Italy’s Debt Sustainability Challenge is Increasing, Though ECB Support Mitigates Liquidity Risk

Concerns about Italy’s debt burden are underscored in Scope Ratings’ revision of the Outlook for Italy’s BBB+ long-term ratings to Negative on 15 May.

Elevated public debt

Italy’s general government debt is set to increase to more than 155% of GDP from 135% at end-2019. Risks to this baseline projection are heavily skewed to the upside. The increase in debt this year could be much greater if the Italian economy contracts more severely and/or the government activates additional resources to cushion a vulnerable economy. Italy has the second highest public debt-to-GDP ratio in the euro area and the highest ratio to GDP with regards to debt owed to the private sector – the segment of sovereign debt rated by Scope.

“We expect that a significant amount of public debt accrued during this crisis will be of permanent nature considering the Italian economy’s weak nominal growth and the government’s track record of pro-cyclical loosening of fiscal policy during phases of recovery after economic crises,” says Dennis Shen, lead analyst at Scope for Italy’s sovereign ratings. “Though the public debt ratio might stabilise or decline moderately immediately after the crisis, we expect the ratio to continue to increase longer term. Debts accrued in past crises have not been reversed in full before the next downturn hit.”

Italy’s record of insufficient debt reduction is in significant part the result of modest nominal growth. Over 2010 to 2019, nominal growth averaged 1.3% – with average real growth of 0.2% per year – which was the weakest in the euro area after Greece. Scope estimates Italy’s real economic growth potential at just 0.7% – the second lowest after Japan’s among sovereigns rated by Scope.

The EU recovery fund helps, but not game-changer alone

“Debt sustainability is challenging even with the assumption of the inception of an EU recovery fund by 2021,” says Shen.

The exact details of the proposed recovery fund have yet to be fully finalised; however, even under an assumption that Italy receives EUR 82bn (4-5% of Italian GDP) per the proposal of the European Commission, through grant monies spread across 2021-24, this significant amount would nonetheless remain insufficient to significantly dent the country’s high public debt burden. Here, this in part recognises that the ultimate economic impact of grants, loans and guarantees disbursed depends on long-run growth multipliers of projects undertaken.

“In addition, challenges relate to higher contingent liabilities from the EU’s joint financing of the fund alongside uncertain implementation of projects in the green and digital economies given Italy’s record of not fully utilising EU funds,” Shen says.

“That said, should EU recovery fund allocations arrive with associated conditionality, including the assurance of enhanced fiscal discipline post-crisis in reversing a significant 2020 deficit estimated at above 10% of GDP, this would make the fund more supportive to Italy’s credit ratings,” says Shen.

“This could partially address a risk we see on the horizon relevant across EU sovereign issuers,” says Shen. “Namely, that after European fiscal rules have been relaxed over this crisis in response to exceptional conditions, re-activation of the pre-crisis budget rulebook and a steering of governments away from any new normal of more elevated spending – especially under an environment of continued ECB support and low financing rates – may prove challenging.”

A more permanent role for the ECB to ensure debt sustainability

Structurally more elevated debt alongside increased government gross financing needs of above 25% of GDP a year over the medium run indicate a more permanent role for the ECB might be required to support the continuous roll-over of Italian debt at sustainable rates.

The Eurosystem now holds more than 20% of Italian medium- to long-term government securities – with this share increasing – representing a transfer of Italy’s marketable debts from the private sector to the ECB balance sheet. This has helped to slow what otherwise would be a sharper increase in the government debt stock owed to the private sector. Here, the extraordinary support from the ECB and EU for Italy as a systemically relevant issuer is slowing the speed of deterioration in the sovereign’s creditworthiness even as gross debt levels increase.

“We expect that the ECB balance sheet will continue expanding over time. While this supposed ‘temporary’ transfer of an increasing share of Italian debt to the Eurosystem books does not itself resolve debt sustainability, it does kick the need to have an answer to the solvency question down the road,” says Shen. “Similar to the case of Greece, Europe will expect Italy’s public debt can be brought down to more sustainable thresholds via reforms to raise growth potential whilst holding interest rates low. However, this strategy is likely to face challenges.”

For now, domestic demand for Italian government bonds supports the nation’s financing at accommodative rates. In May, the Italian Treasury raised more than EUR 22bn from an issuance in the BTP Italia series. The spread to Germany on 10-year Italian government bonds has declined to under 200 basis points, from 281bps mid-March.

Scope’s next scheduled calendar review date on Italy’s sovereign ratings is 30 October.

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