As widely anticipated, yesterday’s general election in Italy resulted in a hung parliament. The incumbent, centre-left government of Paolo Gentiloni lost ground to centre-right populist parties. The populist and eurosceptic Five Star Movement (M5S) earned the greatest share of the popular vote in the lower chamber at 32.5%, but is unlikely to form part of a new coalition government. Instead, a coalition of four centre-right, soft eurosceptic parties that altogether earned about 37% of the popular vote, is favoured to form government after negotiations conclude in the coming weeks or even months.
With 65 governments elected in the last 72 years, political uncertainty is not new to Italy. As such, businesses and the economy more broadly have adapted to operate in an environment of elevated political uncertainty. Overall, the potential for a long process of forming a new coalition government coupled with a likely election within the next year is not expected to have a material negative impact on the Italian or Euro Area economy.
With the election turning out as expected, financial markets largely shrugged off the news, with the only indication of concern registering in a 1.1% decline in Italian equities (FTSE MIB). In the three weeks leading up to Sunday’s election, the spread between Italian 10-yr bonds and German bunds rose to about 140 bps from a 16 month low of 126 bps. As of the time of writing, the bond spread is still roughly at 140bps. Moreover, the euro exchange rate with the U.S. dollar has held steady, a sharp contrast to moves preceding and following Dutch and French elections last year when there was fear that anti-EU candidates might form government.
Italian Economy Slowly Improving, Budget Finance a Key Priority for next Government
Italy’s economy continues to recover from the 2009 Great Recession and the Euro Crisis that followed. Indeed, 2017 recorded the fourth consecutive year of well-above trend growth. Unemployment rates continue to fall, but at 11% remain about four percentage points above the pre-2009 average. Further structural challenges include the need to better integrate the young, women, and immigrants into the labour force. More progress is also required on the resolution of non-performing loans in the banking sector, which is impairing the flow of credit into the economy.
Chronic general budget deficits have driven Italy’s debt-to-GDP ratio to 140%, the second highest in the Euro Area after Greece. General government expenditures have posted strong deficits equivalent to over 4% of GDP on average over the past few years, reflecting legacy debt service payments amongst other factors. In contrast, but similar to its fiscally distressed neighbours, Italy’s cyclically adjusted primary budget balance as a percentage of GDP has been strongly positive over the past decade.
Despite positive primary budget surpluses, weak underlying economic growth makes it difficult for governments to raise revenues to pay off legacy debts. Add the challenge posed by tight fiscal rules set by the European Union, and fiscal policy since the 2009 financial crisis has left policymakers with little room to maneuver to aid the Italian economic recovery.
Long-term Challenges Need to be Addressed
As with much of the Euro Area, an aging labour force is putting pressure on government finances through rising old-age dependency ratios. However, with low fertility rates and the election of a centre-right coalition that includes parties that strongly oppose migrant labour, the demographic situation is unlikely to see much improvement in the near-term.
Productivity growth has been notoriously weak in peripheral Europe, and Italy is no exception. With negligible productivity growth since the introduction of the euro in the early 2000s, there is a sense of urgency for Italy to undertake structural labour and product market reforms that should boost trend productivity growth. However, the lack of a strong government mandate will make reforms difficult to achieve in the near-term.
Overall, these headwinds combine to hold the trend pace of growth near zero percent, all but ensuring that Italy will continue to find it a challenge to bring down its debt-to-GDP ratio. And, with planned fiscal spending by a centre-right coalition to the tune of €161 billion, it may not be long before financial markets once again start to panic about peripheral European debt.
