FITCH Italy July 2011

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Italy

Special ReportRisks to Italys Public Finances

Summary The Italian government has set out an ambitious fiscal consolidation plan thatwould balance the budget by 2014 and firmly place the public debt to GDP ratio ona downward path. In the absence of negative shocks, adherence to the fiscaltargets set out by the government would be consistent with stabilising Italyssovereign credit profile and rating at AA. The Stable Outlook on Italys sovereignratings is based on Fitch Ratings expectation that the government is likely tosucceed in reducing the budget deficit as planned and secure a steady reduction in

the government debt to GDP ratio from 2013. Material slippage from thegovernments stated mediumterm fiscal targets would put Italys sovereign ratingsunder downward pressure.

The public debt to GDP ratio would still fall under current government plans assuming that the economy expanded at 1% or more a year even if 10yeargovernment bond yields were to rise to 7% and stay at that level for a prolongedperiod. This reflects the average life and duration of Italian public debt of 7.1 and4.9 years, and the rising primary (noninterest) budget surplus aimed for by thegovernment. However, such high interest rates would adversely affect public debtdynamics by raising the cost of capital for the economy as whole.

Fitch considers that the main risk to the mediumterm outlook for public financesand Italys sovereign ratings would stem from the combination of weakerthanexpected economic growth and higher interest rates on government borrowing.Under such a scenario, even if the government were able to fully implement itsfiscal consolidation strategy, the budget deficit would remain greater than 1% ofGDP by 2014 and steadily rise thereafter as higher borrowing costs began to feedthrough into the budget, causing public debt to rise again. Nevertheless, Fitchbelieves that there is sufficient room in the 2011 budget and mediumtermconsolidation strategy to absorb somewhat weaker economic recovery than assumedby the government, and a temporarily higher marginal cost of fiscal funding.

Italys low growth rate relative to its highincome developedmarket peers is alongstanding weakness and reflected in Fitchs current sovereign rating. Theagency believes that the longrun potential annual rate of growth of the Italianeconomy is just 1%. However, more radical structural reforms than those set out inthe National Reform Programme, which would be necessary to substantially boostthe potential growth rate, are unlikely before general elections expected in early2013. The low potential growth rate renders Italy sovereign credit profilevulnerable to adverse external shocks.

In Fitchs opinion there is broad political and public recognition of Italys verylimited fiscal space due to the high level of public debt. Moreover, thegovernment has demonstrated its political commitment to meeting its fiscal targetswith a slightly better deficit outturn than budgeted in 2010 (4.6% rather than 5% ofGDP) and additional measures submitted to parliament in June 2011. Nevertheless,the extent and duration of spending restraint required, especially at regional andlocal government level, is challenging in a historical and political context. Inaddition, part of the fiscal adjustment is to be achieved through higher tax receipts

that reflect ongoing efforts to improve tax compliance, which may not succeed.Reforms that would further strengthen the fiscal framework and discipline wouldhelp alleviate Fitchs concerns about the risk of slippage against the governmentsgoal of a balanced budget by 2014.

RatingsForeign Currency LongTerm IDR AAShortTerm IDR F1+

Local Currency LongTerm IDR AA

OutlooksLongTerm ForeignCurrency IDR Stable

LongTerm LocalCurrency IDR Stable

AnalystsDavid Riley+44 20 3530 [email protected]

Paul Rawkins+44 20 3530 [email protected]

Raffaele Carnevale+39 02 87 90 87 [email protected]

Related Research Italy (November 2010)
http://www.fitchratings.com/creditdesk/reports/report_frame.cfm?rpt_id=539420mailto:[email protected]:[email protected]:[email protected]


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Risks to Italys Public FinancesJuly 2011 2

Fiscal Policy Framework and TargetsIn response to the Pact for the Euro agreed by the European Council on 2425March 2011, the Italian government has combined within its Economic and FinancialDocument 2011 (DEF 2011) its Stability Programme (SP) fiscal commitments and aNational Reform Programme (NRP). 1 The DEF is now the governments key multiyear fiscal and economic policy document, replacing the previous multiyearplanning document, the Public Finance Decision (DPF). The preparation of the DEFaccords with the enhanced Europeanlevel review and coordination of Euro AreaMember States economic and fiscal policies. 2

The inaugural DEF was endorsed by parliament and published in April 2011. It setout the governments fiscal targets for 20122014. 3 However, although specificmeasures have been enacted to meet the 2011 and 2012 budget deficit targets,further steps were required to underpin the credibility of the goal of balancing thebudget by 2014.

Figure 1 MediumTerm Fiscal Targets(% GDP) 2009 2010 2011B 2012f 2013f 2014f Net borrowing 5.4 4.6 3.9 2.7 1.5 0.2Primary balance 0.7 0.1 0.9 2.4 3.9 5.2Public debt 116.1 119 120 119.4 116.9 112.8Structural budget balance 3.5 3.3 2.9 2.2 1.3 0.5MemoReal GDP (% change) 5.2 1.3 1.1 1.3 1.5 1.6Effective interest rate (%) 4.2 4 4.1 4.4 4.6 4.8Source: DEF April 2011

Additional Budget Measures June 2011 In the last week of June 2011 the government announced specific fiscal policy andreform measures equivalent to EUR40bn (about 3% of 2010 GDP), largely affecting the2013 and 2014 budgetary position. The government submitted to parliament a DecreeLaw, which will be approved before the summer recess (7 August) that will providethe legislative basis for around EUR25bn of the overall fiscal adjustment. Theremaining EUR15bn are based on fiscalreforms that will be implemented underan Enabling Act, or legge delega .

Fitch expects that a provision will beincluded in the Enabling Act that willauthorise the government to reducetax expenditures (ie, tax deductions

and exemptions) if by October 2012 theEnabling Act does not secure theEUR14.7bn target. Ministerial officialsreport that such a safeguard clausecould be included in the Decree Law.Such provisions would enhanceconfidence in the goal of a balancedbudget by 2014.

1 See Fitchs Comment, EU Summit and ESM: Rating Implications , published on 30 March 2011 andavailable at www.fitchratings.com.

2 The Stability and Growth Pact (SGP) remains the cornerstone of coordination of national fiscal

policies in the euro area, including the excessive deficit procedure (EDP) triggered by a budgetdeficit that exceeds 3% of GDP. Failure to comply with European Council recommendations forcorrecting the deficit over a specified time period can, in theory, result in sanctions and fines.Italy, along with several other Member States, is under the EDP.

3 The 3.9% of GDP deficit target for 2011 was articulated in the DPF 20112013.

Figure 2

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Decree law Enabling act

June Deficit Reduction Measures Cumulative fiscal impact

(EURbn)

Source: Ministry of Economy and Finance


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Of the total EUR40bn of measures, twothirds consist of spending measures, and therest of tax compliance along with the imposition of stamp duty on securities. Localand regional governments will effectively face EUR11.4bn of spending cuts

(EUR6.4bn reduction in national transfers to local authorities and EUR5bn lessregional health spending), while EUR6.1bn of savings will come from currentexpenditure at central government level (mostly the extension of the civil servicepay and hiring freezes until 2014 and 2013, respectively).

Key Risks and Sensitivity AnalysisFitch considers there to be three key risks to the achievement of the governmentsmediumterm fiscal objective of balanced budget and declining debt.

Political opposition to the measures, especially the reduction in regionaltransfers and the implied cuts in spending by regional and localgovernments, which could result in a material weakening of the fiscalprogramme during the process of legislative approval and/or

implementation; Weakerthanprojected economic growth over the medium term; and

Substantially higher interest rates as a result of contagion from the euroarea sovereign debt crisis, and/or a broader upward repricing of sovereignrisk, especially regarding Italy.

Although political risks to the fiscal consolidation strategy are rising as the strainsin the governing coalition become more pronounced, Fitch believes there is broadpolitical and public recognition of Italys very limited fiscal space and the need toreduce the budget deficit and public indebtedness. Nevertheless, as generalelections approach (no later than April 2013), it will become progressively moredifficult to secure agreement for additional fiscal measures and structural reformsto boost the growth potential of the economy.

Fitchs sovereign rating on Italy already incorporates its relatively weak economicperformance over the 2000s and is premised on longrun potential trend rate ofannual growth in the economy of just 1%. However, the agency does share theauthorities opinion that Italy will benefit from a period of abovetrend growthbecause the macroeconomic imbalances and excessive private sector indebtednessthat are weighing on the growth of other major developed economies are notpresent. However, recent economic data has disappointed and Fitch forecasts theeconomy to expand by 0.7% in 2011 compared with the budget assumption of 1.1%.

Figure 3

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Spread (RHS) Yield (LHS)(10r bond yield, %)

Italian Government Bond Yields and Spread

Source: Datastream and Fitch

(Spread over bunds, bps)

The third major risk to the mediumterm fiscal goal of a balanced budget andsteadily declining public debt burden is permanently higher costs of funding for thegovernment. The spread between Italian and German government bonds rose above200bp in June 2011, its highest level since the launch of the euro. However, the


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Italian Treasury has also gradually extended the average life and maturity of publicdebt to 7.09 and 4.87 years, respectively, reducing the shortterm fiscal risksassociated with higher credit spreads and interest rates. Even if credit spreads were

to remain at their current very high levels, it would take several years for the fulleffect to feed through into a higher interest burden on the budget, and public debtwould still fall assuming the government continued to meet its primary (noninterest) budget targets and growth was unchanged.

However, it is the latter assumption that would be tested if credit spreads and thecost of borrowing persist at current levels. Government bonds continue to set thebenchmark for the pricing of nonsovereign credit and higher yields on governmentdebt could raise the cost of capital for the economy as a whole, with adverseimplications for economic growth over the medium term.

The scenario low growth/high credit spreads shown in Figure 5 would, in theabsence of further fiscal measures, result in a widening budget deficit and risingpublic debt from 2015 as the impact of higher interest rates on the budget begins tobe felt more directly. Conversely, a return to precrisis credit spreads and anincrease in the trend rate of growth of the Italian economy to 1.4% theauthorities estimate but do not assume that the measures in the National ReformProgramme could boost the annual growth rate by 0.4 percentage points wouldimply a rapid fall in public indebtedness, again assuming that the governmentadheres to its fiscal consolidation strategy.

Figure 4

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2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020

Baseline Low growth High spreadsLow growth/high spreads High growth/low spreads(% GDP)

MediumTerm Public Debt Scenarios Gross government debt

Source: Fitch

Figure 5

Assumptions Underlying MediumTerm Public Debt ScenariosReal GDP (% change) Yield spread bp

Scenario 20112014 20152020 20112014 2015220 Baseline 1.2 1.0 206 150Low growth 0.9 0.5 206 150High spreads 1.2 1.0 238 250Low growth/high spreads 0.9 0.5 238 250High growth/low spreads 1.2 1.4 131 25Note: Assuming that the current maturity and duration structure of public debt remains unchanged over the projectionperiod. Marginal cost of borrowing is based on forward rates for Bunds plus an assumed credit spread. The elasticity ofthe budget balance to real GDP is assumed to be 0.5, in line with European Commission estimates for Italy.Source: Fitch

7% Interest Rate Scenario Fitch does not regard a 7% yield on eurozone 10year government bonds as

necessarily a critical threshold from a sovereign credit and rating perspective. Thestock and structure of public debt, and the rate of growth of nominal GDP are alsocritical factors in determining the sustainable rate of interest.


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In light of the average duration ofItalian debt, it would take about fiveyears for a permanent increase in the

interest rate on new borrowing (themarginal cost of funding) to be fullyfelt in terms of interest service costsborne by the budget. Moreover, mostgovernments fund themselves acrossthe maturity spectrum, including atshorter maturities that are typicallyat a lower interest rate.

Fitch estimates that if the yield onItalian 10year government bondswere to reach 7% and stay at thatlevel, the effective interest rate on

Italian government debt would rise from around 4% to 5.5% by 2015, and interestpayments would be EUR110bn (6.1% of GDP) compared with EUR75bn (4.8% of GDP)forecast for 2011.

However, Fitchs (and the authorities) current baseline projections alreadyenvisage a rise in the effective interest rate as European Central Bank policy ratesgradually rise. Such a level of interest rates, other things being equal, would notprevent a gradual reduction in the public debt to GDP ratio over the period.However, higher interest rates on government debt raise the cost of capital andrestrict the availability of credit to the economy as a whole, with adverseconsequences for real (and nominal) economic growth. This in turn would weakenpublic debt dynamics and increase the risk that the government would not meet itsdeficit reduction targets.

Figure 6

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2007 2009 2011 2013 2015 2017 2019

7% 10yr yields Baseline(% )

Nominal Effective Interest Rate Italian Public Debt

Source: Fitch


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FITCH Italy July 2011

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