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Italy’s smooth sailing is about to come to an end.
A combination of factors – its Prime Minister’s ‘Super Mario’ brand, negative interest rates and the potential to spend nearly €200bn in EU recovery funds – meant that the third-largest economy in the EU was heading for strong growth this year after being crushed during the pandemic.
These hopes are now dashed. War, inflation and impending elections mean a perfect storm is brewing that threatens to shake the economy on multiple fronts.
Prime Minister Mario Draghi was candid with reporters after a summit of EU leaders in Brussels on Friday on changing expectations.
“In the euro zone, mainly due to energy prices and inflation in general, the forecast for the economy foresees some slowdown in all countries,” he said. Italy’s economy is still doing “relatively well”, notably thanks to a boom in tourism, Draghi said, but he added that maintaining citizens’ purchasing power will be important to maintain “social peace”.
After Italian production fell nearly 9% in 2020, it rebounded more than 7% last year and was on course for above-average growth this year, buoyed by pent-up demand. But war, tight supply chains and soaring energy prices have drastically changed this outlook, reducing the GDP growth forecast for 2022 to 2.4%, according to the Commission, from 4.1% previously. expected.
The economy could contract further if Russia, after cutting gas supplies by 40%, decides to turn off the tap completely.
Italy still depends on Russia for about a quarter of its gas needs. Although this figure is down from 40% last year, Italy remains the second largest European gas buyer after Germany. Thus, a total supply shutdown could trigger closures and layoffs.
“The number one risk that currently exists in the European and Italian economy, in particular, is the risk of a total disruption of the supply of natural gas,” said Filippo Taddei, chief economist for Southern Europe. at Goldman Sachs.
In this scenario, GDP would fall by 2 percentage points on average in the euro zone, with the countries most dependent on gas – Germany and Italy – shrinking further into negative territory, he said.
“Investment drops, consumption drops, and as a result you go into a recession,” he added.
This fear is widespread in Italy. Confindustria, the main business lobby, similarly predicts that a gas supply shutdown would mean a 2 percentage point drop in GDP in 2022 and 2023.
This 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 is also maximizing the use of its coal-fired power plants to save gas in a bid to ensure energy security in the event of a complete Russian shutdown.
The country’s gas storage is just over half full, but if Russia continues to cut flows, Italy could struggle to reach its target of 90% capacity by November, in time for the winter.
There is also an inherent risk of worsening energy price inflation: the lower the supply, the higher the energy prices.
Italian inflation hit almost 7% in May, the highest level in more than two decades, mainly due to energy prices. In an effort to assuage sky-high utility bills, Rome wants to impose a price cap on Russian gas imports – but the idea has yet to convince other EU capitals, who fear it could cause more reprisals from Moscow.
Draghi’s retort is that Russia is already cutting supplies to Europe, driving up gas prices and leading to a situation where Russian President Vladimir Putin “more or less cashes in on the same thing, and Europe is feeling the pain.” ‘tremendous difficulties,’ he said on Friday.
This tight feeling
Rome is also watching nervously at the European Central Bank, which is expected to tighten monetary policy to counter runaway eurozone inflation. The bank ends its net bond purchases – which it intensified during the pandemic to keep interest rates low and facilitate borrowing – and is expected to raise interest rates in July, followed by a second hike in September which could be even greater.
The plans sparked market turmoil, with stock indices plunging and bond yields rising on expectations of higher rates. Italian debt was particularly affected. The difference between yields on Italian 10-year government bonds and its German equivalent, the ultra-safe bund, has reached levels not seen since 2020, raising fears in Rome that the notorious “spread” that has made Italian headlines during the sovereign debt crisis be back.
After the ECB convened an ad hoc meeting last week and announced that it was developing a new tool to limit the divergence in eurozone borrowing costs, that difference between German and Italian yields narrowed, concerns over Italy’s solvency have subsided. But markets will be watching closely as the ECB unveils its rate hike in July and more details on the tool itself.
“I don’t think the markets are testing Italy right now,” Taddei said. “They are testing the ECB’s commitment.”
Even if the ECB increases further and the financing conditions of the most indebted countries in the eurozone deteriorate, yields should not rise to the point of jeopardizing Italy’s ability to pay its debts, agree say many economists.
Indeed, Italy’s current GDP growth rate is still high enough to reduce its large debt-to-output ratio – to 150% in 2021 – even with a budget deficit. Much of this debt is financed at very low interest rates and at long maturities, with an average of seven years. Taken together, this all saves Rome time.
“You have to be very clear about the timetable,” Klaus Regling, managing director of the European Stability Mechanism, said at a recent event in Brussels. “To expect a debt crisis in two, three, five years because interest rates are going up is just totally unrealistic.”
But senior Italian officials remain worried about rising funding costs, with Bank of Italy Governor Ignazio Visco calling the current yield spikes “unwarranted”.
It seems that the famous “Draghi put” that kept the Italian bond market calm for more than a year is fading.
All eyes on 2023
As prime minister, Draghi’s main job has been to deliver on Italy’s commitments to the EU’s recovery fund, which disburses billions in return for structural reforms.
But this task becomes increasingly difficult before next spring, when the Italians go to the polls. These election results will have direct implications for the country’s long-term growth prospects and any future government’s desire to steer the country’s finances towards a healthier territory.
Signs of electoral posturing are already apparent. Last week, the largest party in parliament, the populist 5 Star Movement, split over the supply of arms to Ukraine. These stunts will only increase as elections approach and parties compete for votes, and Draghi may struggle to keep his majority of support 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,” Taddei said.
At this point, a coalition of right-wing Eurosceptic parties — Brothers of Italy and the League — are voting nearly 40%, giving them a lead over a left-wing alliance of the Democratic Party and the 5 Star Movement, according to POLITICO’s Poll. of Polls. An EU-bashing government is unlikely to voluntarily comply with 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 general public, then … a reasonable government can prevent a debt crisis,” said Stefan Kooths, vice president of the Kiel Institute for Economics. world. But if the message goes the other way, and there is a very weak government or populist parties win the next election, which makes it even worse, then it becomes critical,” he added. .
“It’s entirely in the hands of Italian voters.”
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