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The euro zone's third largest economy is causing major headaches for investors — and it might get a lot worse

Alessia Pierdomenico | Bloomberg | Getty Images

When most of the euro zone seems to be flourishing, its third largest economy remains a major headache.

Italy is dubbed by many analysts as the biggest threat to the stability of the euro zone economy, even though recent data have come in above forecasts.

"Italy's GDP (gross domestic product) year-on-year percentage change is only half of the euro zone average," Marco Wagner, senior economist at Commerzbank in Germany told CNBC in an email. "This shall remain so for the time being," he added.

The Italian economy is set to rise 0.9 percent this year and 1.1 percent in 2018, according to forecasts by the European Commission. The euro zone grew at a pace of 2.1 percent year-on-year in the second quarter of this year from 1.9 percent in the first quarter, figures from the EU's statistical office showed earlier this month.

Economy improving in our main markets, France and Italy: Credit Agricole

However, recent Italian data has positively surprised analysts: Unemployment has fallen 0.7 percent in the first half of the year, youth unemployment fell to about 35 percent, a services sector index reached its highest level in a decade and three troubled banks have been rescued, easing concerns over the banking sector.

"The recovery is expected to continue, but risks ahead are significant," the International Monetary Fund (IMF) said at the end of July. The Fund revised upwards its forecasts for Italian growth this year, but warned that the "downside risks are significant."

The main problems

These include "political uncertainties, possible setbacks to the reform process, financial fragilities, and re-evaluation of credit risk during monetary policy normalization," the IMF said.

Erik Jones, professor of International Political Economy at Johns Hopkins University, cited the same reasons driving concerns about Italy.

"There's a giant amount of non-performing loans (NPLs)," he said. "The economic recovery is taking place but at a really slow pace … (And) there's political risks in the horizon with the upcoming general election," he added.

At some point in the future the ECB will raise rates, which question the sustainability of Italy's debt.
Erik Jones
Johns Hopkins University

Bad loans and high debt

According to figures from the IMF, Italy's NPL levels stood at 356 billion euros at the end of June of last year, corresponding to 18 percent of total loans for Italian banks, equivalent to 20 percent of Italy's GDP and one-third of the euro area total for NPLs. The figures have come down since the height of the crisis but they still call for additional measures, the Fund said.

Marco Secchi | Getty Images

High levels of bad loans constrain banks' ability to lend and can divert funds away from more productive parts of the economy. This can be a particular problem for an indebted country like Italy. Public debt is seen at 133 percent of GDP this year and at 131.6 percent in 2018, according to IMF forecasts. If the country doesn't take measures to address this high pile of debt, then Italy could become a bigger problem when the European Central Bank (ECB) begins to raise interest rates, as markets expect.

"At some point in the future the ECB will raise rates, which question the sustainability of Italy's debt," Jones from Johns Hopkins told CNBC over the phone.

Higher interest rates will mean higher rates for borrowers across the spectrum in Italy, increasing the chances of any defaults on car loans, bank loans, mortgages, and so on.

Election risk?

The general election, due next year, is another concern looming over Italy.

Opinion polls show that political parties with Euroskeptic views represent the majority of the voting intentions, a chart compiled by Commerzbank showed.

The chart shows the average of the latest ten polls of various polling institutes. The labels regarding which political party is euro-sceptic, -friendly is Commerzbank’s perception.

This makes any possible governing coalition unclear, Jones explained.

"Italy has started to grow again in recent years. But the recovery has been too weak to help claw back the ground lost from subpar growth that started well before, and was exacerbated by, the global financial crisis," the IMF said last month.

The Fund suggested more public investment, better targeting resources to the most vulnerable, lower pension spending, lower tax rates on labor, and bringing more enterprises and persons into the tax net as the next steps forward.