Italian public debt stood at 133.4% of GDP as of Q1 2018, 31pp above Q1 2008 levels. Italy’s debt ratio has remained high after reaching about the current level in 2014 despite sustained economic recovery since then. The limited scope for fiscal slippage is exhibited in difficulties reducing debt-to-GDP even during good economic times: Italy grew 1.2% YoY in Q2 2018, above Scope’s estimate of potential growth for Italy of 0.75%.
“A failure to firmly improve fiscal sustainability while Italy is growing above potential could leave the economy exposed to significant risk come a future downturn,” says Dennis Shen, analyst at Scope Ratings. “Significant pro-cyclical fiscal expansionary policy is a mistake at this later stage of the global cycle, as it increases the likelihood of pro-cyclical fiscal austerity becoming needed in a recession, amplifying the hardships of that recession.”
“This draft budget is at risk of being found in serious non-compliance by the European Commission, which will request significant modifications be made,” says Dr Giacomo Barisone, managing director of Scope’s Public Finance team. “In that regard, a period of interaction with the Commission will take place starting this month, with a final Italian budget, including possible revisions, due to be approved by parliament by year-end.”
Higher spending and lower taxes curtail future fiscal space while increased government borrowing and higher interest rates could crowd out private investment and consumption.
Scope has noted, for instance, that the IMF’s baseline for a gradual decline in Italy’s debt ratio to 116.6% by 2023 is optimistic, as this assumes budget balances improving from an estimated -1.6% in 2018 to a balanced position by 2021-23 alongside uninterrupted economic growth to 2023. If, for example, the fiscal deficit were raised to 2.4% of GDP and held at that level from 2019 onward, the debt ratio edges down only slightly to 127% of GDP by 2023, assuming nominal growth averages 2.4% over this period.
The debt ratio could climb well above 145% of GDP in a ‘stressed’ scenario in which Scope assesses the impact on Italy’s public-sector balance sheet under conditions of a global economic shock (with the effect of two years of recession in Italy and associated deterioration in the fiscal balance) alongside a simultaneous spike in market financing rates. Viewed holistically, Scope assesses debt sustainability risks as material. “The likelihood of Italy’s debt ratio taking an overall upward slope over a five-year horizon is non-negligible,” says Shen.
Scope awaits details of the new fiscal measures included in the 2019 budget alongside the published Update to the Economic and Financial Document as the budget is due to be submitted to the European Commission by 15 October. At this coming stage, Scope will evaluate the degree of a positive growth impulse based on the composition of the measures.
In Scope’s view, even though the government has held the 2019 fiscal deficit target to under the 3% of GDP Maastricht level, the significant upward revision in deficit objectives, continued non-observance of the debt brake rule, and a breach of Italy’s progress towards its medium-term objective of a balanced budget in structural terms (requiring an annual structural adjustment of about 0.6% of GDP) risk nonetheless a new Excessive Deficit Procedure. The structural deficit is now slated to weaken to above 2% of GDP in 2019.
Party leaders Luigi Di Maio and Matteo Salvini have staked considerable political capital on the elevated budget deficit goal so it may be hard to see them easily reversing course in the near term. From the EU’s perspective, any future consideration of sanctions (of 0.2% of GDP alongside available temporary suspension of European structural and investment fund inflows) must also crucially consider the impact on the May 2019 European parliamentary elections. The degree of market pressure (Italian 10-year bond yields have risen to 3.4%, the highest since 2014) and warnings regarding the budget’s consistency with the Italian Constitution will likewise prove consequential to any budgetary amendments.
On 8 June, Scope affirmed Italy’s sovereign rating of A- but revised the Outlook to Negative from Stable. Italy’s ratings reflect both credit strengths including a 6.9-year average public debt maturity with nearly 70% of debt held by the resident sector, as well as vulnerabilities like gross government financing needs of 21.3% of GDP in 2019 – the highest in the EU.
