European Central Bank

Renzi’s mission: nurse Italy back to health

Italy's incoming prime minister has set an ambitious agenda to nurse the 'sick man of Europe' back to health but massive challenges await him

PUBLISHED : Thursday, 20 February, 2014, 11:50am
UPDATED : Friday, 21 February, 2014, 4:34am

Italy has been the "sick man of Europe" for some time. Matteo Renzi might just be able to restore it to health - but the remedy will not be delivered easily.

There's a huge amount at stake for the 39-year-old leader of Italy's ruling centre-left Democratic Party, nominated this week to form a new government, which he aims to have in place by Monday.

Although popular, energetic and determined to overhaul Italy's sclerotic institutions and radically reform its uncompetitive economy, forming a stable and durable coalition government to push through the changes the country sorely needs is a massive challenge.

It is nevertheless vital to do so if Italy's US$2 trillion economy - one of the world's biggest, the euro zone's third-largest and among the top 10 exporters globally - is to make it off the European Commission's critical list.

Disease set in long before the euro-zone crisis erupted in 2009, as a cursory glance at Italy's economic, institutional and political problems shows, so it's not surprising that Renzi's ambitious agenda to turn things around is being greeted with a fair amount of scepticism.

The most crucial step for him is to secure agreement on a new electoral law designed to give Italy stable and effective governments - a precondition for any meaningful fiscal and structural reform. After that, the battle must be waged on the economic front.

Italy is mired in a domestically driven downturn that has led to the longest recession since the second world war.

Youth unemployment is running at 42 per cent, non-performing loans in the banking sector have tripled since 2007, and the economy, which officially pulled out of recession in the fourth quarter of last year, contracted nearly 2 per cent in 2013.

Italy's principal problems are that it has far too much public debt and a woeful lack of growth.

It has been that way for many years. In 1998, a year before Italy became a founding member of the euro zone, government debt already amounted to a whopping 115 per cent of gross domestic product.

The economy has performed abysmally in Europe's 15-year-old single-currency area, growing at an average rate of just 1.2 per cent before the global financial crisis struck in 2008.

Stagnant productivity and a steady erosion in competitiveness - unit labour costs increased nearly 25 per cent between 1999 and 2007, according to the International Monetary Fund, and, more worryingly, have risen further throughout the euro-zone crisis, in stark contrast to Spain and Portugal - have been thrown into sharp relief, underscoring the urgency of productivity and labour market reforms.

When former centre-right premier Silvio Berlusconi was forced to resign at the end of 2011 amid a near-collapse in Italy's government bond market (the world's third-largest), there were high hopes that his well-regarded successor, the technocratic Mario Monti, would carry out the much-needed reforms demanded by Germany and the European Central Bank.

Yet Monti was not a politician and was out of touch with the political and social mood in Italy, which has turned much more euro-sceptic and anti-establishment over the past two years.

In last year's inconclusive parliamentary election, Beppe Grillo, a comedian-turned-politician, won nearly 25 per cent of the vote, having drawn support away from Italy's two main parties: Renzi's Democratic Party and Berlusconi's Forza Italia - which itself has splintered, resulting in the formation of a smaller, moderate centre-right group that Renzi is counting on to gain parliamentary backing to become premier.

And therein lies one of the biggest problems facing Renzi.

Having forced his Democratic Party colleague, Enrico Letta, to resign as premier, Renzi would be Italy's third unelected prime minister since the euro-zone crisis escalated in 2011.

He would also be dependent on the same fickle parliamentary support that made it impossible for his two predecessors to govern effectively and undertake necessary reforms.

Why might Renzi succeed where others have failed?

The question is particularly pertinent, given that Renzi, who is still the country's most popular politician despite serious misgivings about the undemocratic manner in which he is seeking the premiership, has raised the stakes for Italy significantly.

Given his extremely ambitious political and economic agenda - Renzi wants to agree on a new electoral law this month, launch reforms to the labour market next month, introduce changes to public administration in April and then reform the tax system in May - a "muddling-through" approach could be viewed more negatively by investors this time round.

A popular, business-friendly and reform-minded politician who is not even a member of parliament and who wants to renew and reform the country's discredited institutions, Renzi has clearly lifted the stakes.

Investors, however, are taking the latest developments in their stride. Italian governments rarely last longer than a year or so, and markets are not expecting an awful lot from Renzi.

This is troubling, particularly because investors have become remarkably complacent about Italian politics since ECB president Mario Draghi's July 2012 pledge to do "whatever it takes" to prevent the euro zone from breaking up.

The yield on Italy's benchmark 10-year bonds was already at its lowest level since 2006 before Renzi launched his bid for the premiership.

The only external pressure on Renzi comes from Brussels, which expects him to keep Italy's fiscal deficit under 3 per cent of GDP.

But as that requirement is hardly a recipe for growth, it is one that Renzi must likely challenge if he is to restore the sick man to health.

Nicholas Spiro is managing director of Spiro Sovereign Strategy