Italy’s Debt Sustainability Remains a Challenge, Despite Low Interest Costs and Pro-Growth Agenda
Scope Ratings believes Prime Minister Giuseppe Conte’s coalition government has an opportunity to raise Italy’s rate of recovery exiting this Covid-19 crisis with its pro-growth agenda. However, given the Italian economy’s historically low-growth potential with modest inflation expectations (of 0.8% 12-months ahead according to the latest Banca d’Italia survey), public debt is unlikely to be curtailed significantly post-crisis – even recognising the boon from near-record-low borrowing rates as well as support from the EU’s EUR 750bn recovery fund.
The government’s latest budgetary plan contained in the Documento di Economia e Finanza (NADEF) envisages discretionary measures in 2021 amounting to a fiscal expansion of 1.4% of GDP, including measures for southern regions, business support and funding for ministries. This proposed fiscal stimulus will support growth, but longer-term plans premised on a compilation of reforms to ensure elevated growth medium term, to return the public debt ratio to pre-crisis levels by 2031, face challenges, including in policy implementation.
Government projections for public debt trajectory seem optimistic
We consider Italian Ministry of Finance projections for a reduction in Italy’s public debt ratio of more than 23pps over the next decade as optimistic. The forecasts assume significant primary surpluses equivalent to 2.5% of GDP by 2026, representing a very significant consolidation from the primary deficit of 7.2% of GDP we estimate in 2020. In addition, the government does assume a significant hike in trend growth, averaging 1.6% by 2024-26. This compares with our estimate of the economy’s medium-term growth potential of 0.7%, and pre-crisis output growth that averaged just 0.2% over 2010-19.
In view of the current fiscal stimulus to tackle the economic and public health consequences of the pandemic, alongside still accommodative financial conditions supported by the extraordinary interventions of the ECB, we do not consider the government being able to achieve pre-crisis levels of primary surpluses of near 1.5% of GDP over forthcoming years of recovery as a given. On that basis, achievement of a higher primary surplus of 2.5% of GDP seems optimistic.
Yields nonetheless hit record lows, also fostering risk of budgetary moral hazard longer term
Nevertheless, the yield on the 10-year Italian BTP touched an all-time low of just above 0.6% last week compared with 2.4% at crisis peaks of March, underpinned by a declining disparity in borrowing costs between European nations. Ten-year BTPs have been trading around a spread of only 130bps above German Bunds. Earlier this month, Italy issued a three-year BTP with a zero coupon – the first such issuance on record – which was priced with a negative yield. Over recent months, unlike during past crises, as debt and deficits have risen, yields have declined. There is a risk of moral hazard, nonetheless, linked to this in governments’ spending behaviours longer term even if, short term, counter-cyclical spending amid the crisis is appropriate.
Italy has exercised, however, greater fiscal restraint during this crisis than many other economies of the region such as Germany or the United Kingdom, and authorities are targeting an ambitious longer-term consolidation.
Italy’s debt ratio seen to be on a structurally rising long-term trajectory
Nevertheless, instead of a sustained declining trajectory of public debt beginning in 2021 as assumed under the government or the latest IMF projections, we expect a comparatively flat trajectory of public debt in the years immediately after this crisis, currently projected around a 160% of GDP level, with this ratio potentially displaying a short-run moderate decline during initial 2021 recovery phases. Similar to our opinion before this crisis, we consider Italy’s debt ratio long term to be on a structurally rising trajectory, displaying modest changes during years of positive economic growth but seeing large increases during years of recession such as in 2020.
This pattern had seen Italy’s public debt ratio steadily increase entering this crisis, across multiple business cycles, from 104% of GDP as of end-2001, reaching 135% by end-2019, and around 160% in 2020 under Scope baseline expectations. As we move ahead in this decade, there remains the likelihood of additional adverse shocks that could impact the debt trajectory abruptly. This questions long-run debt sustainability.
Scope’s baseline is for a Q4 economic contraction amid fresh economic restrictions
Scope’s baseline scenario, which assumes a fresh round of economic restrictions in Q4 amid a significant second wave of coronavirus and a return to negative Q/Q growth in Q4 but with a second recovery phase beginning by the spring of 2021, foresees the Italian economy will contract by around 9% in 2020 before rebounding with growth of 6.1% in 2021. The fiscal deficit widens to 10.9% of GDP in 2020 from 1.6% in 2019, before easing to a nonetheless elevated 6.9% of GDP next year.
Alternatively, under a stressed scenario of a return to full national lockdown of the same scale of that of spring 2020 alongside an uneven 2021 recovery due to virus relapses, Scope estimates growth of -13.7% in 2020 before +4.3% in 2021. This stressed scenario could see not only higher explicit public debt but greater risk of crystallisation of contingent liabilities that impact the government balance sheet.
Unprecedented EU institutional support continues to support low-cost refinancing, although poor record of EU fund absorption a risk for sustained recovery
Nevertheless, Italy and other euro area economies are set to receive unprecedented support from EU institutions, including the recovery fund’s EUR 77bn in grants and EUR 128bn in loans to Italy over 2021-26. Italy’s poor record of absorption of EU investment funds poses the risk, however, that Italy’s fiscal response tied to EU funds may not be effective in supporting recovery longer term.
Favourable funding conditions due to ECB interventions have also been critical considering Italy’s elevated gross financing needs (GFNs). In 2020, Scope projects GFNs of about 33% of GDP, well above an IMF threshold of 20%, above which a mature economy is considered by the IMF as being under “high scrutiny”, with GFNs remaining well above a 20% of GDP level through 2025.
We estimate the share of Italy’s government debt held by the Eurosystem to rise to about 25% by end-year, and about 30% in 2021. As such, the nominal stock of public debt held by the private sector will indeed decrease by 2021 compared with 2019 levels even despite the significant debt accumulated in this crisis. This is credit positive near term.
Scope revised the Outlook on Italy’s BBB+ sovereign ratings from Stable to Negative in May.
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Dennis Shen is a Director in Sovereign and Public Sector ratings at Scope Ratings GmbH.