Analysis-Italy defence drive could derail debt, hit ratings

By Sara Rossi and Valentina Consiglio

MILAN (Reuters) - Italy's pledges to increase defence spending to help Ukraine could scupper government efforts to rein in the mammoth public debt, analysts say, posing a threat to the creditworthiness of the euro zone's third-largest economy.

A European Union drive to hike military expenditure, in response to the Trump administration's moves towards a rapprochement with Russia and warnings that European security can no longer be its primary focus, is set to strain budgets around the bloc.

Italy, however, with its extremely low defence spending, heavy debt load and the euro zone's highest borrowing costs, is in a particularly difficult position.

Rome currently spends around 1.5% of gross domestic product on defence, one of the lowest levels in the EU alongside Spain, Portugal and Belgium.

Raising that to 3% over the next four years, as urged by the European Commission, would mean finding an extra 30-35 billion euros ($38 billion), either through extra borrowing or spending cuts.

It is a tough choice that will be closely watched by financial markets and credit ratings agencies focused on the trajectory of the euro zone's second-largest public debt pile.

"If this additional expenditure is financed through new debt issuance, it would weigh on Italy's already strained fiscal outlook," said Eiko Sievert, executive director at Scope Ratings.

RATINGS TESTS

Italy faces more than a month of ratings reviews by all the main agencies, beginning with Fitch on Friday.

Until recently, Rome harboured hopes of upgrades, but these have been dimmed by a weakening economy and the risk of a defence-driven rise in its debt, which at some 135% of GDP is second only to Greece in the 20-nation euro zone.

"We have Italy on a positive outlook, but one of the negative sensitivities we have is a potential change in our assessment of the debt trend," said Federico Barriga-Salazar, senior director, sovereigns at Fitch.

Italy's debt is currently targeted to rise to almost 138% in 2026 due to the lagged effect of a costly state-funded scheme to boost energy-saving home improvements, before declining steadily from 2027.

However, the European Commission's plans for EU-wide increases in defence spending would mean Italy's debt continuing to climb to around 145% by 2029, according to calculations by Scope Ratings, which will review Italy on May 23.

Italy's domestic politics is also muddying the picture.

How, and even whether, to boost the defence budget as promised to Brussels is a growing source of tension in Giorgia Meloni's three-party coalition and threatens the political stability that has so far reassured markets.

Economy Minister Giancarlo Giorgetti, from the far-right League party, said last month he was against increasing public debt but any extra defence spending must also not be funded to the detriment of health spending or public services.

Meloni has taken a non-committal stance and stressed the importance of keeping a lid on debt.

RISING YIELDS

Italy, which spent some 100 billion euros, or 4.5% of GDP, on debt servicing in 2024, has seen its bond yields rise sharply over the last month, alongside those of its euro zone peers, as the prospect of a German-led run-up in defence spending increased.

The yield on Rome's benchmark 10-year BTPs hit an eight-month high last month above 4%. A further increase in borrowing costs would complicate the Treasury's already challenging debt management efforts.

"If this repricing is not reversed, it could lead to a less-favourable path for interest rates, interest expenditure and budget deficits from this year," said Loredana Federico, Chief Italian Economist at UniCredit.

Analysts declined to speculate on what level of increased spending and debt might trigger a sell-off of Italian bonds, which already carry higher yields than those of any other euro zone country - a sign of the risk premium demanded by investors.

Some supporters of an arms drive say it could trigger a sufficient boost to economic activity to make it largely self-financing, but this idea is played down by most economists.

S&P Global said in a report on EU rearmament that it was "unlikely to spur economic growth" due to the import-intensive, fragmented and inefficient nature of the bloc's defence industry.

Italy's sluggish economy eked out growth of 0.1% in the fourth quarter of 2024 from the previous three months after stagnating in the third quarter. No near-term pick-up is expected.

Italy's business lobby Confindustria on Wednesday cut its 2025 GDP growth forecast to 0.6%, down from a 0.9% estimate made in October and just half the government's official 1.2% target.

According to Bank of Italy Governor Fabio Panetta, any defence-driven growth boost would only be short-lived.

"The manufacturing of war equipment does not help increase a country's growth potential," he said in a speech in January as the EU's rearmament plans began to take shape.

($1 = 0.9133 euros)

(Graphics by Stefano Bernabei, editing by Gavin Jones and Alex Richardson)