Italy Report: In dept reviews
ASSESSMENT OF MACROECONOMIC VULNERABILITIES
Gravity, evolution and prospects
Italy’s high level of public debt remains a major vulnerability for the economy. Italy’s public debt is characterised by a residual maturity of around 7 years at end-2022, which is below the euro area’s 8-year average despite increasing between 2014 and 2021. (5) While this maturity has helped in cushioning the impact of the recent increase in government borrowing costs, the average cost of debt increased noticeably in 2022 and is forecast to remain broadly stable in the near future. This, together with high pension expenditure, reduces the resources available for countercyclical policies to cushion negative economic shocks as well as for productivity-enhancing spending and supporting the green transition to improve competitiveness and resource-efficiency.
The Commission’s assessment shows that Italy faces high fiscal sustainability risks over the medium term and medium risks over the long term. (6) Several reforms and investments included in Italy’s Recovery and Resilience Plan (RRP) are expected to strengthen debt sustainability through higher growth and fiscal-structural reforms. However, to further support debt sustainability, the reform and investment agenda will have to be accompanied by prudent budgetary policies with adequate primary surpluses, also in light of a less favourable interest rate-growth differential.
Italy’s government debt continued to decline in 2022 but remains at a high level. In recent years, the government deficits were impacted by a number of policy measures, including the higher-than-expected uptake of tax credits to support energy efficiency in residential buildings, together with a change in their statistical recording that shifted the deficit impact from future years to primarily 2021-22. Italy’s public debt ratio reached its peak in 2020, at 154.9% of GDP, and started to decline afterwards, reaching 144.4% of GDP in 2022 (graph 2.1 a).
The decrease was driven by a strong rebound in nominal growth and the phasing-out of pandemic-related fiscal measures, which more than compensated the budgetary costs of the fiscal measures adopted to counter the economic and social impact of the exceptional increase in energy prices. In the near future, the stock-flow adjustment, also related to the statistical reclassification of tax credits for building renovation works, is projected to provide a debt-increasing contribution. In contrast, favourable economic growth and improving primary balances, also due to the withdrawal of support measures, are expected to reduce the debt. As a result, Italy’s public debt ratio is forecast to reach 140.3% of GDP by 2024, which is still above the already high pre-pandemic level.
Following weak growth over the last two decades, productivity dynamics have been volatile since the start of the COVID-19 pandemic. Weak labour productivity has been a drag for Italy’s economic growth over almost two decades (graphs 2.1 b/c). From 2001 until 2019, GDP per hour worked virtually stagnated and GDP per employed person even fell. In comparison, over the same period labour productivity in both indicators increased by about 20 percentage points more in the EU. Key factors for this structural weakness were predominantly small firm sizes, which make it difficult to take advantage of economies of scale, and low investment, notably in intangibles. In turn, private domestic and foreign investment is hampered by a not particularly supportive business environment and by low average education levels.
From 2019 until 2022, hourly productivity grew by 0.6% per year on average, slightly exceeding its weak average growth of 0.4% during the preceding decade. However, strong fluctuations in both economic output and labour input during the pandemic led to a marked volatility in productivity data during the past three years. The strong increase in hourly productivity by 3.1% in 2020 reflected the effectiveness of government support measures, including through the SURE scheme
In response to the abrupt drop in economic activity firms mostly opted to apply for short-time work schemes instead of laying off employees. Consequently, hours worked fell more than output. In turn, in 2021 hours worked recovered more strongly than output and thus productivity fell by 1%, followed by a small decline in 2022. Productivity is, however, forecast to rebound to a 0.5% average growth in 2023- 24.
While financing conditions are tightening, the green transition, supply chain reorganisations, and the continued effective implementation of the Recovery and Resilience Plan constitute an opportunity to raise productivity. The higher funding costs on capital markets make investments in equipment or intangible assets less profitable for firms. Similarly, also high energy prices and supply chain disruptions, although recently easing, may make capital-intensive production processes more costly.
As a consequence, the economy’s capital deepening process could be at least temporarily impaired. However, structural adjustments to these changing conditions, including market exit of inefficient firms, and the transition towards greener energy sources could help increase efficiency in the medium to long term. Italy already made marked progress in geographically diversifying its sources of fossil fuels and in increasing its stock of renewable energy installations over the past years. Apart from reducing the risk of future energy price shocks, which makes capital-intensive production processes more attractive, the changed external environment and the energy transition could trigger firms to rethink their production processes more broadly. This, together with the required reskilling of the labour force, could eventually lead to structural improvements in the economy’s total factor productivity. Policy measures included in Italy’s RRP support this transition process.
The labour market continues to face structural challenges that dampen potential output, although the low employment rate, in particular of women, and the high youth unemployment are improving. In 2022, women’s employment rate (20-64 years old) was 55%, against men’s 74.7%. For both genders, the employment rates in Q4-2022 were slightly higher than the pre-pandemic Q4-2019 levels (respectively 75.2% vs 73.8% for men and 55.7% vs 53.8% for women).
Regional employment differences remain substantial, with the rate in the North above 70% and that in the South below 50%. Among the younger generation (15-34), employment rates in the North are in line with the euro-area average (around 75%) while they are below 50% in the Southern regions. The youth unemployment rate (15-24) remains above 22%, well above the euro- area 14% average, although it is on a decreasing trend and lower than before the pandemic.
Short- term indicators of labour market dynamics, such as the net balance between hiring and layoffs by private employers, continued to be positive in 2022 and accelerated in the first few months of 2023. Even though the recruitment with permanent contracts and the conversion of temporary into permanent contracts picked up markedly in 2022 and early 2023, fixed-term contracts remain the prevalent form of job on offer for new hires (around 75% of total recruitment). (7) The robust growth in all employment indicators is not expected to reverse in the near future, although the momentum is likely to slow down, in line with the reduced pace of economic expansion (see section 3 for more details).
Wage growth has not picked up in line with inflation, supporting price competitiveness but lowering real disposable income. The wage moderation displayed before the pandemic has not diminished in the subsequent recovery, with the surge in inflation not having been reflected much in wage contract renewals so far, and thus entailing losses in real labour-income and households’ purchasing power. Real wages had fallen by around 5% after the 2008-13 crisis and have stagnated thereafter: as a result, they remain well below their level at the start of the millennium, while in the euro area they rose by some 10% over that time span. Given Italy’s sluggish growth of labour productivity, persistent wage moderation has allowed preserving price competitiveness vis-à-vis its European peers.
The health of the Italian banking sector has strengthened since the global financial crisis and the improvement in asset quality continued in 2022, although challenges remain. The gross non-performing loan (NPL) ratio substantially decreased to 2.9% in Q3-2022 (graph 2.1 f) from a peak of 16.5% in 2014 but remains higher for Less Significant Institutions (8) and in Southern regions (9). However, roughly half of the stock of NPLs is made of unlikely-to-pay loans, which warrant closer oversight. Furthermore, banks have maintained reassuring capitalisation levels (Common Equity Tier 1 ratio of 14.7% in Q3-2022) and liquidity positions above regulatory requirements (Liquidity Cover Ratio of 190.2% and Net Stable Funding Ratio of 133%, in December 2022) (10).
The normalisation of monetary policy also contributed to a rise in bank profitability with Return on Equity reaching 6.5% in Q3-2022. This positive trend was mainly driven by an increase in net interest income (+9.2% in Q2-2022 compared to Q2-2021). (11) Looking ahead, banks are expected to be able to cope overall with the challenges posed by the phasing out of the Targeted Longer-Term Refinancing Operations (TLTRO) funding, as around half of TLTRO III (12) will expire by June 2023. The slowdown in economic activity may weigh on borrowers’ ability to repay loans and therefore negatively affect asset quality.
The increase in the cost of lending for both non-financial corporations and households may weigh on credit demand, while the debt servicing cost of loans with variable interest rates has been increasing. However, the low debt level of the Italian corporate sector, its abundant liquidity and the strong profitability performance after the pandemic mitigate downside risks. (13) Finally, the Italian financial system remains predominantly bank-based and despite some progress in recent years, access to non-bank finance remains underdeveloped and concentrated in Northern regions.
While there have been some improvements, Italy continues to face vulnerabilities with cross-border relevance, relating to the high government debt and weak productivity growth, in a context of labour market fragilities and some weaknesses in the financial sector. The pandemic crisis and its aftermath brought a sizeable increase in public debt. It started edging down in 2021 with the economic recovery and is set to decline further over the period to 2024. However, according to the 2023 Stability programme the public debt ratio would be expected to increase again in subsequent years in the absence of consolidation measures. Fiscal sustainability risks remain high over the medium term and medium over the long term. High volatility in productivity growth since the pandemic crisis has masked the underlying persistent structural shortcomings, and tightening financing conditions dampen the prospects for further capital deepening