Italy: Three Scenarios for 2008

For the second year in a row, Italy’s economic growth will have come close to hitting the 2%Y mark in 2007 — a positive and rare event. On top of that, the Budget for next year has been pushed through Parliament, and the main corporate tax rate is coming down, which is good news for the corporate sector. So perhaps it is not too surprising that most forecasters don’t expect the Italian economy to slow too abruptly, despite the darkening global outlook, and a soft patch in the euro area. Has the Italian economy finally turned the corner?

The global setting is hardly inspiring… We are now predicting a recession in the US next year (defined as two consecutive quarters of negative quarter-on-quarter growth) and we expect a significant slowdown in the euro area, to 1.6%Y in 2008. Tighter credit conditions, steep euro appreciation and higher energy prices are the main reasons why, along with slower external growth, we are predicting a “soft patch” in Europe. We expect the recovery to gather traction in Italy in the latter part of next year, as economic growth picks up across Europe and beyond, and net exports start to contribute positively to growth. Only at that point do we expect domestic demand to strengthen gradually.

…and Italy is no economic powerhouse. Our central forecast is for Italian economic growth to slow to 1.0%Y in 2008, from 1.8%Y this year, but even this may turn out to be too optimistic. The key problem in such a challenging macro environment is that Italy’s potential growth rate is comparatively low (somewhere around 1.2-1.4%Y, on our estimates). This means that you do not need that large a macro shock(s) to push the economy into recession. It is no coincidence that since 2001, Italy has endured three recessions, compared with one in France and none in the UK. Below we explore three scenarios for next year, starting with that of a sharp macro slowdown.

Scenario #1: Recession
A growth recession is a material possibility, our subjective assessment, shown in Exhibit 1, is that risks are skewed strongly to the downside of our central forecast. Even annual GDP growth of 0.5%Y next year has a significant possibility of occurring, as shown by our model’s forecast error bands.

We think that the deceleration is likely to be driven by a combination of slower consumption and investment growth. Our expectation of slower consumption growth stems mainly from a rise in precautionary savings triggered by a more uncertain macro environment. After all, tax pressure has increased and the labour market outlook is likely to react to slower growth both domestically, and globally. Besides, disposable income growth is slowing as wages are barely rising on an inflation-adjusted basis. And static to falling house prices could weaken household consumption further, via negative wealth effects.

On the investment side of the equation, we expect tighter credit conditions to result in slower, but still positive, lending growth, which in turn is likely to dent fixed investment growth. This concern is heightened by Italian firms’ relatively high reliance on banks to finance investments. This is evident by looking at the comparative low rate of internal financing of Italian firms.

Scenario #2: Catch-22 Before New Elections
The Budget has made it through the Senate, but the government coalition remains fragmented, and so is the opposition. The likelihood of an early election seems to be increasing, and the political balance remains as delicate as ever. There is growing agreement only on one point: elections without a new electoral law have a very high chance of resulting in lack of policy effectiveness, particularly in the Upper House. The first hurdle before going into new elections would be a tall order: finding an agreement between the opposition and the majority on how to enact a more stable and effective electoral system. A positive resolution would be a major breakthrough, but finding a lasting solution is likely prove taxing, divisive and time-consuming.

A successful electoral law will require a stronger non- proportional representation in the Upper House, and a reduction of the influence of smaller parties, which is a major cause of Italy’s political fragmentation. The problem is the approval of such a law would need the endorsement of smaller parties: a Catch-22 situation. For this reason, the run-up to elections, via a new electoral law, could involve a prolonged period of political uncertainty.

Economic policy would likely suffer in this environment, increasing the chances of fiscal slippage. In our central scenario the budget deficit edges towards 2.8% of GDP next year (see The Hidden Risks of a Fiscal Overshoot, November 28). But in a prolonged period of political uncertainty expenditure control and the successful fight against tax evasion would likely lose effectiveness. Hence, under this scenario we could see the budget deficit approaching the 4% in 2008, and Italian government bond spreads vs. their German counterparts would likely rise further, via rising risk premia. Notwithstanding the initial period of uncertainty, a successful implementation of a sound and effective electoral law would be good news for Italy’s longer-term economic prospects and investors with longer investment horizons.

Scenario #3: Unexpected Resilience
We have seen tentative signs of improvement in Italy’s growth patterns in the last two year, but it’s hard to separate what’s cyclical from what’s structural. Our pessimism about growth next year could prove excessive. In particular, the impact of credit tightening could prove to be less restrictive on investments than we currently envisage. Consumption, while slowing, might continue to benefit from the labour market fundamentals, which remain relatively solid.

Conclusions — In an environment where adverse macro shocks have a higher than usual chance of materializing, the Italian economy does not appear an ideal place to be: we yet have to see convincing signs that Italy’s economy has made material and lasting progress, or that its vulnerability to shocks has improved significantly relative to the recent past. As an equity investor, given the chance of a sharp slowdown, I would not want to be long on Italian stocks (unless they are defensive). As a fixed income investor, given the chance of fiscal slippage, I would not be keen to hold longer-dated Italian government bonds.

By Vladimir Pillonca London
Morgan Stanley
December 16, 2007