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Italy’s public debt: Fragile growth, new government’s programme raise questions on sustainability

The trajectory of Italy’s public debt is a cause for concern given weak medium-term growth potential of 0.75% alongside the new government’s plans to roll back reform, raise spending and cut taxes, says Scope Ratings.

At 131.8% of GDP as of Q4 2017, Italy’s public debt remains 32pp above Q4 2007 levels and the second-highest in the euro area after Greece’s. Italy’s debt ratio has remained stubbornly high since 2014 despite sustained economic recovery and above-potential growth of 1.0% and 1.6% respectively in 2016 and 2017.

“This speaks to the scale of challenges in bringing about meaningful debt reduction,” notes Scope analyst Dennis Shen.

Difficulties in reducing public sector leverage partially reflect successively neutral to expansionary government budgets, including in 2018, with weaker than anticipated structural deficit adjustments. Moreover, EU bank bail-in rules have been bypassed owing to domestic concerns, resulting in the use of government monies to conduct bank rescues. The fact that Italy’s debt-to-GDP has not dropped to date despite peak economic growth raises questions on the long-term trajectory of debt, in view of inevitable pressures in an economic downturn.

The formation of the Five Star Movement-Lega government clouds the outlook for macroeconomic and fiscal policies. The coalition’s programme—pledging to scrap a 2019 VAT hike and reverse 2011’s pension reform—would place a strain on debt, even if only a modest slice of the more than EUR 100bn (greater than 5.8% of GDP) package were implemented. Italy’s fiscal space is restricted owing both to elevated debt and fragile nominal growth, noting inflation of just 1.1% in May and Scope’s estimate of Italy’s medium-term annual growth potential of a modest 0.75%.

In Scope’s view, the IMF’s baseline for a gradual decline in Italy’s debt ratio to 116.6% by 2023 is optimistic, as this assumes primary surpluses rising from 1.5% in 2017 to 3.6% by 2022-23. If, for example, primary surpluses were instead held constant at 2017 levels of 1.5% of GDP from 2019 onward, the debt ratio falls only to 125% of GDP. Moreover, in a “stressed” case, 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, the debt ratio rises well above 145% of GDP.

On 8 June, Scope affirmed Italy’s sovereign rating of A- but revised the Outlook to Negative from Stable. This reflected i) alterations in the Italian political landscape raising questions over the will and capacity of current and future governments to resolve Italy’s significant structural challenges, and ii) the programme of this singular government in challenging pre-existing debt sustainability concerns.

Scope observes, however, that Italy’s A- sovereign ratings remain underpinned by euro area membership, Italy’s systemic importance (holding Europe’s largest debt stock) and support from European institutions in adverse scenarios, a relatively long 6.9-year average debt maturity, moderate levels of private debt and implicit government liabilities, and the country’s large, diversified economy (2017 nominal GDP: EUR 1.72tn).

Please click here for Scope’s latest rating report on Italy from 8 June.