International investors were gloomy about the prospects for structural reform in Italy not too long ago. In late 2016, Schroders commented, soon after the resignation of former prime minister Matteo Renzi, that he had been “Italy’s best hope of enacting badly-needed economic and structural reforms, and so his departure is a major blow for Italy’s medium to long-term outlook.”
Schroders warned: “The change in leadership in Italy will mean a delay in the introduction of economic and structural reforms. Without such reforms, Italy is likely to remain stuck in a low growth deflationary dynamic.”
It is easy enough to see why Renzi is immediately associated with reform in Italy. When he became Italy’s youngest ever prime minister in early 2014, the leader of the centre-left Democratic Party was enthusiastically greeted as a zealous reformer who would shake up Italy’s archaic political system and accelerate a much-needed programme of structural reforms.
In the event, he promised rather more than he was able to deliver, and resigned after 59% of voters in a referendum rejected his proposals on constitutional reform.
“Although the Renzi government failed to introduce institutional reform, it succeeded in pushing through a number of economic reforms,” says Paola Monperrus-Veroni, chief European economist at Crédit Agricole in Paris.
The curtain raiser
True enough. But Lorenzo Codogno, founder and chief economist at LC Macro Advisors in London, says that the first of the big recent structural reforms in Italy predated Renzi’s accession to power by over two years. This was the far-reaching pension reform the Monti government introduced in 2011, aiming to chip away at Italy’s mountainous pension costs by ushering in key changes including an increase in the retirement age.
This reform, say economists, paved the way for the restructuring of the labour laws which many regard as the most significant of the initiatives from the Renzi government. The Jobs Act was enacted to tackle the perennial menace of unemployment by dismantling some of the well-intentioned but counterproductive regulations which discouraged businesses from hiring new workers.
The central pillars of the Jobs Act were measures to make it easier to fire employees and provide fiscal incentives for companies creating permanent job opportunities on less protective terms. “The Renzi reforms have been successful in making the jobs market more flexible and linking employee protection to age and experience,” says Monperrous-Veroni.
It was also under the Renzi government that essential reform of Italy’s precarious banking system was accelerated. This was based principally on allowing for the securitization of non-performing loans (NPLs), promoting consolidation in the banking sector, accelerating the process of credit recovery and supporting initiatives to strengthening banks’ capital ratios.
Initial indications suggest that bank reform is already generating positive results. According to a recent DBRS analysis, by the end of the third quarter of 2017, total gross and net NPE [non-performing exposure] ratios had improved to 15.7% and 8%, respectively, from 17.9% and 9.5% at December 2016. “Improvements in asset quality were supported by disposals, higher collections and lower NPE inflows as economic prospects improved,” DBRS notes.
Economists say capital increases and banking reforms are playing a critical role in addressing the challenge of poor asset quality among Italian lenders. “Everybody across the investment community now agrees that all the large systematic players in the banking sector have been dealt with,” says Marco Valli, chief European economist at UniCredit.
“Credit recovery times have been shortened and are now more closely aligned with those elsewhere in Europe. Because this only applies to new loans it won’t help with the existing stock of impaired assets, but it has positive implications for future NPL formation.”
More to do
While economists and investors have warmly welcomed the reforms of recent years, it is widely agreed that much more needs to be done if Italy is to address the multiple challenges of low growth, feeble productivity, serial youth unemployment and a high pile of external debt.
The IMF has called for a number of measures to counter these corrosive influences on the Italian economy. These include wage bargaining, an improvement in product and service markets, an acceleration of the clean-up of bank balance sheets, and the enhancement of efficiencies in the public sector and civil justice system.
The IMF adds that although Italy has succeeded in containing spending by freezing wages and cutting public investment, it has not yet been able to reverse pre-crisis spending, which grew faster than national income. In response, the IMF recommends a package of “high quality measures on the spending and revenue side” including more public investment, reducing pension spending which is still the second highest in the euro area, and lower tax rates on labour.
Decisive implementation of all these measures, says the IMF, could raise Italian incomes by over 10%, create jobs, improve competitiveness, and “substantially” reduce public debt over the next decade.
Just as well, then, that structural reform in Italy did not come to an immediate halt following Renzi’s resignation. “Reforms in areas such as public administration, government spending and the justice system will all take time,” says Monperrus-Veroni. “However, the Gentiloni government is moving ahead with reforms silently and decisively. This is building on Italy’s track record on reforms, which has already ticked a lot of the boxes presented in the OECD’s structural reform agenda.”
The OECD’s 2017 report on Italy’s progress on structural reforms is broadly positive. At the fiscal level, it acknowledges some success in broadening the tax base and reducing tax evasion, as well as reducing the debt ratio and implementing a balanced budget rule for sub-national governments. On financial issues, meanwhile, the OECD welcomes the measures that have been taken on NPLs and the creation of bad banks. The report also recognises progress in increased efficiencies in product markets, and in boosting innovation through measures such as R&D tax incentives and other schemes to promote start-ups and SMEs.
On labour market reforms, the OECD acknowledges the role of the Jobs Act in promoting permanent contracts. It also welcomes initiatives such as the National Agency for Active Labour Market Policies (ANPAL), the support of incentives for employing so-called NEETs (young people not in education, employment or training) and the implementation of a universal unemployment insurance system (NASPI). The OECD also reports on measures taken to increase female employment.
Another area identified in the OECD’s report is education. The Buona Scuola reform programme approved in 2015 has started to address some of the shortcomings in the Italian education system by recruiting more teachers and promoting digital and language skills.
While Italy has made progress in implementing structural reforms and bolstering efficiencies, there have been setbacks in areas such as privatisation, which has failed to generate the revenues that Renzi had targeted to help reduce the national debt. The privatisation of the national railway operator and the offloading of the 65% of the post office still in state ownership have both met with stiff political opposition. More recently, the planned sale of stakes in the air traffic controller, ENAV, and the energy company, Eni, have stalled.
Real estate ambitions
How much of a role privatisation will play in improving Italy’s debt to GDP ratio is open to question. “There is not much left to be privatised, although the government still has huge real estate assets that need to be sold,” says Monperrus-Veroni. “Since 2012, the government has planned to sell real estate assets worth about 1% of GDP per year. This has now been scaled back to 0.5% annually, which is still a very ambitious target.”
Economists say that the biggest immediate political threat to the structural reform process, and to Italian capital markets, would be a victory in the 2018 election for the anti-establishment Five Star Movement (M5S), described by Monperrus-Veroni as Italy’s black swan. UniCredit cautions in a recent report that a Five Star government would be perceived as “the worst-case scenario by financial markets, due to the risk of an unwinding of previous reforms and, potentially, the beginning of a debate to reform the EU treaties.”
Given that it is ahead in the opinion polls, it would be premature entirely to rule out a victory for M5S in March. But economists say that even though M5S may be able to count on up to 30% of votes, according to recent polls, an M5S-led government remains the unlikeliest outcome of the election. This is because a coalition between M5S and either of the two other most popular parties has been more or less ruled out.
As Monperrus-Veroni explains, under Italy’s new “Rosatellum” electoral law, an individual party would need to poll 40% of the vote to qualify for a so-called “majority premium” of a further 50 seats, creating a clear governing mandate. In spite of the growing appeal of the anti-establishment movement, polls suggest this is well beyond the reach of M5S which was co-founded by the comedian, Giuseppe Piero Grillo (popularly known as Beppe) in 2009. This will be reassuring to investors.
As BNP Paribas noted in an October update on Italian politics: “In the eyes of the market, the likelihood that [the Rosatellum law] might erode Five Star’s influence and reduce its chances of winning the next general election is probably positive news.”
M5S has toned down its anti-European rhetoric, and its new leader, Luigi di Maio, has said that the party does not support an Italian exit from the EU. But it is still committed to a referendum on membership of the euro if reforms to the single currency do not transpire.
Thankfully for financial markets and the future of the single currency, economists believe the most likely outcome of the election will be a hung parliament. This would probably pave the way for the formation of a grand coalition government bringing together former president Silvio Berlusconi’s centre-right and Renzi’s centre-left parties.
Although that may look like an step backwards for Italian politics, Codogno says that a grand coalition along these lines might be the best chance Italy has to pursue structural reforms. “It would not be pleasant for democracy, as it would leave only the anti-establishment or extreme parties in opposition,” he explains. “However, this scenario would not be adverse for the economy as the government would be free to implement unpopular reforms that no party would individually do.”