Draghi’s historic opportunity to invest in Italy’s economic future

The 73-year old enjoys overwhelming backing across the political spectrum, including from the rival 5-Star Movement and Lega parties. Matteo Renzi, a former prime minister, withdrew his ‘Italia Viva’ party’s support for the previous government, forcing President Sergio Mattarella to ask Mr Draghi to try to form an alternative coalition. If only to avoid the public-health difficulties of a general election in the midst of a pandemic.

Markets welcomed the appointment. In response to the Mr Mattarella’s call to form a government on 3 February, Italy’s borrowing costs have fallen. The government 10-year debt spread narrowed from 113.8 basis points on 2 February to 91.2 bps against the German bund on 12 February, its slimmest margin in five years. The spread between Italian and German sovereign debt is used as a measure of political risk for the eurozone. The Italian stock market rallied, with the benchmark FTSE MIB index gaining 2.1% on 3 February.

Mr Draghi’s government is scheduled to be approved by Italy’s parliament this week. It includes politicians from the major parties as well as technocrats, and plans to develop a much-needed programme of structural reforms, ranging from education, administration and justice to infrastructure and accelerating the vaccination programme, supporting households and firms through the pandemic, as well as a recovery spending plan. Mr Draghi also considers climate change a strategic focus of his government and has already created a new ministry to oversee the transition to a sustainable economy.

Pandemic priorities

Italy was the European Union’s worst affected state in the first stages of the Covid-19 crisis and the first to impose strict regional lock-downs. With 2.7 million Covid cases, the country now has fewer absolute infections than the UK, France and Spain, but in mortality terms remains second in Europe to the UK with more than 93,500 deaths. Like its EU neighbours, Italy is struggling with Covid vaccine supplies. Vaccinations are running at 4.9% of the population (based on 13 February data), ahead of the EU average of 4.7% and Germany, France and Austria, but lagging Spain’s 5.2%.

As a result, Italy is battling to recover from a recession that shrank the economy by -8.8% in 2020, a post-war record. Depending on the public health measures necessary in the coming weeks and months, the economy may not return to growth until at least the second quarter of this year. Next month, Italy’s pandemic moratorium on companies firing workers ends, likely triggering a jump in unemployment that has consistently hovered around 10%. We expect Italy’s GDP to expand by 4.8% for this full year, and consumer price inflation to rise by 1.0%.

The Italian economy is now operating at around 80% of its pre-pandemic activity level. The country’s economic recovery to date largely mirrors its neighbours, as tracked by our high-frequency activity indicator (see chart).

Productive debt

The timing for an Italian turnaround is good. In the past, technocrat prime ministers have inherited the job needing to implement austerity measures. That has tended to undermine their political support very quickly. Since 1993, Italy’s technocrat prime ministers have enjoyed a political life expectancy of only 16 months. In contrast, Mr Draghi has a window of opportunity in the form of lower borrowing costs and political support for fiscal spending.

In July 2020, the European Union agreed a pandemic recovery fund worth EUR 750 billion. The deal gave the European Commission, the bloc’s executive, the ability to issue debt on behalf of member states for the first time. Italy and Spain are the recovery package’s largest beneficiaries.

By the end of April, the new government should present a spending plan to the European Commission for its national allocation of EUR 209 billion from the recovery fund in the form of grants and loans. That equates to 10% of national GDP. In total, the country has already injected extra spending or tax reductions worth around 5% of 2019’s GDP in response to the crisis. That work to contain the pandemic is forecast to take government debt to almost 160% of GDP in 2021.

Other member states, including the so-called ‘frugal four’ governments of Austria, Denmark, the Netherlands and Sweden who resisted more generous support last year, will be watching for signs that Italy spends the money wisely. In their eyes, that would involve spending on infrastructure and efforts to expand an economy that has stagnated for more than two decades, even occasionally threatening the stability of the single currency.

New European leadership?

In August 2020, Mr Draghi presented the pandemic as an opportunity to use the EU’s seven-year, EUR 1.1 trillion budget and recovery fund both at a national and bloc-level, to stabilise and strengthen economies. He added that high debt levels would only be sustainable if “used for productive purposes” such as public investments into “human capital” and “crucial infrastructure for production.”

During the 2012 eurozone sovereign debt crisis, Mr Draghi needed German Chancellor Angela Merkel’s backing to save the euro. Germany is now transitioning to new leadership with Mrs Merkel poised to step down as Chancellor in September. That may allow Mr Draghi to position Italy closer to the centre of Europe’s strategic leadership, liaising with French President Emmanuel Macron’s vision for a more federalised European Union.

Mr Draghi’s speech last year went further. He proposed further EU federalism, suggesting that the common budget and common debt “can form the basis of the design of a common Treasury ministry.” Leadership from Italy in terms of structural reforms, ahead of changes from France or Germany, would lend legitimacy to the EU’s recovery package. That could in turn have more permanent consequences for the bloc’s fiscal architecture.

The political and economic expectations for Italy’s new prime minister are high. Mr Draghi has the opportunity to plot a long-term course for growth in Italy, as well as solidify the EU project at an historic point in time.

Whether his leadership will prove more than an interim appointment remains to be seen. It is also possible that, like the nineteenth century historian’s ‘Great Man’ theory that emphasises the impact of individuals, observers are expecting too much from a technocrat tackling a pandemic-triggered recession and a complex political landscape.

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