Italy’s new coalition government has a rare opportunity to strike the right balance between growth and austerity, leveraging near record low yields. However, addressing the problems of persistently high public debt and low growth remains a huge challenge, Scope Ratings GmbH, a leading European credit rating agency, believes. Italy’s public debt is unlikely to change and is predicted at 132% of GDP in 2021, the same level as that at the end of 2018.
“We will be reviewing our debt sustainability projections as well as our underlying assumptions including a fiscal deficit of 2% of GDP in 2019 before 1.9% in 2020 and growth forecasts later this autumn as details of the 2020 budget and medium-term fiscal program come in,” Dennis Shen, lead sovereign analyst on Italy at Scope, says. “The new government has a rare opportunity to strike the right balance between pro-growth policies and fiscal discipline as it draws up its 2020 budget at a time of ultra-low interest rates.”
“We also acknowledge the long-standing inability of Italian governments to significantly reduce public debt even at times of a growing regional and global economy, as evidenced over recent years. We have highlighted in the past that this failure to reduce debt during good economic times increases risks to Italian debt sustainability when the global economy inevitably faces a more significant future downturn,” Shen adds.
The new leftist government composed of the Five Star Movement (M5S), the Democratic Party (PD) and Free and Equal was sworn in on Thursday. According to Scope, formation of a M5S-PD government would be the most market-friendly outcome after Lega pulled out of its coalition with M5S.
“This new, less anti-establishment government has committed to improving Italy’s tense relations with the rest of the EU,” Giacomo Barisone, managing director in sovereign ratings at Scope, believes. “The appointment of ex-MEP Roberto Gualtieri as finance minister is perhaps the best sign of a new, less confrontational approach.”
“The still significant rally in Italian bond yields since mid-August reflects significantly reduced redenomination risk – which markets had associated to an extent with the risk of euro exit tied to Lega’s Euroscepticism and policy suggestions like mini-BOTs – as well as reduced fiscal risks,” Shen says. “Investors are right to be somewhat less on edge now that outsized delays to forming the 2020 budget appear less likely and the new government has said it will respect European fiscal rules.”
“The market rally also reflects the removal, at least for now, of snap election risks and associated extra political and policy uncertainty,” Barisone thinks. “Less policy uncertainty and greater political stability could boost Italian confidence and investment and, hopefully, support an economy badly in need of it: we estimate Italy will only grow 0.1% this year, before 0.6% next year. However, the sustainability of this new coalition government has its many doubters. It will be up to this government to prove currently low expectations wrong with regards to what it can achieve and whether there will be sufficient cohesion to enact meaningful structural reform, such as cutting the tax wedge, reducing the number of parliamentarians, facilitating the green economy transition and investing in higher long-term economic potential.”
The new government’s 26-point agenda includes an expansionary 2020 budget and an introduction of a minimum wage.
“In light of the weak Italian economy, a minor degree of fiscal accommodation is probably warranted,” Barisone says. “However, the devil is in the details: how will the government offset the planned scrapping of an increase in VAT in 2020 with alternative revenue-generating and cost-cutting measures?”
The decline in Italian yields, supported by market anticipation of ECB easing, has brought Italian 10-year borrowing rates to just under 1% and the spread on 10-year BTPs to Germany to about 150 bps.
“Lower borrowing rates support Italian debt sustainability; however, even with near record low rates and a more market-friendly policy programme, putting public debt on a more sustainable footing remains a prodigious challenge for the incoming government,” Shen says.
Scope estimates Italy’s medium-run growth potential at 0.7%, amongst the lowest for economies in Scope’s rated sovereign universe.