is among the lowest in the eurozone (Figure 5). What is more, other alternative measures such as the length of a judicial trial or processes for enforcing contracts (Figure 6 and 7) confirm the terrible performance of the Italian administrative system. Draghi has highlighted the need to speed-up judicial trials and fight against corruption. In the upside scenario we assume that his and subsequent governments would gradually tackle these long-standing issues. Clearly this is not an easy task, but other countries have shown that progress is possible. We assume that the improvements in the World Bank’s governance indicators shown in Figure 5, which are then used in our model for building a measure of institutional quality, are in line with the best performers among the eurozone countries.
- Better educational quality. Draghi has mentioned several times in his speech the need to improve the education system, to better meet the needs of the labour market. In our scenario we use average years of education as a proxy, and assume the period increases at a quicker rate than in our baseline.
- Additional fiscal easing as the debt burden becomes less heavy. All the measures above would already contribute to much better fiscal metrics than in our baseline, as they push up potential output. In the upside scenario we assume there is scope for additional fiscal spending. Via higher government investment and spending, we estimate a primary surplus of around 3% of GDP in 2030-2040, broadly double that in our current baseline. Still, due to much stronger growth and despite lower inflation (Figure 8), the debt to GDP ratio decreases at a much faster pace than in the baseline (Figure 9).
Overall, under these assumptions Italian GDP would almost double its annual pace of growth over 2021-2040, from 0.7% in the baseline to 1.3%. The level of GDP would be around 12% higher than in the baseline in 2040. Stronger supply in the economy would result in faster employment creation, with the number of employed up by 1.5 million by the end of 2040. Moreover, one of the most important takeaways under this optimistic scenario is that Italy’s debt sustainability would drop down the list of Europe’s key worries, with public debt dropping to 120% of GDP in 2040, and around 95% of GDP in 2050. This is 30ppts lower than in the current baseline.
Both supply-side and demand-side stimulus would push up actual GDP as well as potential output. The main contributors to the stronger GDP profile are the increase in the participation rate and the improvement in the Italian institutional framework (Figure 10). Both directly affect the currently subdued potential output. However, while the new growth dynamic would be considerably higher than in our baseline (Figure 11), it would be only enough to prevent a widening in the gap with the rest of the eurozone (Figure 12).
Our scenario is, by definition, a simplification of what could happen in the Italian economy. As with most models, it does not differentiate between a bad government investment or a good one, nor does it explicitly take into account the economic costs of supply-side reforms.
Still, it is a useful guide to quantify the potential benefits of Draghi-style structural reforms. What’s more, our results show that regardless of the political orientation of government, the critical issue for Italy continues to be solving its structural issues. Doing so would not only be hugely beneficial for the country itself, but it would also help Italy stop being considered the eurozone’s main liability and a permanent threat to the stability of the union.
Appendix – Calibration of the upside scenario
Here we summarize the steps taken in creating our upside scenario:
- Italian 10-year government bond yield spread (RLG_SPREAD) increases only marginally from the current level and stabilizes at around 100bps after 2021, in line with the 10-year government bond yield of Spain.
- The Recovery fund has a much faster absorption than in baseline. Different from the baseline, we assume higher government investment (GI) over a much shorter time horizon (2021-2025).
- The implied gender gap participation rate is reduced by 10ppts, with the overall participation rate (PART) gradually increasing over the next 10 years.
- The quality of Italy’s institutions (INSTIT) improves over the next 10 years, in line with the average of the first quartile for eurozone countries for the four subsectors for which Italy is well-behind the eurozone peers.
- Average years of education (EDUCAVE) increases at a quicker rate than in the baseline and reaches 15 at the end of the scenario simulation (2050).
- Additional fiscal easing in government consumption (GC) and government investment (GI), from mid-2020, targeting a government debt as a % of GDP of around 95% in 2050 and a primary surplus (GBPRIM%) of around 3% of GDP.