Sovereigns

Italy SpecialReport

Risks to Italys Public Finances

Summary
AA F1+

Ratings
Foreign Currency LongTerm IDR ShortTerm IDR Local Currency LongTerm IDR

AA

Outlooks
LongTerm ForeignCurrency IDR LongTerm LocalCurrency IDR Stable Stable

Analysts
David Riley +44 20 3530 1175 david.riley@fitchratings.com Paul Rawkins +44 20 3530 1046 paul.rawkins@fitchratings.com Raffaele Carnevale +39 02 87 90 87 203 raffaele.carnevale@fitchratings.com

The Italian government has set out an ambitious fiscal consolidation plan that would balance the budget by 2014 and firmly place the public debt to GDP ratio on a downward path. In the absence of negative shocks, adherence to the fiscal targets set out by the government would be consistent with stabilising Italys sovereign credit profile and rating at AA. The Stable Outlook on Italys sovereign ratings is based on Fitch Ratings expectation that the government is likely to succeed in reducing the budget deficit as planned and secure a steady reduction in the government debt to GDP ratio from 2013. Material slippage from the governments stated mediumterm fiscal targets would put Italys sovereign ratings under 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 10year government bond yields were to rise to 7% and stay at that level for a prolonged period. This reflects the average life and duration of Italian public debt of 7.1 and 4.9 years, and the rising primary (noninterest) budget surplus aimed for by the government. However, such high interest rates would adversely affect public debt dynamics by raising the cost of capital for the economy as whole. Fitch considers that the main risk to the mediumterm outlook for public finances and Italys sovereign ratings would stem from the combination of weakerthan expected economic growth and higher interest rates on government borrowing. Under such a scenario, even if the government were able to fully implement its fiscal consolidation strategy, the budget deficit would remain greater than 1% of GDP by 2014 and steadily rise thereafter as higher borrowing costs began to feed through into the budget, causing public debt to rise again. Nevertheless, Fitch believes that there is sufficient room in the 2011 budget and mediumterm consolidation strategy to absorb somewhat weaker economic recovery than assumed by the government, and a temporarily higher marginal cost of fiscal funding. Italys low growth rate relative to its highincome developedmarket peers is a longstanding weakness and reflected in Fitchs current sovereign rating. The agency believes that the longrun potential annual rate of growth of the Italian economy is just 1%. However, more radical structural reforms than those set out in the National Reform Programme, which would be necessary to substantially boost the potential growth rate, are unlikely before general elections expected in early 2013. The low potential growth rate renders Italy sovereign credit profile vulnerable to adverse external shocks. In Fitchs opinion there is broad political and public recognition of Italys very limited fiscal space due to the high level of public debt. Moreover, the government has demonstrated its political commitment to meeting its fiscal targets with a slightly better deficit outturn than budgeted in 2010 (4.6% rather than 5% of GDP) and additional measures submitted to parliament in June 2011. Nevertheless, the extent and duration of spending restraint required, especially at regional and local government level, is challenging in a historical and political context. In addition, 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 would help alleviate Fitchs concerns about the risk of slippage against the governments goal of a balanced budget by 2014.

RelatedResearch
Italy (November 2010)

www.fitchratings.com

13 July 2011

Sovereigns
FiscalPolicyFrameworkandTargets
In response to the Pact for the Euro agreed by the European Council on 2425 March 2011, the Italian government has combined within its Economic and Financial Document 2011 (DEF 2011) its Stability Programme (SP) fiscal commitments and a National Reform Programme (NRP).1 The DEF is now the governments key multi year fiscal and economic policy document, replacing the previous multiyear planning document, the Public Finance Decision (DPF). The preparation of the DEF accords with the enhanced Europeanlevel review and coordination of Euro Area Member States economic and fiscal policies.2 The inaugural DEF was endorsed by parliament and published in April 2011. It set out the governments fiscal targets for 20122014. 3 However, although specific measures 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 the budget by 2014.
Figure 1

MediumTerm Fiscal Targets

(% GDP) Net borrowing Primary balance Public debt Structural budget balance Memo Real GDP (% change) Effective interest rate (%)
Source: DEF April 2011

2009 5.4 0.7 116.1 3.5 5.2 4.2

2010 4.6 0.1 119 3.3 1.3 4

2011B 3.9 0.9 120 2.9 1.1 4.1

2012f 2.7 2.4 119.4 2.2 1.3 4.4

2013f 1.5 3.9 116.9 1.3 1.5 4.6

2014f 0.2 5.2 112.8 0.5 1.6 4.8

Additional Budget Measures June 2011

In the last week of June 2011 the government announced specific fiscal policy and reform measures equivalent to EUR40bn (about 3% of 2010 GDP), largely affecting the 2013 and 2014 budgetary position. The government submitted to parliament a Decree Law, which will be approved before the summer recess (7 August) that will provide the legislative basis for around EUR25bn of the overall fiscal adjustment. The remaining EUR15bn are based on fiscal reforms that will be implemented under Figure 2 an Enabling Act, or legge delega. June Deficit Reduction Measures Fitch expects that a provision will be Cumulative fiscal impact included in the Enabling Act that will Decree law Enabling act authorise the government to reduce (EURbn) tax expenditures (ie, tax deductions 40 and exemptions) if by October 2012 the 30 Enabling Act does not secure the EUR14.7bn target. Ministerial officials 20 report that such a safeguard clause 10 could be included in the Decree Law. 0 Such provisions would enhance 2011 2012 2013 2014 confidence in the goal of a balanced Source: Ministry of Economy and Finance budget by 2014.
1

See Fitchs Comment, EU Summit and ESM: Rating Implications, published on 30 March 2011 and available at www.fitchratings.com. 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 budget deficit that exceeds 3% of GDP. Failure to comply with European Council recommendations for correcting 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. The 3.9% of GDP deficit target for 2011 was articulated in the DPF 20112013.

Risks to Italys Public Finances July 2011

Sovereigns
Of the total EUR40bn of measures, twothirds consist of spending measures, and the rest of tax compliance along with the imposition of stamp duty on securities. Local and regional governments will effectively face EUR11.4bn of spending cuts (EUR6.4bn reduction in national transfers to local authorities and EUR5bn less regional health spending), while EUR6.1bn of savings will come from current expenditure at central government level (mostly the extension of the civil service pay and hiring freezes until 2014 and 2013, respectively).

KeyRisksandSensitivityAnalysis
Fitch considers there to be three key risks to the achievement of the governments mediumterm fiscal objective of balanced budget and declining debt. Political opposition to the measures, especially the reduction in regional transfers and the implied cuts in spending by regional and local governments, which could result in a material weakening of the fiscal programme 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 euro area sovereign debt crisis, and/or a broader upward repricing of sovereign risk, especially regarding Italy.

Although political risks to the fiscal consolidation strategy are rising as the strains in the governing coalition become more pronounced, Fitch believes there is broad political and public recognition of Italys very limited fiscal space and the need to reduce the budget deficit and public indebtedness. Nevertheless, as general elections approach (no later than April 2013), it will become progressively more difficult to secure agreement for additional fiscal measures and structural reforms to boost the growth potential of the economy. Fitchs sovereign rating on Italy already incorporates its relatively weak economic performance over the 2000s and is premised on longrun potential trend rate of annual growth in the economy of just 1%. However, the agency does share the authorities opinion that Italy will benefit from a period of abovetrend growth because the macroeconomic imbalances and excessive private sector indebtedness that are weighing on the growth of other major developed economies are not present. However, recent economic data has disappointed and Fitch forecasts the economy to expand by 0.7% in 2011 compared with the budget assumption of 1.1%.
Figure 3

Italian Government Bond Yields and Spread

(10r bond yield, %) 7 6 5 4 3 2 1 0 Jul 00 Jul 01 Jul 02 Jul 03 Jul 04 Jul 05 Jul 06 Jul 07 Jul 08 Jul 09 Jul 10 Source: Datastream and Fitch Spread (RHS) Yield (LHS) (Spread over bunds, bps) 300 250 200 150 100 50 0 Jul 11

The third major risk to the mediumterm fiscal goal of a balanced budget and steadily declining public debt burden is permanently higher costs of funding for the government. The spread between Italian and German government bonds rose above 200bp in June 2011, its highest level since the launch of the euro. However, the
Risks to Italys Public Finances July 2011

Sovereigns
Italian Treasury has also gradually extended the average life and maturity of public debt to 7.09 and 4.87 years, respectively, reducing the shortterm fiscal risks associated 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 full effect to feed through into a higher interest burden on the budget, and public debt would still fall assuming the government continued to meet its primary (non interest) budget targets and growth was unchanged. However, it is the latter assumption that would be tested if credit spreads and the cost of borrowing persist at current levels. Government bonds continue to set the benchmark for the pricing of nonsovereign credit and higher yields on government debt could raise the cost of capital for the economy as a whole, with adverse implications for economic growth over the medium term. The scenario low growth/high credit spreads shown in Figure 5 would, in the absence of further fiscal measures, result in a widening budget deficit and rising public debt from 2015 as the impact of higher interest rates on the budget begins to be felt more directly. Conversely, a return to precrisis credit spreads and an increase in the trend rate of growth of the Italian economy to 1.4% the authorities estimate but do not assume that the measures in the National Reform Programme could boost the annual growth rate by 0.4 percentage points would imply a rapid fall in public indebtedness, again assuming that the government adheres to its fiscal consolidation strategy.
Figure 4

MediumTerm Public Debt Scenarios

Gross government debt
(% GDP) 130 120 110 100 90 80 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 Source: Fitch Baseline Low growth/high spreads Low growth High growth/low spreads High spreads

Figure 5

Assumptions Underlying MediumTerm Public Debt Scenarios

Scenario Baseline Low growth High spreads Low growth/high spreads High growth/low spreads Real GDP (% change) 20112014 20152020 1.2 1.0 0.9 0.5 1.2 1.0 0.9 0.5 1.2 1.4 Yield spread bp 20112014 2015220 206 150 206 150 238 250 238 250 131 25

Note: Assuming that the current maturity and duration structure of public debt remains unchanged over the projection period. Marginal cost of borrowing is based on forward rates for Bunds plus an assumed credit spread. The elasticity of the 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. The stock and structure of public debt, and the rate of growth of nominal GDP are also critical factors in determining the sustainable rate of interest.

Risks to Italys Public Finances July 2011

Sovereigns
In light of the average duration of Italian debt, it would take about five years for a permanent increase in the interest rate on new borrowing (the marginal cost of funding) to be fully felt in terms of interest service costs borne by the budget. Moreover, most governments fund themselves across the maturity spectrum, including at shorter maturities that are typically at a lower interest rate.
Figure 6

Nominal Effective Interest Rate

Italian Public Debt
(% ) 6.5 6.0 5.5 5.0 4.5 4.0 3.5 3.0 7% 10yr yields Baseline

Fitch estimates that if the yield on 2007 2009 2011 2013 2015 2017 2019 Italian 10year government bonds Source: Fitch were to reach 7% and stay at that level, the effective interest rate on Italian government debt would rise from around 4% to 5.5% by 2015, and interest payments 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 already envisage a rise in the effective interest rate as European Central Bank policy rates gradually rise. Such a level of interest rates, other things being equal, would not prevent 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 and restrict the availability of credit to the economy as a whole, with adverse consequences for real (and nominal) economic growth. This in turn would weaken public debt dynamics and increase the risk that the government would not meet its deficit reduction targets.

Risks to Italys Public Finances July 2011

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Risks to Italys Public Finances July 2011