ITALY AND…THE TITANIC SYNDROME

An analysis of COVID19 impact on ITALY’s economy and public finance.

The authors of the VISION paper are Maria Costanza Cau, Antonio Negro and Francesco Grillo.

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After the first, dramatic, phase of the pandemic COVID-19, Italy has just entered an even more delicate period. We are walking on a narrow path, suspended between two even more serious crisis: on one hand, the risk of a rise of the contagion curve that could produce a new lockdown; on the other hand, the possibility that the State may not able to honour a public debt which is going to exceed – according to the Government’s “Nota di Aggiornamento al Documento di Economia e Finanza” (the forecast of the state of public finance for 2020, approved on the 24th April 2020) - – the 150% of GDP. Vision proposes an analysis that has two added values compared to similar ones:

  1. The first is that our analysis differentiates the impact per sector in 2020; this makes it possible to evaluate the real possibility that the recession will have a V shape, as expected by the government (and not an L one with a much more limited rebound). 
  2. The second is that we focus the dynamic of public finances in 2021 which is going to be much more critical than in the current year.

The bottom line is going to be that two conditions are both indispensable to avoid the crisis spiralling out of control:

  1. An exceptional support from the European Union;
  2. A not less exceptional transformation of the mechanisms through which scare taxpayers’ resources are allocated.

The feeling is that the third largest economy of continental Europe is gently navigating towards an iceberg. We urgently need to conceive a strategy which is not about saving lives and jobs, but transforming a State which needs to liberate energies and radically change priorities.

IMPACT ON ITALIAN GDP 2020 – AN ANALYSIS BY SECTOR

The point here is to understand the impact that the actions taken to fight the pandemic COVID-19 (inter alia lockdown, re-open date) are having on our economy and, most of all, what are the results on the different sectors.

Vision has produced these data starting from the breakdown of the Italian economy (excluding public services and public transfers) by sectors (ISTAT, 2017). Each sector coincides with the so-called second level of “ATECO code”, resulting into a decomposition of the entire Italian economy into 81 areas: this accounts for about 52% of the country’s GDP (being the rest the sum of public expenditures for public services – i.e. salaries for delivering healthcare, education,..–, transfers – including almost 280 billion euro for pensions, public investments).

The forecast of the shrinking of ITALY’s GDP in 2020 was forecasted by splitting the 2020 into three periods: the “prior lockdown period” (January – February ) for which we assumed that business was conducted according to past projection; the “lockdown period” (March – April ) during which the lockdown was imposed; and, finally, what we called the “post lockdown period” (May - December).

This provisional tripartition will be, indeed, reviewed according to the changes in the lockdown policy. In fact, our analysis currently estimates the impact of a two-month closure (until May 4th): continuing the restriction (partially or fully), our forecast will change accordingly.

Thus, Vision analysis differentiates itself from the ones of many macroeconomic models because it is based on a policy assessment at the sector level of the lockdown policy which will be very differentiated in different areas (although it is obvious that many firms do work between industries and that the boundaries amongst industries are themselves becoming blurred).

This kind of forecast is, however, much more useful than pure macroeconomic ones for two reasons:

  • it gives industry specific hints to entrepreneurs and workers;
  • it provides a more realistic test on the shape of the recession and on whether it is going to be similar to an L (loss of GDP with no or late recovery) or a V (loss with immediate rebound);
  • it is flexible and can be perfected with more industry specific trends that VISION is collecting.  The figure below is an illustration of the industry specific impact of the lockdown.

Figure 1 – Different sector economic reaction to the COVID19 pandemic (percentage of “not public sector” value added)

Figure 1

 Source: Vision

The productive sectors are divided into 6 categories, based on the reactions to the “lockdown period” and the “post lockdown period”:

  • Rebounders: those who stop the activity during the lockdown, and then experience an over production (compared to the pre-lockdown standard) period to respond to piling orders, i.e. “construction”
  • Limbo: those who stop the activity during the lockdown and then are just able to reach the pre-lockdown level of activity, i.e. “other services” (repair of computers and personal and household goods and other personal service activities)
  • Losers: those who stop or consistently decrease their level of activity during the lockdown and then are not able to reach the pre-lockdown standard, i.e. “Tourism” in Italy is a paramount example of this; “Wholesale and retail trade”, restaurants are also important.
  • Winners: those who experience an increase of activity during the lockdown period and then keep the new level of production (this may be the example of E-commerce) or go down to the regular pre lockdown standard, where groceries could fit this situation.
  • Business as Usual: those who do not experience significant change in the production level both during and after the lockdown, i.e. “Agriculture, forestry, and fishing"
  • Delayed: those who did not suffer restrictions and yet experienced a strong decline of activity because of the restrictions hitting their suppliers or clients; t “Mining”, “Water supply; sewerage, waste management and remediation activities” may all fall into this category.

It is interesting to notice that:

  • there are industries which are being positively impacted (a rather obvious case are e-commerce companies and providers of tools for on-line education);
  • some sectors are being badly damaged although they have not been closed (for instance, because integrated into complex value chains);
  • more importantly almost two third of Italy’s business added value is concentrated in “losers” industries which will not recover to pre-crisis levels of turnover by the end of the year.

We, therefore, attached five different kinds of impact of the lockdown policy – both during and after its implementation - on the 81 sectors, whereas their activity may turn to be (as a percentage of the pre – lockdown turnover):

  • Better than usual: Value added ≥ 110% higher than in the pre – lockdown period
  • Business as usual: 90% ≤ Value added < 110%
  • Worse than usual: 70% ≤ Value added < 90%
  • Negative impact: 20% ≤ Value added < 70%
  • Lockdown: Value added < 20%

The results are, therefore, summarized in the table below, where we only report the results for nineteen larger aggregation of economic activities.

Table 1 – Value added by sector and share of GDP, million euro (LEVEL one ATECO)

Source: Vision on Istat data

While during the lockdown period only 3 sectors are able to keep or increase their value added (Better than usual and Business as usual), all the others experience lower level of value added compared to the same period of the previous year the previous year (6 in Lockdown). During the remaining 8 months the situation clearly improves for all sectors, even though 8 sectors are still not able to reach the previous year level (Better than usual and Business as usual) of value added.

Overall, the private sector is expected to lose a staggering 181 billion euro (20,2% of its added value).

Having calculated the added value of the productive sectors (2020), it has been made a regression between the value added of productive sectors and GDP of the years 2008 – 2017.

The correlation is significative, resulting in a 2020 GDP estimation of 1.620.606 million euro (-9,3% compared to 2019).

It can be, then, safely assumed that this is the economic impact of LOCKDOWN which we can take as already certain. There are, however, two possibilities that may worsen such forecast:

  • The first is an extension of the restrictions in a lighter form beyond the two months period that our calculation assumes. This is, in fact, certain and yet we still need to calculate how will this impact further: this will depend on how will the extension last and which industries are going to “reopen”): our preliminary hint is that this may increase the negative impact of a further third (-3,1%).  
  • The second uncertainty is about the possibility that the curve of the contagion may resume its rise and that, thus, a stronger lockdown may be re-established. This possibility cannot be excluded and some epidemiologists fear that it may happen after the summer 2020. A preliminary measurement of the cost of such circumstance will have to be calculated when it materializes; however, a cautionary estimation of the cost of this may be around two third of the impact of the first lockdown (assuming that the country may leverage on the learning experience) (-6,2%).

This may, thus, bring us to estimate that the final impact of the crisis may be in a zone between a best scenario (the GDP shrinks of 9,3%) and a worse one (-18,6%).             

IMPACT ON ITALIAN PUBLIC FINANCES in 2021

Given the GDP trend and the difficulties of various economic sector, it is plausible to expect strong consequence on the public finance of the Italian state.

The danger is that the central government will have to steer the country to a “new normal”, while tackling a very weak financial position: the chances are that it will have to spend much more money, while collecting much less revenues.

Considering the revenues and the expenses of the state we have considered two options based on what expressed in the previous chapter

  • Best scenario: 2020 GDP -9,3%
  • Worst scenario: 2020 GDP -18,6%

Having in mind these two prospects for 2020, we forecasted the evolution of State’s revenues (tax revenues) and expenditures, in 2020 and 2021.

A further assumption of our estimate is that the 2021 GDP will rebound with the same intensity after the 2008-2009 (modifying the “Worst scenario” by -40%). Thus for 2021, it is foreseen

  • Best scenario: 2021 GDP +5,77%
  • Worst scenario: 2021 GDP +7,68%

The impact on Tax revenues

We, therefore, firstly evaluate how the shrinking of the GDP will impact overall Tax revenues, providing also a provisional estimation of the impact on IRPEF and IVA. A regression performed between those variables and GDP (2005 – 2019) has shown a statistically significant correlation.

The results for 2020 and 2021, considering the “best scenario”, are reported in Table 2.

Table 2 – Comparison 2019-2020-2021 “Best scenario” Tax revenues, IRPEF, IVA, million euro

Table 2

 Source: Vision on data Ragioneria Generale dello Stato

Very different are the numbers considering the “worst scenario”, in Table 3.

Table 3 – Comparison 2019-2020-2021 “Worst scenario” Tax revenues, IRPEF, IVA, million euro

Table 3

 Source: Vision on data Ragioneria Generale dello Stato

It is evident, from both Table 2 – 3, in 2020, an overall increase of “tax revenues” and IRPEF, and a decrease of IVA, while the trend is the opposite considering 2021 (this is obvious taking into consideration the methodology explained in methodology).

In both the scenarios the real problem, considering 2020, is not connected to the amount of tax revenues expected, but those that will concretely be paid (currently, it is discussed the possibility to postpone the payment of the taxes, but it cannot be excluded the cancellation of the same, at least partially).

The real problem will come in 2021, when it will be experienced an overall loss of tax revenues (-13,53% “Best Scenario”, -26,93% “Worst Scenario”) and of IRPEF (-15,15% “Best Scenario”, -30,16% “Worst Scenario”). This is going to put a lot of pressure on the State, that will experience a lack of resource to fund its regular activities (-49.877 million euro “Best Scenario”, -119.064 million euro “Worst Scenario”, compared to 2019 ).

The impact on public expenditures

The lockdown of many productive sectors has clearly generated a worsening of their economic situation, resulting in an increase of the unemployment rate.

A regression between the GDP and unemployment rate variation (2006 – 2019) has shown a significative correlation, and also positive is the correlation between unemployment rate and social safe expenses (2007 – 2016).

In Table 4-5, unemployment rate and social safe expenses in 2020 and 2021 considering “Best and worst scenarios”.      

Table 4 – Unemployment rate and social safe expenses (million euro) 2019-2020-2021, “Best scenario”

Table 4

 Source: Vision on data Ufficio Parlamentare di Bilancio

Table 5 – Unemployment rate and social safe expenses (million euro) 2019-2020-2021, “Worst scenario”

Table 5

 Source: Vision on data Ufficio Parlamentare di Bilancio

The comparison between the two scenarios shows that both are extremely expensive for Italy, both in terms of sustainability of public finance and social cohesion.

The impact on costs to serve public debt

Furthermore, the crisis will also produce an increase in public debt and, presumably, in the interest paid on average on its STOCK, which will generate a further increase in spending.

To estimate the increase of the latter, we started, from a prudential perspective, from the forecasts of the "Economic and Finance Document", which estimates a net debt of 10.4% in 2020 and 5.7% in 2021.

Specifically, we applied a public debt service cost (for 2020 and 2021) of 2.5% for the best scenario and 3.88% for the worst scenario.

2.5% represents the cost of the service of the public debt (%) of Italy in 2019, while the one for the worst case scenario is cost of the service of the public debt is 2011, the year in which the spread between BTP and BUND peaked.

Table 6 - Expenditures for interest on public debt (million euro) 2020 - 2021

Interests

 

Source: Vision

Our calculation therefore assumes the optimistic hypothesis that in the best scenario, the worsening (compared to the forecast of the DEF) of the ratio of the government debt to GDP does not increase the percentage cost of the service the debt itself. We assume that the intervention of the European Central Bank sterilizes further penalties for government bonds (Republic of Italy).

Net of our prudential hypothesis for the calculation of the interests paid on the stock of debt, in our model we see a spread of the gap between expenses (including our esteem for social security expenses and interests) and revenue (taking into account our prospect of tax revenue) of the State that will increase the financial GAP.

Note that our projection of the net debt is more prudential compared to the one in the " Economic and Finance Document " for 2020. However, by applying the same prudential method to 2021, there is a marked worsening of the public financial GAP, which makes it more serious compared to both what is estimated for 2020 and in the " Economic and Finance Document ".

The overall impact

The results are then summarized in graph 1.

Graph 1 – Income and expenditure trend 2016-2021, Best/Worst scenario

Graph 1

Source: Vision

As for the graph, we, therefore, envisage a financial gap which can be as large as 100 billion EURO (which would be around 6,2% of the GDP) in the “best scenario” which can be more than doubled in the worst. This would lead the Republic of Italy’s bonds in a PRE-DEFAULT situation. The impact would be not less dramatic for the EURO area itself which would face a much worse crisis than the one faced in 2012 with the rescue of the sovereign debt with the ECB’s quantitative easing. This is because Italy is certainly is a much bigger financial problem to be swallowed and the munitions of the monetary policy have been almost entirely depleted. The outcome entirely depends on a complex game whose determinants are:

It is clear by Graph 1 that Italy will play a complex game whose determinants are:

  1. the quality of the re-opening of the system;
  2. the credibility with the EU institutions;
  3. the scope of the reforms needed to cover a large financial gap.

The various negotiations have produced a series of instruments to manage the crisis, and those are

  • SURE / ESM Pandemic Crisis Support / EIB Guarantee Fund for Workers and Businesses: € 540 billion
  • Next Generation EU: € 750 billion The second appears to be more ambitious (both considering the resources and the fields of applications).

However, the effects, whether adequately used, are going to have some impacts since 2021, and in the same 2021 these might be not fully realized (this instrument increases the 2021-2027 EU budget). The bulk of the funding (around 80%) will be used to support public investment and key structural reforms in the Member States. This makes the instruments clearly positive, but at the same time, the totality of the positive results will be visible later rather than sooner. Moreover, it is necessary to underline that what presented above derives from the draft of the European Commission. Many changes can occur during the following negotiation and approval by the Member States. This section might be changed according to the occurred modifications. A more immediate and direct impact might be generated by the use of the other instrument, especially the MES. However, the politic and economic conditionalities connected to this instrument are a strong disincentive to its usage.

IMPLICATIONS: DEEP REFORM AS A MORAL IMPERATIVE

Considering the strong negative impact on the Italian economy of pandemic COVID19, it is fundamental to organize the s-lockdown as carefully as it is possible to prevent the further diffusion of the virus, but at the same time it is also essential to produce those economic and social reforms able to finally generate a strong GDP growth and guarantee the social cohesion, fundamental preconditions for a better and fastest end of the actual crisis.

The option to go “back to normal” is simply not existent.

The pandemic simply remembers us that

  1. it is irrational to spend 4,5 times more in pensions than in education
  2. it was illogical to move scarce resources away from local administrations (the front line of the crisis) and towards central administration (the hypertrophic back office);
  3. it would have been fundamental the percentage of public expenditures spent on expenditures (while all the other European countries have increased it);
  4. it is counterproductive to tax more labour and companies, and less property assets, benefits and inherited capitals.

The numbers VISION is elaborating suggest that for Italian economy and society is essential not to waste another crisis (like Italy and most of Europe may have done with the 2007 – 2008 financial one). In order to survive, we want to dramatically change the way we allocate scares resources to different policies, move away from long lasting privileges, reward innovation and knowledge.

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