Italy: Looking beyond the political noise

DBRS Illustrative Insights

As expected, the new Italian government has unveiled a budgetary plan that implies a looser fiscal position and a less steep decline in the public debt-to-GDP ratio compared to the previous government’s projections. DBRS is not overly concerned about the expected deterioration in the fiscal deficit, provided Italy’s economic fundamentals do not deteriorate. That said, economic growth assumptions in this budgetary plan appear optimistic.

Much will depend on economic growth performance and whether policymakers can adequately strengthen Italy’s resilience to potential shocks. If implemented broadly in line with government proposals, the budget could inject some short-term stimulus into the economy in the form of increased infrastructure investment and social transfers, but these are unlikely to have a material impact on the real economy until H2 2019 or thereafter.

Meanwhile, economic activity already appears to be slowing in the wake of a less supportive external environment, lower business confidence and higher interest rates. In this context, DBRS does not expect a material improvement in Italy’s growth performance, and in the very near term (i.e., the next few quarters), the economy may be adversely affected. The main issue going forward is whether the government can formulate and deliver on a pro-jobs agenda that sustains, rather than reverses, Italy’s growth performance.

Will politics reverse Italy’s progress?

Italy has improved its ability to grow. Total employment is now above the pre-crisis level, reflecting the economic recovery since 2014 (see Exhibit 1). Moreover, Italy’s external position has improved with the current account surplus at 2.8% of GDP in Q2 2018 and an almost balanced net international investment position (NIIP). Despite rising sovereign bond yields, the implicit interest cost projected at 2.85% in 2018 remains the lowest in more than two decades (see Exhibit 2). The banking system has made progress in reducing the stock of NPLs and strengthening capital buffers. In DBRS’s view, risks to financial stability caused by the widening of Italian sovereign bond yields appear contained for the time being.

Despite the adverse market reaction since the new government’s formation, DBRS takes a balanced view of the government’s budget. In the draft budgetary plan, the government projects a fiscal deficit rising from an estimated 1.8% of GDP in 2018 to 2.4% in 2019, but then returning to 1.8% in 2021. The plan projects that the public debt-to-GDP ratio declines to 126.7% of GDP by 2021. As expected in July this year (DBRS Confirms Italy at BBB (high), Stable Trend), the measures outlined by the government in the draft budget imply only a gradual and partial implementation of the estimated EUR 100 billion measures announced in the governing contract in May. The government intends to boost public infrastructure investment, strengthen the poverty reduction mechanism and make pension requirements less stringent, by offering the opportunity for early retirement. In total, the poverty reduction mechanism and the option to retire early in 2019 could account for around EUR 14 billion of spending in 2019.

The timeline, the characteristics and implementation of these measures are key factors in assessing their likely fiscal impact. For example, the degree of penalisation for early retirement and if it will remain in place going forward with the same characteristics, are both important features. The new poverty reduction mechanism and the early retirement option are likely to be implemented later in the year and could be subject to potential recalibration. Delaying the timing of the expenditures could have an impact on economic growth starting from H2 2019 or thereafter. Moreover, the government excluded second-round effects in its fiscal projections. Such effects might reduce fiscal slippage, if policies generate a positive impact on growth. A lower deficit would bode well for debt sustainability and would reassure market participants.

Politics are a real issue

The two voices at the heart of the coalition government, the Five Star Movement and the League, are currently both very close in the opinion polls at around 30% of total votes. As a result, they continue to look to the European elections in May 2019 as an opportunity to gain some advantage, instead of working on an agenda that really would address the structural weakness of the country. That lack of focus is a concern. While the expected fiscal deterioration is unlikely to have an immediate adverse impact on Italy’s sovereign rating, an unexpected reversal of recent economic progress could have an impact. A prolonged period of market volatility and high spreads could also pose a challenge for Italian banks, undermining business confidence, affecting credit growth and contributing to asset re-pricing.

Inconsistent messages during the summer on euro area membership have also generated concerns. However, DBRS considers that a government intent on exiting from the Eurozone would have not presented a draft budgetary plan with expansionary measures of only around 0.4% of GDP, excluding the deactivation of the safe guard clauses (0.7% of GDP) for 2019. DBRS sees very little incentive for the Italian authorities to revive earlier proposals regarding a potential exit from the euro area, particularly given the likely effects such a revival would have on confidence.

At the same time, DBRS does not rule out that internal tensions in the governing coalition and within parties might test the duration of the government. In DBRS’s view this government is unlikely to serve its full legislative term.