Italy’s prime rating constraint

Italy’s debt sustainability remains a prime constraint on Italy’s ratings. While the expansionary 2020 budget will support the currently weak economy and raise growth potential, it will also aggravate near-term budgetary and debt dynamics, Europe’s Scope Ratings says, noting soft economic growth, estimated at 0.6% in 2020 after just 0.2% in 2019, and low inflation, running at 0.2% YoY in October, continue to impair debt sustainability in Italy.

“A core dilemma for the government in Rome is the continuing gap between real interest rates on outstanding debt and real economic growth rates, even though Italy can borrow now at rates near record lows,” Dennis Shen, lead analyst on Italy’s sovereign ratings at Scope, says. “This differential prevents declines in debt as a percentage of GDP, offsetting the impact that significant primary fiscal surpluses are having in reducing debt. The greatest constraint on Italy’s reduction of high public debt is limited growth – which we estimate at just 0.7% per year over the medium run.”

Italy’s 2020 fiscal program includes some encouraging initiatives. Reducing the tax wedge for workers, promoting public and private investment, and increasing resources for education, science and industrial innovation help in raising Italy’s growth potential. However, those measures will have an impact over the longer term. In the meantime, the Italian government’s plans widen deficits and raise debt.

“Measures included in the draft budget will widen the budget deficit by 0.9% of GDP in 2020 – mainly via the repeal of a scheduled VAT increase worth 1.3% of GDP – offset only partially by fiscal consolidation elsewhere,” Giacomo Barisone, managing director in sovereign ratings at Scope, says. “Here, we ought not lose sight of the fact that 2020 represents another year of fiscal expansion in Italy, occurring under conditions of a growing global economy and limited Italian fiscal space. This curtails Italy’s remaining fiscal tools to support the economy counter-cyclically in the context of a more severe future global and euro area downturn.”

On 20 November, the European Commission (EC) noted that Italy is expected to show large deviations from its debt reduction benchmark in both 2019 and 2020 and was among a group of only four countries whose risks, according to the EC, relate both to the insufficient reduction of high levels of debt and to the projected deviation from the EC’s recommended fiscal effort.

Italy’s 2020 budget foresees a deficit of 2.2% of GDP, roughly unchanged on the estimated deficit in 2019. This is to be followed by deficits of 1.8% of GDP in 2021 and 1.4% of GDP in 2022. The Commission forecasts a slightly higher deficit in 2020 of 2.3% of GDP.

“While Scope forecasts a deficit of around 2.2% of GDP next year, the government’s 2021-22 budgetary expectations of 1.8% and 1.4% appear overly optimistic,” Shen says.

The EC has expressed its opinion that Italy’s Draft Budgetary Plan is at risk of non-compliance with the Stability and Growth Pact, projecting a risk of a “significant deviation” in 2019 and 2020. Italy’s structural deficit is seen by the EC widening by 0.3% of GDP next year, after a 0.2pp structural improvement to an estimated 2.2% of GDP structural deficit this year. The slight 2020 deterioration compares with a recommended 2020 structural improvement of 0.6% of GDP under EU rules.

“In the end, there’s certainly significant deviation from EU rules even allowing for Brussels’ willingness to tolerate somewhat looser policy given the Italian economy’s soft state and the extra spending necessitated by the 2018 Genoa bridge collapse,” Barisone believes. “However, the scale of the 2020 fiscal deviation, while large, technically is not nearly as large as what we saw in the 2019 budget tabled late in 2018 by Italy’s previous government.”

The new government’s comparatively more constructive approach in relations with the EU and the European Central Bank’s ultra-accommodative monetary policy also remain important factors in allowing Italy to keep rates low, supporting debt dynamics.

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