The impact of the COVID-19 outbreak on the Italian economy
- Italy’s GDP is expected to fall between 8% and 10% in 2020
- The government is implementing massive fiscal stimulus
- There are sectors and businesses that have been growing despite the lockdown
- The sustainability of Italy’s government debt has been called into question
On Monday 18 May, Italy emerged from the strict two-month lockdown imposed by the government in the wake of the COVID-19 pandemic. Most businesses, including shops and restaurants, were allowed to resume their activities after it became apparent that the spread of the disease had slowed down significantly.
The sudden and nearly full interruption of economic activity will lead to an unprecedented drop in Italy’s GDP for 2020. The European Commission (EC) forecasts that GDP will contract by 9.5%. Only Greece is expected to deliver a worse performance. The estimate seems in line with the most recent readings as Istat, the country’s national statistics institute, recorded a 28% fall in industrial activity during March.
In an equally unprecedented effort to respond to the crisis, the Italian government allocated a huge amount of fiscal resources. Three major packages were approved to support the economy: the ‘Cura Italia’, ‘Liquidità’ and ‘Rilancio’ decrees. These will generate net borrowing to the tune of 7.1% of GDP, according to the government. However, the overall amount of financing that the government has mobilised through state guarantees and tax relief is far greater, exceeding 50% of GDP.
Fiscal expansion will lead to a huge increase in the country’s debt-to-GDP ratio. The EC forecasts that it will reach 158.9% by the end of this year, from 134.8% at the end of 2019.
For institutional investors, understanding the impact of the COVID-19 pandemic on Italy’s economy matters for a variety of reasons.
Italy was not the first European country to lift lockdown restrictions. But as the first European country to be hit by the outbreak, owing to its strong commercial ties with China, it was the first to impose such punishing restrictions. For a long time it was the hardest-hit by the spread of the disease. In that sense, Italy can be seen as a worst-case scenario.
Italy is also the testing ground for the EU’s response to the crisis, which consists of an unprecedented effort in terms of fiscal and monetary policy.
The surge in public debt raises questions over its sustainability. This is a problem not just for the country’s future economic development but for Europe as a whole. An escalation of the euro-zone debt crisis would be a serious threat for the continent’s economic and political stability.
How the country deals with the aftermath of the pandemic is a key factor in determining the performance of the European economy as a whole.
The outlook looks bleak but there are glimmers of hope, according to economist Fabrizio Pagani, global head of economics and capital market strategy at Muzinich, the specialist credit investment manager.
Pagani, who served as chief of staff in the Italian finance ministry during the Renzi and Gentiloni governments, says: “The Italian economy is a very diversified one. It does not rely on individual sectors or companies. That means there are areas of the economy that can continue to work countercyclically. Furthermore, while Italian companies have been facing a cash-flow problem, they tend to have a good balance sheet.”
Pagani, who was also a non-executive director at Italian oil and gas giant ENI, points out that certain sectors have continued to grow during the lockdown. “Italy has very strong pharmaceutical and healthcare sectors. The food processing industry also performed strongly. I am actually optimistic about the ability of businesses to adapt,” says Pagani.
Certain key sectors, tourism in particular, will be hit hard, but the critical situation could lead to consolidation and reduce fragmentation, creating the conditions for long-term growth and supply of higher-quality products.
One specific weakness relates to Italy’s heavy bias towards exports, according to Pagani. He says: “The country depends on exports in a massive way, and we might see disruption in international trade. Tensions in this area will not help the Italian economy. On the other hand, the country may benefit from the reshoring of industrial production. Many Italian entrepreneurs offshored production in the years after the  financial crisis and now they are questioning the viability of global supply chains.”
However, Pagani says the opportunity for investors in Italy are many, particularly for those looking for private-market investments.
While it is self-evident that different sectors will be affected differently by the lockdown, identifying which sectors could drive a potential recovery is more difficult. Luca Bucelli, country head for Italy at the €25.4bn private markets manager Tikehau Capital, sees three areas of possible growth: digitalisation, healthcare, and sustainability.
“It is important, especially for private capital, to back businesses that operate in those areas. The lockdown has seen technology among the winners. However, while Italy is strong in mechanical engineering, it is weaker in software development,” says Bucelli.
“The healthcare sector, in the broadest sense, stands to benefit from this crisis. As a way to leverage both opportunities, we have recently invested in a firm that produces software for hospitals. But there are also opportunities in life sciences, a sector in which a number of Italian SMEs are leaders for their respective fields. As for Italy’s automotive sector, it is important for businesses to move towards sustainability, which is the next frontier.”
Investors in private equity and debt have looked at the vast range of Italian SMEs with interest for many years. Bucelli says that prior to the crisis there was a clear trend of family-owned businesses turning to institutional investors for growth capital.
“Business owners see the benefits from the level of professionalism and drive for internationalisation that institutional ownership brings. Minority ownership by general partners [GPs] has become more commonplace as a way to dispel entrepreneurs’ fears of excessive external control,” he explains.
“The share of private institutional capital in the economy is lower in Italy than other European countries but the trend is positive. Before the lockdown there was excess demand for transactions. The crisis is an opportunity to accelerate the institutionalisation trend.”
During the lockdown, the private capital market did not cease to function, according to Bucelli. “During the first phase of the lockdown our primary concern was making sure our investee companies had sufficient liquidity, and that we were relaying that information to our GPs. After that, we continued looking at potential opportunities, and most recently we have closed a number of transactions.”
Standing in the way of a recovery is Italy’s huge pile of public debt. The projected rise in the debt-to-GDP ratio, as the government raises external borrowing to finance fiscal stimulus, would be alarming, if it were not for two main factors.
Many EU countries will see their public debt levels rise as their governments implement fiscal measures. At the same time, the renewed quantitative easing (QE) efforts of the European Central Bank (ECB) are easing tensions on bond markets. This is keeping yields on Italian government bonds (BTPs) at affordable levels for the Italian government and speculative attacks at bay for the time being. For the same reasons, rating agencies have not turned overwhelmingly negative towards Italian sovereign debt, maintaining ratings above junk status and outlooks more or less stable.
However, the picture is complicated, to say the least. Pagani says: “It is possible that the international investment community will look at the rise in Italian government debt levels in a more benign way, as average government debt levels in Europe and around the world will rise as well. But it is essential that the government and the EU keep stimulating the economy and that tensions on BTPs are avoided.
“Any spikes or volatility in BTP yields would be very damaging. This is both because they would result in higher costs for the government and be interpreted as a signal that the combined action of the ECB, the government and the EU is not working properly. So far, the reaction of these three actors has been very prompt, but we need to see how the recovery shapes up. It is really difficult to make any predictions because they depend on the development of the pandemic as well.”
Andreas Billmeier, an economist and sovereign research analyst at Western Asset, points out that while debt-to-GDP has historically been used as a measure of debt sustainability, it may be less relevant in the current environment.
Billmeier, who previously worked for the International Monetary Fund, says: “One could argue that what matters is whether Italy can afford the debt service, and one way to determine that would be to look at the share of tax revenue that should go towards debt-servicing costs. Those costs are a function of interest rates and the stock of debt. Italy has massively benefited in the last few years from the drop in interest rates. In that sense, Italy’s debt has almost never been as affordable in recent history.
“You can find ways to make the debt burden look less menacing. Yet, key stakeholders such as rating agencies do look at the debt-to-GDP ratio as an important indicator.”
Billmeier adds: “Whether or not one takes the ratio into account, it does not tell us anything about whether Italy will be capable of reducing the debt stock. Everything the government is doing at the moment, in terms of fiscal spending, seems appropriate. But after the crisis, the country needs to implement a responsible fiscal policy. It needs to go back to running a primary surplus for a long time, but the point is to make the primary surplus large enough to make a dent in the debt-to-GDP ratio. That is something investors with a longer-term view look at.”
For Zsolt Darvas, economist and senior fellow at Bruegel, a Brussels-based think tank, the probability that Italy will experience a fiscal crisis is 50%. While the ECB has acted to calm bond markets, Darvas believes it faces more limitations than under former president Mario Draghi. It already holds about 20% of euro area public debt in its balance sheet, so the scope for additional big increases is limited, due to the EU Treaty-based prohibition of monetary financing. “Support is also conditional to the development of the pandemic. If the pandemic continues, the ECB might be more inclined to extend its QE programme, otherwise at some point it may be limited in terms of its reach,” says Darvas.
“Furthermore, the EU-level instruments that are in place to avert a crisis, such as the European Stability Mechanism, do not have enough firepower to support an economy of the size of Italy.
“If the economy performs more poorly than forecast, which is my expectation, I see a high risk that the market might question the sustainability of Italy’s debt. At the same time, the fact that Italy would struggle to accept a financial bailout with conditions, at least in the initial stages, could accelerate the crisis. Some form of debt restructuring would be the outcome.”
It may take a few years before the risk of a debt crisis is reduced significantly, according to Wouter Sturkenboom, chief investment strategist at Northern Trust Asset Management.
He says: “The ECB can buy Italy the time it needs, if it manages to keep interest rates below the nominal growth rate of GDP. Italy needs that support because on its own the debt is not sustainable. But during that time, Italy needs to enact structural reforms that boost productivity and kickstart growth. Once growth reaches a certain level, debt levels can start declining quite rapidly.
The ECB can buy Italy the time it needs, if it manages to keep interest rates below the nominal growth rate of GDP. But during that time, Italy needs to enact structural reforms that boost productivity and kickstart growth” - Wouter Sturkenboom
“There are short-term risks, such as the possibility that the ECB has to dial down its QE programme as a result of external political pressure. At the same time, central banks globally are going to be under a lot of pressure to provide the circumstances under which the debt that is being incurred can be managed without too much fiscal pain.”
Sturkenboom continues: “That, to me, means financial repression. We have seen it in the past, when governments basically mandated low interest rates, even with robust growth and inflation, in order to inflate the debt away. This is a best-case scenario, however, because it needs inflation to materialise first.”
The pandemic will leave permanent scars on Italy’s economy. But, so far, the international investor community seems to be weighing the situation and the government’s response with the severity of the impact of the lockdown. After all, many countries are experiencing a similar situation.
There are plenty of unknowns but sooner or later the discussion will turn towards the need for structural reforms. Pagani says the priorities for the government, once the economy is back on track, are easing red tape and reforming the tax system. Both are huge undertakings that require not just economic but political stability as well. The lack of stable politics over the past two decades has perhaps hurt the country more than the lack of economic growth.
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