Italy: High Debt-to-GDP Remains a Risk, Especially Should Central-Bank Support be Scaled Back

On Wednesday, the Italian Ministry of Economy and Finance (MEF) released the updated economic and fiscal plan for forthcoming years (NADEF), anticipating strong nominal economic growth and reduction of government debt to 146.1% of GDP by 2024 before achieving pre-crisis levels (134.3%) by 2030.

While recovery of Italy’s economy has been impressive over 2021 – in August, we revised up a 2021 forecast to 6.1% growth, the government’s assumptions for growth and inflation remaining very elevated over 2022-24 appear, however, rather optimistic.

Rosy assumptions and an expansionary fiscal policy mean government debt projections could prove sanguine

Rosy nominal growth assumptions alongside a fundamentally expansionary fiscal policy expected until the economy has fully recovered to pre-crisis trend levels of output – seen by government to not occur until 2024 – mean MEF longer-term projections concerning reductions of debt-to-GDP may prove sanguine.

For 2021, on the basis of strong nominal economic growth, we reduced our forecast for the general government deficit to 8.5% of GDP from an 11.7% estimate before, consistent also with a more constructive expectation for a reduction of the public debt ratio to 153% this year, after a record 155.6% in 2020.

We see reduction in the public debt ratio over 2021-22 based on assumed high nominal economic growth of 7.7% and 5.2% during initial recovery. However, there is risk an ambitious objective of the Ministry to achieve pre-crisis debt by 2030 does not materialise in view of uncertainty around potential changes to the EU’s budgetary rules post-crisis, and the government’s expectation for the headline deficit to narrow only gradually over time, remaining above 3% of GDP by 2024.

A prudent fiscal stance whilst retaining a pro-growth composition of expenditure key to debt sustainability

Scope Ratings expects a primary balance of an average of -1.8% of GDP over 2022-2026, remaining, though, below average primary surpluses of 1.5% over 2010-19. In the longer term, rather than reliance upon growth alone, a prudent fiscal stance seeking return to modest primary surpluses whilst retaining a pro-growth composition of expenditure will prove key to assurance of debt sustainability.

The sustainability of Italian debt will also hinge on the timely and effective deployment of Next Generation EU funding and their ultimate growth dividend. Assuming comparatively robust economic growth of an average of 1.8% over 2022-26 under a baseline economic scenario, Scope expects general government debt of around 153% in end-2026, still above an (already) elevated 134.6% of GDP pre-crisis (as of 2019).

An upward structural trajectory of government debt

The expectation for debt remaining well above pre-crisis ratios under benign baseline economic assumptions of no interruption to the recovery to 2026 underscores our view of Italy’s debt to GDP ratio remaining on an upward structural trajectory. Unless debt can be curtailed substantively during the coming period of favourable conditions for economic growth, public debt ratios will inevitably increase longer term given meaningful increases in debt expected in future crises.

High debt remains a core credit rating constraint at the BBB+ rating level we assign to Italy.

A scenario of more persistent inflation and abrupt withdrawal of monetary support represents a central risk

Concerns over long-run debt sustainability are mitigated by today’s accommodative market conditions, supported by the European Central Bank’s policy framework.

The ECB’s asset purchases and communication of continued exceptional support even after this Covid-19 crisis have anchored borrowing conditions of EU member countries with the most significant propensity for market stress such as Italy. Over 25% of Italian general government debt will have been transitioned to the joint Eurosystem balance sheet by end-2021, from 17% pre-crisis.

However, an adverse scenario of significantly more elevated and/or persistent euro-area inflation represents a vulnerability, which could result in a more abrupt withdrawal of monetary support. Such a scenario could subject highly indebted countries such as Italy to a more significant repricing of sovereign risk in debt capital markets – crystallising latent risk associated with debt and deficits accrued during the pandemic.

Scope Ratings revised the Outlook of Italy’s BBB+ long-term credit ratings to Stable, from Negative, on 20 August.

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Giacomo Barisone is Managing Director of Sovereign and Public Sector ratings at Scope Ratings GmbH. Dennis Shen, Director at Scope Ratings, contributed to writing this commentary.