UK EU exit vote is likely to damage Italian recovery momentum in 2017

IHS believes that the Italian growth outlook has weakened appreciably following the United Kingdom's decision to leave the European Union (EU) in its 23 June referendum. The fall triggered by the referendum result is being felt more intensely in the more troubled Eurozone states. First, the markets seem in little doubt that the UK vote bodes ill for the Eurozone. The euro has weakened markedly against the US dollar (from around USD1.14 to trade around USD1.105) although unsurprisingly it is up sharply against the UK pound. Secondly, Italian equity markets have suffered heavy losses. For example, Italy's FTSE MIB was more than 12% lower at the close of trading on 24 June, with the country's major banks enduring sharp falls of more than 20%, already under pressure due to their vast portfolio of non-performing loans.

The potential risk to its already troubled banking sector is significant, and the country appears to be preparing a plan to stabilise its banking sector. According to daily newspaper Il Fatto Quotidiano, the Italian government could take stakes in ailing banks, and would issue new public debt of around EUR40 billion to finance the partial nationalisation scheme. The article also reports that Prime Minister Mattteo Renzi is already in talks with the European Commission about potential support measures. The main trigger would be Italy taking advantage of possible exemptions to European state-aid rules in case of "exceptional events", according to other newspapers Corriere della Sera and La Repubblica.

Outlook and implications

UK exit vote triggers lower Italian growth forecasts

Italy's fragile recovery is expected to take a hit from the fallout of the UK exit vote, and given the fragile baseline assessment already in place for the country, the impact on its short-term growth prospects could be more noteworthy when compared to the other major economies across the European Union (EU). Even before the UK vote, Italy was struggling to develop a more sustainable and broad-based recovery, weighed down by some lingering downturn characteristics after the economy exited its longest post-war recession in early 2015. Unfortunately, the financial volatility and uncertainty triggered by the UK vote are set to engulf the Eurozone and global economies, presenting a further headwind to the recovery momentum in Italy. Our preliminary new central baseline signals a broad-based hit, affecting both consumer spending and business investment intentions, alongside damage to trade flows across the EU (which are partly mitigated by the prospect of weaker euro in the remainder of 2016 and 2017). Overall, Italian real GDP is expected to expand by 0.7% in 2016 (down from 0.9%) in 2016, 0.5% (from 1.0%) in 2017 and relatively unchanged at 0.96% in 2018. These are provisional estimates, but broadly similar adjustments will be reflected in the July forecast update.

Unicredit, Italy's largest bank is lowering its 2017 GDP growth forecast for Italy to the range of 0.2 and 0.7% from its prior 1.2%. Meanwhile, the economy minister Pier Carlo Padoan believes the UK referendum vote could lead to a hit on Italian growth prospects. He said, "We have to be very clear: it can't be ruled out that, following Brexit, for reasons outside our control, the economic picture worsens and we will have less growth."

Business investment set to take biggest hit

Worryingly, the impact of the UK exit vote presents a further obstacle to the recovery in credit flows to Italian non-financial firms, with their financial situation already difficult in light of inadequate internal financing as a result of weak pricing power and profitability. Despite a resumption of growth in Italy since early 2015, the investment cycle has lagged behind the overall recovery story. Indeed, fixed investment machinery and equipment and weapon systems rose by 3.1% in 2015 to EUR90.322 billion in 2015, but it has fallen steadily since 2011 when it stood at EUR109.676 billion in 2011. Many Italian firms remain reluctant or unable to release pent-up demand for capital goods when faced with lingering obstacles, namely disrupted credit markets, weak pricing powers and significant past income and profit losses. Not surprisingly, entrenched corporate credit risk has weighed down on external financing to non-financial firms for investment purposes. Indeed, total loans to non-financial firms continued to shrink during March, and have fallen in almost every month since mid-2012. In addition, doubtful loans remained at painfully high level, with the bad-debt ratio of 17.7% in March 2016. In our new UK EU exit assessment, industrial investment will continue to grow in 2016 and 2017 but at a less pronounced pace than assumed in the June forecast update. Clearly, some firms are likely to delay capital projects when faced with a new dual threat of weaker near-term growth prospects both in Italy and across the EU in the wake of the UK exit decision. Overall, we now expect fixed investment growth at 1.2% in 2016 (down from 1.5%), to 0.8% (from 1.7%) in 2017 and unchanged at 1.1% in 2018.

Italian consumers will continue unwind pent-up demand

Despite the prospect of more difficult growth environment, we still expect the main narrative of consumer spending underpinning near-term growth outlook to remain intact, but less pronounced than previously anticipated. In our new baseline assessment, we now expect private consumption to expand by 1.2% (down from 1.3%) in 2016, 0.9% (from 1.1%) in 2017 and 1.2% in 2018. The rise in consumer confidence witnessed during 2015 is likely to be pushed back in light of the aftershocks of the UK vote, but Italian households are still enjoying a more relaxed backdrop, led by recovering real household incomes is a result of marginal consumer price developments, falling energy costs, and the abolition of property tax on primary residences. However, we acknowledge the real household income gains during 2017 could be lower than previously anticipated with firms likely to be more cautious employers, which could trigger higher levels of unemployment. However, Italian households are in the process of unwinding pent-up demand, and we expect this to continue in the remainder of 2016 and 2017, albeit gradually.

More fiscal support likely in Italy

We believe that Renzi will target a further shift in the focus of fiscal policy from austerity to growth when noting the new recovery strains. Again, he is likely to take an even more belligerent stance against the European Commission about the need to apply more fiscal muscle to protect the recovery. He is likely to argue that Italy needs additional fiscal assistance to protect the recovery during 2016/17 from a troubled EU economy in light of the UK exit vote alongside deep concerns about the health of the Italian banking sector. Therefore, we argue that Italy is on course to overshoot its near-term general government budget deficit targets, and will have to repel pressure from the Commission to introduce a further round of relatively deep austerity measures. Importantly, Renzi is likely to argue that the Italian economic recovery remains too fragile to absorb another round of significant spending cuts to hit agreed fiscal goals and to fund further household and corporate tax cuts. Therefore, we anticipate Italy will struggle to deliver its newly agreed general government budget deficit targets of 2.3% of GDP in 2016 and 1.8% of GDP in 2017. We suspect the Commission will have little choice but to grant Italy more flexibility given the exceptional circumstances trigged by the UK exit vote.