Even before the novel coronavirus severely struck Italy, the country was already in bad shape economically. At the end of last year, GDP was down 0.3% during the final quarter. A couple of weeks after two COVID-19 clusters were discovered in northern Italy, the government locked down the entire country. Every month of full lockdown in Italy sinks GDP by about 3% to 3.5%.

There’s been a sharp decline in business and consumer confidence. PMI data for March 2020 showed a massive collapse. The services sector index was down to 17.4, manufacturing to 40.5, and the composite indicator to 20.2. The latter is strongly correlated with GDP growth. But these indicators aren’t reliable when discussing major shifts in the economy – that’s why it’s difficult to have a clear view of where it’s headed. One thing is clear: Returning to normalcy may take a while. My preliminary assessment is a contraction for the current year by about 10% GDP. It’ll rebound next year by about 7% due to a carryover effect.

The Policy Response

After overcoming some initial confusion, the Italian government’s response was textbook. Based on the experience of prior crises, Italy introduced several measures, including fiscal relief for households; worker protections, including wage supplementation funds; measures to inject cash into small- to medium-sized enterprises; and a suspension of payments to social contributions in taxes. Eventually, the country will offer guarantees for companies through the banking sector. The government’s challenge will be to make sure that support for businesses is automatic and respects market rules. This would provide support to companies that are better positioned to survive in the future.

The problem is that the financing of these measures was done initially for only one to two months – clearly, there’s a need for more. Parliament approved and announced a package of only 25 billion euros. The next package will likely cost twice as much. To float a package that large, Italy needs the EU’s help.

Since Italy is at risk of a major financial crisis, the immediate solution is for Italy to seek an enhanced precautionary credit line with conditionality provided by the European Stability Mechanism (ESM). That amount would open the door for a possible intervention by the European Central Bank (ECB). That’s the only way to stop potential financial market pressure and keep interest rates low. Otherwise, the risk of an economic contraction would be very high.

A Lot Depends on Europe

Last year, the Italian deficit was 1.6% and the debt to GDP was short of 135%. The debt to GDP might easily exceed 160% due to the crisis, and that would clearly be extremely worrying for financial markets. That’s why the precautionary line is needed. The second line of defense would be measures to help the overall European economy, including some form of common funds either through the European Investment Bank (EIB), a commission-directed sponsor, money from the ESM, or some form of European fund for extraction. There could also be a measure of public investment in Europe and some expenditures related specifically to the contagion to support companies and households. It’s possible at next Tuesday’s Eurogroup meeting that some limited form of Eurobonds could be introduced.

Unfortunately, the crisis hit the Eurozone economy before any measures could be introduced to improve the economy’s macroeconomic stabilization function. Introducing a Eurobond or a safe asset in a rush may prove difficult because it means changing the treaties and regulations. It will need strong political backing in the face of opposition from some member countries. It’s unlikely that Europe will go for a full-fledged Eurobond, but these are already in play to some extent because the EIB is financing itself in the market. European leaders may lend extra money to the EIB and have it serve as the leading institution in Europe’s reconstruction in supporting companies and providing help to countries suffering the most.

Italy is two notches above investment grade by S&P inflation, and one notch above investment grade by Moody’s. S&P’s next decision is on April 24. There’s a high risk that rating agencies will trigger a downgrade. It very much depends on the European response; if Italy asked for a precautionary credit line, and that activates outright monetary transactions by the ECB, it would be a factor in avoiding a downgrade. The situation may change before the decision is made, however.

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About Lorenzo Codogno

Lorenzo Codogno is Founder and Chief Economist of his own consulting vehicle, LC Macro Advisors Ltd. He was previously Chief Economist of the Italian Treasury from April 2006 through February 2015, where he oversaw the economic analysis and planning directorate. Throughout this period, he was Head of the Italian delegation at the Economic Policy Committee of the European Union, which he chaired from January 2010 to December 2011, thus attending Ecofin and Eurogroup meetings with ministers.

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This article is adapted from the April 3, 2020, GLG teleconference “COVID-19 in Italy Economic Forecast.” If you would like access to this teleconference or would like to speak with Lorenzo Codogno or any of our more than 700,000 experts, contact us.