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Dennis Shen
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In a new report, Scope Ratings outlines a severe decline in nominal GDP in Italy (rated BBB+/Stable) this year from the Covid-19 crisis, with real economic output set to contract by 7.5% – and downside risk to this estimate. Italy’s budget deficit could widen to more than 10% of GDP while public debt is expected to rise above 155% of GDP from 135% at end-2019.

The ECB’s bond-buying programmes are crucial in ensuring Italy benefits from low interest rates, so a future move to wind down net purchases could increase longer-term financing risks given structurally higher yearly funding demands.

“We expect public debt to rise above a 155% of GDP level in 2020 with this debt ratio maintaining an upward trajectory longer term – remaining relatively unchanged in years of positive growth but adjusting significantly upwards in years of recession,” says Dennis Shen, lead analyst on Italy’s sovereign rating at Scope and co-author of the report. “This unfavourable long-term trajectory reflects in significant part weak nominal growth dynamics.”

Short- and longer-term debt sustainability risk

“In addition, with concern to short-term debt sustainability, we expect 2020 gross financing needs for Italy to rise above 30% of GDP under a baseline and then to fall somewhat, as fiscal deficits are trimmed after the crisis, but remain above 25% of GDP a year through 2024,” says Shen. “As such, financing needs are significantly above an IMF gross financing needs threshold of 20% of GDP, above which an advanced economy is categorised as under ‘high scrutiny’.”

In addition to its baseline debt projection, Scope sets out in the report a stressed scenario in which public debt levels rise more significantly.

Although government debt is increasing, budget stimulus of 4.5% of GDP in 2020 alongside 40% of GDP in public guarantees on bank loans are key components of the government’s counter-cyclical fiscal response, similar to that announced by countries like France and Germany.

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ECB actions mitigate immediate liquidity risks

For now, the ECB’s forceful actions have helped to avoid a liquidity crisis in the euro area and eased concern to an extent about Italy’s medium- to long-run debt sustainability.

Yields on 10-year Italian government bonds are below 2%, comparatively low when viewed against the above 7% reached during euro area sovereign crisis peaks of 2011-2012.

ECB intervention remains vital for the preservation of Italy’s market access and facilitating sustainable funding rates for the government to cover elevated financing needs.

We estimate the ECB could indirectly cover additional gross funding needs Italy has during this 2020 crisis beyond pre-crisis financing requirements of 2019 in full.”

This acknowledges the flexibility the ECB has – specifically with concern to the Pandemic Emergency Purchase Programme – to deviate from capital key purchase targets for a period of time and acquire more or less of a specific country’s bonds if it chooses. “This includes higher purchases for a while for those governments most exposed to the crisis, including Italy.”

Any winding down of ECB interventions presents challenges

“Nevertheless, our new analysis shows that Italy is likely to experience structurally higher debt post-crisis, alongside structurally higher annual funding needs, raising longer term questions over the sustainability of Italian debt especially under any scenario of greater reduction in intervention post-crisis from the ECB,” Shen says.

Future winding down in ECB crisis-era net purchases and any movement, in the long run, towards reducing the size of the ECB balance sheet – including, for example, any non-re-investment of maturing Italian government bonds – could present significant challenges for Italy and result in the more likely materialisation of debt sustainability concerns.

“Significant market assistance from Italian banks and Italian savers through so-called home bias – with 65% of Italian government debt held by domestic investors ensuring a stable local buyer base in moments of crisis – would only partially compensate in this scenario,” Shen concludes.

Download Scope’s full report

Dennis Shen is a Director in Public Finance at Scope Ratings GmbH.

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