Resurgence of COVID-19 deals a blow to Italy’s nascent economic recovery

Over the past months, the Italian economy has surprised many on the upside. After a massive contraction in the first half of 2020 (17.8% vis-a-vis 2019Q4), the economy rebounded strongly in Q3. It grew by 16.1% compared to Q2 (figure 1), leaving the GDP level 4.4% lower than end-2019. While that is still a large gap, it matches the loss in euro area GDP and is much smaller than the loss of 9.1% in neighbouring Spain. However, looking ahead, the outlook for the fourth quarter is weak due to the rapid increase in virus infections and strengthened containment measures since end-October. We expect the economy to contract with over 2.5% q/q in Q4 and to more or less stagnate in Q1. Thereafter there is scope for recovery, based on the assumption that the second wave in Italy and broader Europe will have passed by then and that vaccination of the elderly and vulnerable population in the first half of the year offers scope to gradually loosen the reins again end Q1/early Q2. Inoculation of the entire population and complete removal of containment measures will take a bit longer, but should pave the way for more relaxations in the second half of 2021. All in all, we expect the economy to contract by 8.8% this year and to grow with 5.2% in 2021.

There are several reasons for Italy’s large rebound in Q3. Importantly, by going on a spending spree the Italian government, supported by the EU and the ECB, was able to prevent a massive drop in household income and rise in corporate defaults. Hence once containment measures in Italy were lifted in May and June, consumers took back to the high street, catching up demand. Another important feature of the recovery was that supply chain disruptions halting industrial production in the first half of the year quickly faded and global demand for many goods quickly rebounded, once containment measures were lifted in large parts of the world. This induced a rapid rebound in manufacturing production, business investments and exports. That said, not all containment measures were lifted (figure 3). Furthermore, especially international tourists largely eschewed the country(in Q3, almost 65% fewer international tourists arrived at Italian tourism accommodations). Moreover, while workers could not be fired due to a ban on lay-offs (still running) and businesses and self-employed have received subsidies, households still suffered income losses over the past quarters. People in short-time work schemes only receive 80% of their income and subsidies only partly cover drops in income of the latter two.

Consequently, GDP has not yet recovered to pre-crisis levels and the recovery differs much between sectors. On a higher aggregate, as everywhere, the industrial sector is outperforming the service sector. Yet within industry, there are large differences as well. The recovery of manufacturing of textiles, wearing apparel and leather, for example, is clearly lagging the average: respectively, -16% and -4.7% compared to pre-COVID level. Meanwhile, in services, retail sales were only 0.9% below pre-crisis levels in September, whereas especially hospitality venues still have a much larger recovery to run. In September, occupancy rates in hotels, for example, were some 35% below February rates (seasonally adjusted).

Going forward, differences between the manufacturing and services sector are likely to grow again in Q4, as will the differences between regions. The re-introduced containment measures since the end of October still fall short of the nationwide lockdown of end March/early April, but include a nationwide curfew, closure of many recreation venues and limited capacity and opening hours for bars and restaurants. On top of that, more intense lockdown measures apply in highly Covid-19-affected regions. These measures include the closure of hospitality venues and retail stores and limitations to travel in and out these regions. On 29 November, bars and restaurants were closed in about 52% of regions (based on GDP) and non-essential shops in about 16%. Apart from the regional approach, another main difference with the first lockdown is that plants are allowed to remain open, manufacturing production is not set to be hit by severe supply chain disruptions as in 2020H1 and that the external environment is more favorable/less weak. Accordingly the impact on manufacturing production will be significantly lower. All in all, we forecast the economy to shrink with over 2.5% q/q, which is substantial but clearly much less than in Q1 and Q2.

Beyond the very short term, the major question is what will happen once support to companies and workers will be reduced. So far, for this year, the Italian government has implemented several support packages worth in total over EUR 100bn (5.6% of 2019 GDP) and guarantee schemes with the potential to unlock over EUR 700bn loans to a broad range of businesses. Next year’s budget will include additional deficit spending to extend certain support measures, among which the short-time work scheme. But overall support to the economy will be less than this year and at some point the government will have to decide to let the economy adapt to the new normal, including letting go of the current ban on layoffs – or risk long-term paralysation and debt unsustainability. In our current projections we assume that that point will come over the course of next year. In our view this would inevitably lead to a rise in defaults and unemployment. Especially because, in October some 330 million hours (a bit less than 10% of total hours worked) were still authorized to be paid via the short-time work scheme for COVID-19 related reasons. While difficult to pinpoint exact figures, we forecast unemployment to rise from 9.6% in September 2020 to around 14% end 2021, remaining above the current unemployment rate level for several years. As consequence of, amongst other things, a projected rise in defaults and unemployment, we expect the economy to reach its pre-crisis GDP level only in 2024.

In our baseline we do incorporate the downward effect that the provisional agreement on the EU’s crisis recovery fund in July has had on interest rates, but not yet the EUR 80bn funds (4.5% of GDP) Italy is assumed to receive in grants between 2021 and 2026 if a final agreement on the EU budget and the fund is reached. The recovery instrument is still not final, nor is it definitive how much grants Italy would receive and when, let alone known where it would be spend on.