The combination of the government’s emergency policies and the plunge in economic activity means Italy’s fiscal health will see a massive blow. As analyzed in the most recent briefing, in our baseline we assume that the fiscal deficit will increase to around 10% of GDP and the government debt will see a level shift to around 155% of GDP. From the start of 2021, we expect Italian fiscal authorities to implement some tightening measures, gradually bringing the primary surplus to around 1.5% of GDP in 2022. Several risks, such as how the pandemic progresses and the length of the lockdown, could threaten our baseline view.
The table (Figure 2) below shows the debt-to-GDP ratio that’s likely to occur by 2025, starting from the estimate we currently have for government debt in 2020. It assumes different profiles for nominal GDP and fiscal easing and considers interest rates to be exogenous and around 2.5%. The latter is broadly in line with current Italian interest rates and with the 2019 figure. Moreover, fairly low interest rates, coupled with relatively long debt maturity, mean interest rates per se will not derail debt dynamics, at least in the short term. The risks to our debt baseline projections are linked to a combination of fiscal policy assumptions and growth projections.
If the primary balance stabilises at 0% in the medium term instead of our 1.5% baseline and nominal GDP growth fails to be more than 3%, the path for debt sustainability gets even narrower, with debt over GDP likely increasing over the next five years. But with respect to fiscal stances, Italy has proved that reaching a primary surplus of 1.5% is realistic. Indeed, it has achieved a 1.5% primary surplus on average since 2011. There’s a risk that as a consequence of the dire economic conditions the appetite for fiscal tightening could be lower over coming years. But even the populist government formed by the Five Star Movement and the Lega helped reach a primary surplus of 1.7% and a headline deficit of 1.6% in 2019, the lowest since 2007.
Therefore, the risks around Italian debt are more related to nominal growth rather than fiscal policies. And while our baseline forecast already sees a big hit to 2020 activity, it assumes a gradual recovery in H2. We expect real GDP growth to average almost 2% in 2020-2025, with inflation around 1%, leaving nominal GDP growth at around 3%. While this is lower than other eurozone peers, it’s quite high relative to recent Italian standards.
Nominal GDP growth at around 2%, 1ppt lower than our current baseline, means that in order to decrease the debt by around 10ppts by 2025, the primary balance would have to increase to 3% of GDP. Other than further reducing support for growth, this tighter fiscal stance will be difficult to achieve from a political point of view, highlighting the importance of economic growth as a key factor in ensuring debt sustainability.
Another way of looking at risks around our baseline forecast is to focus on the different narrative-based scenarios that we produced alongside our April baseline. Figure 1 shows Italian debt dynamics for four scenarios: our baseline scenario, an upside scenario, and two downside scenarios.
The two downside scenarios differ only in the medium-term dynamics. The key difference is that the impacts in the more severe case (Coronavirus Medium-Term Downside) are longer lasting due to a financial crisis, which limits credit supply to the economy. As a consequence of some austerity measures that bring the primary surplus to 2% of GDP by 2023, the debt, after having peaked above 180%, will stabilise but remains above 170% in the more severe downside scenario. Debt stays above 160% of GDP in the Coronavirus Pandemic Downside, after having peaked at 185% of GDP.
Furthermore, in the more negative scenario, we would expect the “doom loop” between banks and government debt to swiftly come to the fore again. Italian banks still own a big portion of Italian debt, representing around 10% of their total assets, as banks have increased their sovereign holdings in periods of debt stress (Figure 3). While today banks are better capitalized and the ECB’s QE keeps sovereign interest rates at reasonably low levels, the sovereign bank doom loop remains a threat for Italy.
A range of solutions can put Italian debt on a sustainable path
After having discussed the current environment and the risks around our baseline, in Figure 4 we summarize the strategies (some of the available options can be complementary) Italy can use to maintain its debt on a sustainable path, differentiated by the level of stress on the financial markets.
Below, we describe the options that will support Italy in maintaining its access to the financial markets in case of increasing market tensions that could lead to rising borrowing costs, but not to a loss of market access. We can also implicitly assume that some of these options are already considered in the baseline and will help Italy maintain its debt funding cost at low level and at around 2.5% over the forecast horizon. In the last section of Figure 4 we also present more drastic options that Italy could rely on in case of solvency issues.
Currently, Italy can count on a few EU instruments. Alongside the current ECB’s aid package (PEPP and TLTRO), Italy can rely on the recovery fund recently proposed by the Eurogroup and endorsed by the European Council. Even though the fund’s final size and strategy are still under discussion, we expect that a portion of the funds will be made available directly in the form of grants, while another portion will generate investment through loans.
In case of increasing market tensions, Italian debt can still count on the ECB, which under the current asset purchase program and via Bank of Italy currently holds more than 20% of Italian government debt. In addition, the ECB may increase the share of Italian bonds in its asset purchases, given that the new PEPP is not strictly following the principle of proportionality to the capital key. PEPP is set to expire at the end of 2020, but given the size of the pandemic crisis, it’s likely to continue and probably even expand. In this context, as one of the most affected member states, Italy will probably continue to be the main beneficiary. But tensions between euro area countries could arise with respect to the ECB’s exposure towards a single country.
The political debate about a possible debt mutualisation has paused for political reasons. The plan could consist of common debt issuances to finance the part of debt accumulated to mitigate the effects of the COVID-19 crisis. Italy would then benefit from more favourable borrowing costs because it would be jointly backed by all the member states and could have market access in a phase of mild market stress.
At the moment, the most probable and nearly immediate feasible solution in case of market stress for Italian BTPs would be the pandemic credit support granted by the ESM. Italy could apply for a credit line that would be available to all countries of the single currency bloc to cover expenditures related to direct and indirect health care costs. This credit line is worth up to 2% of each country’s GDP (around €36bn for Italy), so it’s very likely not sufficient for Italy’s financial needs. It will offer immediate funds to be reimbursed at very favourable terms, with a likely lower stigma attached than what we saw during the sovereign crisis.
The design phase of the instrument has generated a debate about the possibility of the pandemic line to gain access to the ECB’s Outright Monetary Transactions programme (OMT). Still, although the decision lies ultimately with the ECB, we think using the OMT for pandemic support will be difficult given the very light conditions attached.
A proper ESM credit line (ECCL) is unlikely at the moment given the high political resistance. The size of the aid would be bigger than the pandemic assistance and proportionate to the crisis, but stricter conditions would be involved. The downside of using this instrument is the stronger stigma attached. Given the current Italian political stance towards European institutions, we think the ECCL is very unlikely to be used in the near term.
These options would be only enough to allow Italy to maintain access to financial markets in a period of stress. Other more drastic options for putting Italian debt on a sustainable path (such as a proper macro-adjustment program with some debt restructuring) don’t currently enter into our baseline scenario.