As Italy is one of the largest member states of the eurozone, its economic prospects attract significant attention from analysts trying to forecast the financial stability of the eurozone. Many are asking whether Italy remains the weakest link in the euro area.
Two recently published reports highlight different aspects of Italy’s persistent economic challenges. The European Commission (EC) Spring Country Report delves into long- standing structural weaknesses of Italy’s public sector, which remain one of the main barriers to investment and productivity growth. The EC urges the Italian government to address the low employment rates, particularly for women in southern regions, and high youth unemployment.
The International Monetary Fund (IMF) Concluding Statement of the 2022 Article IV Mission reiterates its concern about Italy’s structural economic weaknesses. Still, it focuses more on the country’s banking system and its importance for financial stability.
Despite some progress achieved following the 2008 financial crisis, the Italian banking system continues to be fragmented, with political intrigue leading to inaction on the consolidation plans for the industry.
Both the EC and the IMF reports highlight how the Italian economy achieved an impressive recovery from the pandemic shock, returning close to the pre-COVID level of output in 2021. Thanks to taxpayers’ funded aid to families and businesses, the labour market rebounded while private consumption helped to boost growth. Still, like all EU member states, Italy is now facing formidable new economic challenges due to old unresolved problems and the war in Ukraine.
The IMF report argues that Italian banks are in better shape despite the economic disruption caused by the pandemic due to “further reductions in nonperforming loans, recourse to the public guarantee scheme and fiscal support to borrowers” granted by the government. The high savings rates of Italian households cushion against the pressures that high inflation could inflict. Still, the savings buffer does not protect the more financially distressed families.
The IMF report, however, leaves no room for complacency for policymakers. It recommends caution, given the elevated uncertainty and sequential nature of the current crisis. The Italian government intends to introduce a new loan guarantee scheme targeting energy-intensive firms to help them finance their higher expenses. The IMF advises that “eligibility should be selective, with enhanced credit risk assessments at origination and guarantee coverage rates lower than in pandemic schemes. Banks should diligently apply loan classification standards and recovery procedures on their guarantee portfolios”.
The Italian banking system continues to be fragmented, with political intrigue leading to inaction on the consolidation plans for the industry
This sobering advice comes in the context of liberal, conditions-lite schemes supported with generous government guarantees introduced by many eurozone countries in the last two years. These schemes have helped some businesses to keep afloat and protect employment. Now banking regulators and international institutions like the IMF are urging banks and governments to start dealing with the consequences of these policies that have served their purpose, but that now need to be slowly withdrawn.
The IMF does not underestimate the risk of elevated uncertainty impacting the Italian and many other EU economies. It advises the Italian banks to prepare for severe downside events using scenario-based credit quality assessments and other exposures. If these scenario tests indicate a sharp growth downgrade, comprehensive policy responses similar to those applied during the pandemic would be appropriate.
Weaker Italian banks will likely face significant challenges if slower economic growth prevails. The IMF advises: “Robust supervisory assessments with targeted asset quality reviews to continue in order to pre-emptively identify vulnerable banks.” The report further advises the Italian government to guarantee business exposures with banks judicious.
The IMF mission argues that “publicly-guaranteed loans are preferable to moratoria (on repayments), which obscure borrowers’ true repayment capacity. New guarantees could be made available, and the maturing of exiting guarantees lengthened. However, banks should be required to retain a larger part of the credit risk on their own balance sheets for new and lengthened guarantees, and excessive issuance should be avoided”. Moral hazard increases when taxpayers’ money is used too liberally.
Mario Draghi, Italy’s currently prime minister, is undoubtedly the most qualified and competent person to lead the country out of the present economic turmoil. Italy’s banking sector weaknesses will not be resolved at any time soon. The realities of Italian politics will put a brake on all attempts to speed up reform.
General elections are permanently on the political radar. Draghi will continue to struggle to keep together for much longer in his coalition the mixed bunch of political parties with conflicting self-centred ambitions.
In this context, one has to reluctantly acknowledge that Italy remains the weakest link in the eurozone.