Editor's Note: This assessment is part of a series of analyses supporting Stratfor's upcoming 2019 Second-Quarter Forecast. These assessments are designed to provide more context and in-depth analysis on key developments over the next quarter.
2019 will be a year marked by a weakening economy and growing political uncertainty in Italy. In December 2018, Italy's coalition government convinced the European Union it would implement an expansionary budget while keeping the country's deficit at 2 percent of gross domestic product (GPD). This promise was based on expectations of economic growth that were ambitious even then, but seem increasingly unlikely now.
The country is, once again, officially in a recession after its GDP contracted in the last two quarters of 2018. And to salt the wound, the International Monetary Fund (IMF) recently downgraded its 2019 growth projection for Italy from 1 percent to 0.6 percent. Driven by structural factors and external forces, Italy's sluggish economy will put pressure on the Italian government to raise taxes and moderate its spending plans. Otherwise, it risks ending up with a higher-than-expected budget deficit, which would lead to volatility in financial markets and renewed pressure from the European Union.
Italy is the third largest economy in the eurozone and has the highest debt in the bloc in absolute terms. Combined with a higher deficit, the country's slowing economic growth could raise concerns about its ability to pay back banks in Italy and elsewhere in the eurozone that hold much of its debt. A financial crisis in Italy could, therefore, soon spread to other European economies, abetted by a contagion of uncertainty across the Continent.
No Room to Grow
Italy's economy, which is still about 5 percent smaller than it was at the start of the global financial crisis in 2008, will continue to weaken in 2019 due partially to structural factors that limit its room for growth.
The country's economic model, for one, is based on small and often family-owned companies that are less equipped to compete with foreign rivals. The Italian state has notoriously high levels of bureaucracy as well, in addition to one of the heaviest tax burdens on companies and households in Europe, and complex laws that often deter investment and employment. Furthermore, Italy's debt-to-GDP ratio is the second-highest in the European Union after Greece, which limits Rome's ability to stimulate economic growth by spending money on areas such as infrastructure.
In addition, several circumstantial factors have recently exacerbated Italy's economic slump. The economies of some of Italy’s main export destinations — notably Germany and the United States — are slowing down amid domestic pressures and mounting uncertainty about the future of global trade.
Growing fears about a generalized economic slowdown have started to rattle confidence in Italy as well, leading consumers and businesses to delay investment and spending plans. And the country's banks are worried, too. According to the Bank of Italy, access to both credit and private sector loans tightened in the last quarter of 2018. Meanwhile, the European Central Bank (ECB) continues to pressure regional banks to reduce their high number of non-performing loans, further restricting their ability to lend money to Italians.
The Deficit Dilemma
Italy's growing economic troubles coincide with the new government planning to increase the country’s fiscal deficit through measures such as introducing a monthly 780 euro ($900) payment for low-income people and lowering the retirement age.
In order to appease the European Commission, Rome eventually agreed to lower Italy's deficit target for 2019 to 2 percent of GDP from an original plan of 2.4 percent. And while this deficit goal was much higher than the 0.8 percent that the previous government had promised Brussels, it was based on the prediction of a 1 percent growth rate in 2019, which is an increasingly unlikely scenario.
Without any corrections to Rome's expensive economic plans, Italy's deficit will almost certainly exceed the 2 percent goal it promised to Brussels. But even if that happens, Italy's government is unlikely to change its budget, which remains popular among Italian voters, before the elections for the European Parliament on May 26. After the vote, Italian leaders will start making plans for the future, which could include another scuffle with the European Commission over the country’s deficit.
Since June 2018, Italy has been governed by a coalition between the populist Five Star Movement, which derives its support from the country's more rural southern regions, and the right-wing League, which represents Italy’s more industrial north. The two groups often have conflicting political agendas, which has led to constant disagreements in the short time they've been in power. When it comes to fiscal policy, for example, the Five Star Movement supports more generous welfare programs, whereas the League opposes subsidies and supports more tax cuts. The parties also have differing views on issues such as infrastructure projects and immigration and security.
To avoid choosing between surrendering to Brussels and generating a financial crisis, Italy's governing coalition may opt for a third option: letting the government collapse.
The governing parties have so far demonstrated pragmatism to maintain their alliance, despite their competing aspirations to someday take control of Parliament. However, the true strength of the coalition will first be put to the test in late May when the parties compete against each other in the elections for the European Parliament. Both parties are polling strongly, and Italian media have reported rumors that the League might consider an early election if its electoral performance is particularly good and its leaders suspect it can win more seats in Parliament.
Should the coalition manage to stay together after May, the next — and much more telling — challenge will come in October when Rome presents its 2020 budget plans to the European Commission. As mentioned, the government managed to persuade Brussels to accept a higher-than-promised deficit for the 2019 budget because of optimistic growth projections at the end of 2018. But the context of dwindling growth would make it much harder for Rome to keep its expansionary policies intact in its 2020 budget. This could lead to more disagreement between Rome and Brussels, while also increasing borrowing costs for Italy, posing questions about the sustainability of its debt and bruising the balance sheets of its banks in the process.
Against this backdrop, the League and the Five Star Movement would face a similar predicament as they did late last year: either make another (and likely more severe) compromise with Brussels at the cost of alienating voters, or ignore Brussels and preserve their populist measures at the cost of a financial crisis. But with Italy's slowing economy and growing deficit, the stakes would be much higher and the government’s room for action much smaller this time.
To avoid choosing between surrendering to Brussels and generating a financial crisis, Italy's governing coalition may opt for a third option: letting the government collapse. This would place the situation in the hands of Italian President Sergio Mattarella, who would likely push Parliament to form a national unity government to avoid an early election. However, the fall of the government would spark more uncertainty about the Italian economy at a time when market confidence is already waning.
More Economic Struggles Ahead for Italy
Financial markets tend to see Italy's deficit as an indicator of both Rome’s commitment to fiscal discipline and the sustainability of its debt. A worsening deficit makes it harder for Italy to reduce its debt burden and could, therefore, lead to higher borrowing costs for Rome, as investors become skeptical of Italy’s ability to pay back its debt and begin demanding higher interest rates.
In December 2018, the ECB also ended its bond-buying program known as quantitative easing, removing a source of demand for Italian debt that had kept Rome’s borrowing costs low. ECB President Mario Draghi noted the institution could decide to relaunch the program, though Draghi's term ends in October and his successor could be less willing to do so. To help revitalize the Italian economy, the ECB could instead deploy targeted long-term refinancing operations (TLTROs), which are essentially cheap loans that banks in the eurozone can use to fund loans to businesses and households. However, the monetary policy hawks within the ECB traditionally resist TLTROs, so the institution would likely only consider them if an economic slowdown takes hold of the greater eurozone.
Uncertainty about the future of Italy’s debt can also have a negative effect on its banks, which hold billions of euros in Italian sovereign bonds. When the value of those bonds deteriorates (as they have been for the past year), the balance sheets of the Italian banks holding those bonds take a significant hit. While two-thirds of Italy’s debt is held domestically, the rest is largely borne by other banks in the eurozone. Banks in France, Germany, Spain and Belgium, for example, reportedly hold about 390 billion euros ($450 billion) of Italy’s debt collectively — highlighting the extent to which an Italian default could reach beyond national borders.
The Eurozone Fallout
Last year’s clash between Italy and the European Union did not significantly impact other countries in the eurozone. But that was when the bloc's economic growth still seemed relatively strong and Italy hadn't officially entered a recession. Renewed concerns about the sustainability of Rome's debt could lead to higher borrowing costs for other countries in the eurozone — especially those in the south and especially in the context of a greater slowdown in the currency area, a circumstance that's already looming. On Jan. 31, the European Union announced that the eurozone grew by only 0.2 percent in the final quarter of 2018.
At the same time, questions about the fragility of Italy’s banks could start plaguing other banks in the euro area, beginning first with those that hold high amounts of Italian debt. So, while the country's economic and political problems may seem self-contained for now, Italy's economic entrenchment within the eurozone means its woes could soon be that of Europe's.