Italy: Fiscal Prudence Requires Attention Even as Draghi Investment Plan Critical to Reviving GrowthItaly (rated BBB+/Negative Outlook) is relying on public investment to revive longer-term growth after the pandemic, but expansionary fiscal policy resting on somewhat optimistic growth assumptions inevitably raises questions with respect to debt sustainability longer term.
The Italian government presented earlier this month the fiscal plan and economic strategies for 2021 and beyond under the Economic and Financial Document (DEF). This week, the government of Prime Minister Mario Draghi outlines historic plans to put to prudent usage EUR 191.5bn of EU loans and grants – including spending on critical areas such as the green transition, digitalisation and infrastructure, targeting Italy’s less-developed southern regions – alongside around EUR 70bn of other national and EU resources and associated structural reform.
The government puts growth this year at 4.5%, rising to 4.8% in 2022, before falling back to 2.6% in 2023, 1.8% in 2024, and averaging 1.1% a year at the end of the decade under a scenario that incorporates the full effects of Next Generation EU (NGEU) funding from which Italy is the most significant EU beneficiary.
Sustained growth of above 1% per year seems optimistic
The sustained growth of well above 1% per year after Covid-19 does seem very optimistic – even with the positive economic support from the NGEU and associated government investment. Looking back over the last decade, economic growth averaged only 0.3% in the decade before the coronavirus crisis.
Our estimate of Italy’s potential growth of 0.7% is similar to a government estimate of 0.8-0.9% medium-run growth under government scenarios of incomplete implementation of NGEU. Italy’s realised economic growth has fallen short of comparatively modest potential growth estimates in the years pre-pandemic – constraining a higher estimate at this stage for future growth potential. Next, the scale of the growth impetus of this historic post-Covid-19 investment programme is unclear at this stage and will rest on how effectively implementation proceeds.
Italy is unlikely to reverse debt ratios by such a scale as to reach pre-crisis levels
The government expects economic impetus as well via an additional EUR 40bn (2.4% of 2020 GDP) fiscal package after the earlier EUR 32bn “DL Sostegni” support sleeve.
Italy’s budget deficit will widen at minimum short term: the government’s estimate in 2021 is 11.8% of GDP – above an earlier 7% government estimate as well as above Scope’s December forecast of 9% for this year – before shrinking to 5.9% of GDP next year and to the 3% Maastricht limit by 2025. Under government projections, public debt rises to around 160% of GDP in 2021 from 156% in 2020 before declining, under a scenario of “full NGEU effects”, to 135.5% of GDP by 2032, close to the 134.8% level before the crisis.
In our view, Italy is unlikely to reverse debt ratios by such a scale as to reach pre-crisis levels. The risk to budget deficits is, furthermore, skewed to the upside – as many households and businesses may require extended support and growth expectations might prove optimistic. While we are similarly of the view concerning the appropriateness of governments spending counter-cyclically during crisis, the issue, during a present early recovery, will be in deciding when and for which sectors government support will be pulled back to allow markets to again function and re-allocate resources more effectively, as well as when to allow select insolvencies.
Fewer restraints preventing higher sovereign borrowing
In view of ongoing transitions in fiscal orthodoxy in favour of pro-growth policies, the checks and balances pre-crisis that restrained the scale of spending have been eased exiting this crisis. Market disciplining powers against high spending and government excess are also likely to remain suppressed for a prolonged phase as ECB intervention has put in place an implicit put option, likely holding more durable signalling effects even after central bank purchasing begins to be wound back – restricting market willingness to sell off past boundaries.
Within such conditions of curtailed guardrails restricting sovereign balance sheet expansion, we have touched on in the past that projections of the government, the IMF and other forecasting organisations for a swift, sustainable decline in Italian public debt ratios starting from 2021 might be optimistic. Instead, we expect the Italian debt ratio to remain on an upward trajectory longer term – looking through the cycle. In this respect, general government debt might reach meaningfully higher levels beyond 160% of GDP.
Italy may not need to reverse public debt to pre-crisis levels
But, at the same time, Italy may not need to reverse public debt to pre-crisis levels.
Italy can sustain somewhat higher debt ratios at prevailing BBB+ credit rating levels than it could pre-crisis. This is partly because of the extraordinary European monetary and fiscal support but as well because of improvements in the profile of Italy’s government debt.
The weighted average cost of outstanding debt has fallen from 4% as of 2012 to an estimated 2% this year. With a 10-year BTP yield of only 0.8%, this weighted average cost of outstanding debt will continue declining. The Italian Treasury has lengthened the average life of debt to 7 years from 6.7 as of August last year.
Even if Italy’s current 160% debt ratio does not automatically signal crisis as this would have 10 years ago, there are nevertheless limits to how much debt Italy can ultimately hold within a monetary union in which the Italian sovereign does not have an independent monetary policy.
In the end, monetary space creates fiscal space
In the end, monetary space creates fiscal space – and how much fiscal space Italy has, as an example, to spend counter-cyclically in a future crisis even with higher levels of debt – depends on market confidence in the efficacy of Italian government policies, which might presently be high, but also on how much support the ECB is willing to give Italy and other euro area member states and the associated constraints the ECB itself faces in being able to provide continued scale in such support.
At this stage, we believe that even with high public debt, Italy has the fiscal space in a next crisis partly in view of the capacity for the ECB to ensure accommodative market conditions. But this, in and of itself, does not mean governments can ignore longer-run fiscal sustainability challenges.
For a look at all of today’s economic events, check out our economic calendar.