Italian economy on course to surprise on the upside during the first quarter
Raj Badiani, Senior Economist, IHS Global Insight
Italian economic performance in the fourth quarter of 2016 was generally in line with expectations, with the economy growing for an eighth successive quarter. According to a “flash” estimate from the Statistics Bureau, seasonally and calendar-adjusted real GDP grew by 0.2% quarter on quarter (q/q) in the fourth quarter, compared to a 0.3% q/q gain in the third. In addition, it grew by 0.1% q/q in the second quarter and 0.45% q/q in early 2016.
The annual comparison was far from solid, with real GDP up by just 1.0% year on year (y/y) in both the final quarter of 2016 and the year as a whole. This was preceded by the economy (seasonally and working day adjusted) expanding by 0.6% in 2015 as a whole, a moderate but still welcome turnaround from drops of 0.4% in 2014 and 1.8% in 2013.
IHS Markit had expected growth at 0.2% q/q and 1.0 y/y during the fourth quarter, according to the January forecast, but we had anticipated a slightly stronger performance after notable industrial output gains in the final two months of 2016.
The national statistical office revealed limited detail about fourth-quarter GDP in terms of expenditure, suggesting predominately that a positive contribution from domestic demand offset a negative contribution from net trade. We estimate some modest contribution from consumer spending, with households enjoying solid albeit diminishing income growth during late-2016 and further unleashing of pent-up demand. Meanwhile, with manufacturing sentiment was uneven during the fourth quarter despite firmer output developments and a more competitive euro, and we suspect the investment cycle remained subdued, with some firms continuing to sit on capital projects in the face of disrupted credit channels, still challenging domestic trading conditions and the banking sector tensions.
According to the statistical office, the value-added contributions to growth were positive from services and industry, offsetting faltering agricultural output. Also, they previously reported that the average level of industrial production in the fourth quarter was 1.5% higher than in the third quarter, and we had forewarned that better than anticipated industrial output developments suggested overall economic growth could hit 0.3% q/q during the fourth quarter.
Outlook and implications
The economy is on course to surprise on the upside during the first quarter of 2017, with real GDP probably expanding by around 0.15% q/q, revised up from 0.1% q/q published in the January forecast. The upward adjustment reflects improved manufacturing and services purchasing managers’ index (PMI) data in early 2017 alongside solid gains in industrial output in late-2016. Still, the growth outlook for the remainder of 2017 faces headwinds, while brittle confidence has watered down our previous growth narrative of continued consumer spending gains. The main message continues to be an uncertain outlook, highlighted by still volatile industrial output developments during 2016, confirming that domestic demand conditions remain too fragile to elevate the recovery to a higher and more sustainable plane.
Overall, we expect the economy to by expand 0.6% in 2017 (up from 0.4%) and 0.70% (up from 0.6%) in 2018, according to our yet to be published February forecast update. The upward revision to our 2017 projection reflects the prospect of firmer than previously anticipated growth in the first quarter of the year and moderate upward revision to GDP developments in the first three quarters of 2017.
However, we still remain wary of downside risks facing the country, with consumer and business sentiment under threat from concerns over the health of the country’s financial system alongside the potential for further political disruption after a new interim government was formed after the government lost the constitutional referendum in late 2016 triggering the resignation of Prime Minister Matteo Renzi. In addition, some economic and financial tensions as the Brexit process accelerates added another layer of uncertainty to an already-challenging near-term outlook.
A challenging growth and labour market environment and loss of confidence has diminished our main growth narrative of continued consumer spending gains. The prospect of higher inflation and less generous multi-year wage awards are set squeeze real wages in both 2017 and 2018, and restrain private consumption growth. Indeed consumer confidence faltered during second half of 2016, not helped by the unemployment rate hitting 12.0% in late-2106 and intensifying banking sector tensions
The recovery in Italy will continue to be held back by a lack of new credit flows to nonfinancial firms, with their financial situation already difficult owing to inadequate internal financing as a result of weak pricing power and profitability. Despite a resumption of growth in Italy since early 2015, the investment cycle has failed to sparkle. Italian firms remain reluctant or unable to release pent-up demand for capital goods when faced with lingering obstacles, namely limited access to credit markets, weak pricing powers, significant past income and profit losses, and volatile industrial output developments. The problem remains acute, with Italy swamped with nonperforming loans to nonfinancial firms. Healthier credit flows to the corporate sector is a must, but the Italian government is struggling to resolve the issue of Italian banks swamped with doubtful loans to nonfinancial firms.
However, there are some offsetting positive factors. First, the negative drag from Brexit in 2017 is unlikely to be as severe as we had anticipated initially. Second, the euro has retreated sharply to USD1.076:EUR1 at end-January 2016, compared with USD1.13:EUR1 during mid-August 2016. And further losses are expected during 2017, with the euro expected to hit parity against the USD in the first half of 2018. Clearly, a weaker euro will relieve some of the pressure on Italy’s export market shares from high unit labour cost growth and increased global competition in Italy’s areas of specialisation.
There are some notable downside and a few upside risks to our current baseline assessment
The downside risks are broad-based
- The painful UK departure from the European Union damages trade flows across the region, offsetting the expected boost from a cheaper euro.
- Italy fails to overhaul the banking sector by much needed state aid to help troubled banks and address record-high nonperforming loans alongside further reform and consolidation across the sector. This would signify a major risk to Italy’s medium- and long-term growth potential via repressed lending to firms and households.
- Italy’s fragile economic recovery could be further damaged should a state recapitalization of its banking sector trigger substantial losses for small retail investors, with the main mechanism being a further unwinding of the consumer confidence. Although we still expect further growth in consumer spending in 2017 and 2018. However, we acknowledge the increasing risk to this narrative should Italy be forced to adopt “bail in” rules as a prerequisite of banking-sector recapitalization, damaging household wealth and confidence.
- The collapse of the new interim government results in precarious snap elections in the first half of 2017. Should fresh elections be called at a time of heightened political and financial chaos, the outcome could bring about a populist government led by the Five Star Movement, which is demanding a referendum on Italy’s membership in the European Union. This could deliver a massive blow to Italy, which is already facing significant deep-rooted economic and financial risks.
Economic, financial, and political tensions push Italy into a new sovereign-debt crisis, which damages confidence in Italy and the Eurozone as a whole.
An upside could evolve
- The euro depreciates more acutely in 2017 and 2018 than we are currently anticipating. Clearly, a weaker euro is great news for Italy’s export prowess in the face of high unit labour cost growth and increased global competition in Italy’s areas of specialisation.
- EU sanctions a relatively painless state rescue of struggling Italian banks and the use of taxpayers to fund bad bank to remove toxic loans from balance sheets. Healthier and tighter banking sector is key for the resumption of normal credit channels, essential for accelerating economic growth.
- One of the traditional parties wins comfortably the next general election no later than early 2018, allowing Italy to purse more deep-rooted economic reforms to deal with Italy’s structural problems and boost productivity growth.