Quarterly Economic Outlook December 2018 - Highlights

2019 Italian growth revised downwards to +0.5%


Signs of a global economic slowdown are increasing for next year. In particular, the forecast for the euro area has been revised downwards. After the drop in GDP in the third quarter, Italy should be able to avoid, technically, a recession. However, due to the weakness of activity in the second part of 2018 and the reduction in the expansionary thrust of the budget for next year, 2019 growth is expected well below the Government's forecasts.


The main forecasts of the Quarterly Economic Outlook December 2018 are:

  • Italy's 2019 growth cut to +0.5% (from +0.9% in October), due the effect of the absence of any "carry-over effect" inherited from 2018 and the expectation of a reduction in the net expansive scope of the budget from 0.5 previously estimated to 0.1 percentage points of GDP, consistent with a deficit at 2% read more
  • GDP in 2018 slightly revised downwards to +0.9% (from +1% in October): all the growth has been achieved in the first part of the year, with a second semester basically flat, which would therefore leave no positive carry-over for 2019
  • Italian deficit/GDP in 2019 at 2.3%, because, despite the reduction in the expansionary effect of the budget in order to contain the deficit within 2%, growth will be well below what indicated by the Government and this will have a negative impact on public accounts
  • A simulation analysis by Prometeia shows that Italy should be able to reduce its public debt to below 90 per cent of GDP over a 20-year horizon. To do so, however, it needs a medium-term fiscal and reform plan, supported by Europe
  • We still do not believe that the trade tensions between the United States and China will result in a full-scale trade war. However, the effects are being felt: in the Prometeia scenario, world trade will slow down (+4.1% in 2018, +2.9% in 2019), bringing about a deceleration in world GDP (+3.7% in 2018, +3.3% in 2019, +3.1% in 2020)
  • The further deterioration in global trade will particularly hinder investment and growth expectations in the Eurozone, all the more so given the possible strengthening of the euro. Downward revision of 2019 growth estimates for the euro area to +1.2% (from +1.6% in October), despite expectations of an improvement in the labour market
  • The ECB is normalizing monetary policy while the economy decelerates. To make the path as smooth as possible, according to Prometeia, next year new financing operations will be carried out, aimed at facilitating credit to the economy (TLTRO III), and the rise in rates will take place more gradually than expected: only two increases of 25 basis points each, one in December 2019 and the other in early 2020

The "new" budget and its impact on growth

The original budget proposal, as is well known, set a deficit target of 2.4% of GDP for 2019 and did not foresee a balanced budget over the planning horizon. For the pension system revision ("quota 100") and the citizenship income, the draft budget indicated only the amount of resources allocated (6.7 billion for both, 13 billion overall) without giving details, referring to appropriate legislative measures to be approved after the budget law approval, probably in January. As the draft budget included the sterilization of the safeguard clause (0.7% of GDP) and taking into account that the worsening of the macroeconomic context accounted for an increase in trend indebtedness by 0.4 percentage points, the deficit target of 2.4% (from 0.8% approved by the previous government) implied an effect on indebtedness equal to 0.5% of GDP.

Now an initial agreement with the European Commission seems to have been reached on a new budget. In our forecast, we assume that the compromise will involve a reduction of the deficit to 2%, obtained through a reduction of the expenditure allocated to the reforms of pensions and citizenship income, which would reduce the net expansive scope of the budget from 0.5 to 0.1 percentage points of GDP. This would be sufficient to ease the spread (slowly), but not to end the Commission's close monitoring of our accounts. Given the trends of the public budget, which is burdened by high interest rates and low growth, we expect that the deficit as a share of GDP will be higher than the official target and equal to 2.3% in 2019 and that it will not fall in subsequent years, when it will be necessary to replace again the VAT clause to prevent the deficit from increasing.

In this context, the Italian economy in 2019 would record, quarter after quarter, positive growth rates of GDP but such as to allow it to reach only +0.5% on average for the year. This is a clear revision with respect to the October forecasts (+0.9%), well below what is expected from the European partners, and it will likely end the reduction in unemployment. Nevertheless, it could be considered optimistic in light of the many internal and external risk factors. It is a revision due to the lesser expansive new budget and the negative legacy that the six months of uncertainty since the formation of the new government will leave to the next year. Our assumption of a spread fall-back to 250 basis points at the end of 2019 would not be enough to reverse the sign of these negative impulses.

For the following years, in a modestly worsening international context, Italian growth could continue, accompanied by neutral budgetary policies which would maintain the deficit just under 2% of GDP. As a result, debt would not fall below 130% over the forecast horizon.


Is the Italian economy already in recession?

In the third quarter of the year, the Italian economy recorded a contraction in economic activity (-0.1% compared to the previous quarter). The sharp slowdown is part of a process of the world cycle slowing down and growing uncertainties, a slowdown that the Italian economy had already been experiencing for a year and that is also shared by the major economies in the euro area. How can this slowdown be explained, after the highest growth rate since the early 2000s was recorded in 2017? Part of the explanation lies precisely in that "exceptional" result, in the sense that 2017 saw the combination of numerous expansive impulses (global growth, exchange rate, low oil prices, expansive fiscal and monetary policy) whose occurrence is not going to be repeated this year. But on this slowdown, to some extent natural, the change of government played a role with the announcements September of a change of pace in the conduct of fiscal policy, then concretized in the Budget Law presented to the Parliament and the European authorities.

With the resulting rise in yields, given the issues of government bonds already made during the year, we estimate that the highest interest burden is already equal to 1 billion in 2018, and it will be 2.6 billion in 2019. To these "direct" costs, uncertainty has probably added others, since it has affected the choices of households, in their purchases, of businesses in their choices of investment, production, employment. The abrupt slowdown of the third quarter is therefore considered to be the reflection of this blockade of decisions.

In the meantime, the uncertainties of the international context are adding to the national ones, reflected in all the economic indicators, in the opinions and expectations of the operators who are definitely turning to the worst.

The Prometeia models say that, in any case, the increase already achieved in the growth of industrial production in September and October would be able to achieve a slight increase in production (after three quarters in retreat) compatible with a modest increase in GDP in Q4. 2018 would therefore close with an average growth of 0.9%, all achieved in the first part of the year, followed by a second semester almost still, which would leave no legacy to 2019.

Thus the recession should be avoided, but next year everything will be uphill. A modest contribution from abroad, even if oil prices will be falling, with an exchange rate that will tend to appreciate, since from the middle of the year, the ECB will begin its normalisation process when the Fed expects it to stop.


A debt/GDP of less than 90% over the next 20 years is within Italy's reach

The fact that the high level of public debt, the third highest of the advanced countries in relation to GDP after Japan and Greece, is a factor of vulnerability in the Italian economy is widely acknowledged, especially since it is combined with economic growth that has been weak for more than twenty years now. The theoretical recipes proposed in recent years have often been oriented towards suggesting a combination of neutral/restrictive fiscal policies associated with structural reforms on the supply side. There is no shortage of opinions clearly against this approach, which is considered radically wrong, as the only objective should be to provide support for growth: as a consequence, debt reduction will also be achieved. Prometeia has therefore explored the possibility that debt reduction and growth recovery can go hand in hand, provided that the necessary decision is taken, with a medium to long-term fiscal and reform plan, the credibility of which should be built in collaboration with European partners. 

Starting from a "no policy change" scenario, i.e. from the assumption that in the next 20 years the budgetary policy will remain substantially unchanged, and blocking the primary balance at around 2% of GDP as in 2018, despite a spread only slowly decreasing below 80 basis points in 2038, the high debt would keep interest expenditure high (4% of GDP) and the so-called "snow ball effect" unchanged at almost 1.5 percentage points. The path of decline of the debt would therefore take place very gradually, up to 113% of GDP in 2038. It is clear that such a hypothesis, "technically" possible and governable, would leave Italy exposed to negative events that, in such a long horizon, cannot be excluded.
With the use of Prometeia's model for the Italian economy, we have assessed the effects of a commitment to reduce debt credible enough to align the yields on Italian debt with those of France and Germany, as has happened since the start of monetary union up to the financial and sovereign debt crisis. The sudden reduction of the spread to around 30 basis points would imply the substantial cancellation of the "snow ball effect", with a much more marked reduction in debt. Compared to the baseline scenario, an average of 22 billion euros in interest payments would be saved each year, which could be used to reduce the deficit and debt. Lower spreads also imply a better macroeconomic environment: less uncertainty and lower rates would favour the growth of investments and household consumption. The higher growth of GDP in turn improves the primary balance (on average by 0.2 percentage points each year), reinforcing the positive effects on deficit and debt, in absolute terms and in relation to GDP. Moreover, the option of redistributing, in whole or in part, the benefits due to the lower spread would open up, with the possibility to allocate them to support the economy - in particular actual and potential GDP - rather than to reduce the deficit. In this context, we have considered a scenario in which half of the savings on interest expenditure is spent on infrastructure investments and the other half goes to reduce the tax wedge on households (through a reduction in IRPEF).
Such a favourable debt service situation could be used also to implement the many structural reforms that Italy needs. Not only that. There is a wide literature showing how expansive fiscal policies can complement a season of intense structural reforms, enhancing their effects and mitigating their economic, social and distributive costs. The list of reforms that could be implemented is numerous, from the completion of labour market reforms to the liberalisation of product and professional markets, to the reform of public administration and the judicial system. Using as a metric the assessments made several times by the MEF and international bodies (EU Commission, OECD, IMF), it has been assumed that these reforms have positive effects on GDP over the 20-year period considered for a total of 2.5 points. This would be the most favourable case: the multiplier effects and the endogenous nature of the budget mean that, despite expansionary policies, deficit and debt would fall more in relation to GDP than if the lower interest burden were used entirely to reduce the deficit and public debt over GDP could easily fall below 90% in the 20-years projection horizon.