In a quite direct ‘threat’ to the newly formed Italian coalition, Moody’s warned that Italy will face a downgrade from its current Baa2 rating (potentially more than one notch to junk status) due to the lack of fiscal restraint in the new “contract” and the potential for delays to Italy’s structural reforms.
While Italy’s current rating is Baa2, and a downgrade would leave it at Baa3 (still investment grade), one look at Italian debt markets this week and one can be forgiven for thinking it is pricing in a multiple-notch downgrade to junk… and thus potentially making things awkward for its ECB bond-buying-benefactor and its banking system’s massive holdings of sovereign bonds.
Moody’s Investors Service has today placed the Government of Italy’s ratings on review for possible downgrade. Ratings placed under review are the Baa2 long-term issuer and senior unsecured bond ratings as well as the (P) Baa2 medium-term MTN programme, the (P)Baa2 senior unsecured shelf, the Commercial Paper and other short-term ratings of Prime-2/(P) Prime-2 respectively.
The key drivers for today’s initiation of the review for downgrade are as follows:
1. The significant risk of a material weakening in Italy’s fiscal strength, given the fiscal plans of the new coalition government; and
2. The risk that the structural reform effort stalls, and that past reforms such as the pension reforms implemented in 2011 are reversed.
Moody’s will use the review period to assess the impact of the fiscal and economic policy platform of the new government on Italy’s credit profile, with a particular focus on the effect on the deficit and debt trajectories in the coming years. The review will also allow Moody’s to assess further whether the new government intends to continue to pursue growth-enhancing structural reforms, or conversely to reverse earlier reforms, such as the 2011 pension reform, as well as other economic policy initiatives in the coming months that may have an incidence on the country’s growth potential over the coming years.
Italy’s long-term and short-term foreign-currency bond and deposit ceilings remain unchanged at Aa2 and P-1, respectively. Italy’s long-term local-currency bond and deposit ceilings also remain unchanged at Aa2.
RATIONALE FOR PLACING RATING ON REVIEW FOR DOWNGRADE
On 23 May, more than two months after the general elections on 4 March, the president mandated the prime ministerial candidate put forward by the Five Star Movement (5SM) and the Lega to form a coalition government. Together, the two parties command a reasonably solid majority in the lower house and a narrower majority in the upper house, and should therefore receive a vote of confidence in both chambers of parliament, with the votes likely to take place in the coming days.
When Moody’s affirmed Italy’s rating with a negative outlook in October 2017, the rating agency noted that Italy’s key credit vulnerability is the government’s very high debt burden. Moody’s explained that it would consider stabilizing the Baa2 rating if it had a high level of confidence that the debt ratio would be put onto a sustained downward trend, which would require a reorientation of fiscal policy towards achieving higher primary surpluses on a sustained basis.
Conversely, Moody’s stated that the rating would likely be downgraded if policies enacted or anticipated proved insufficient to place the public debt ratio on a sustainable, downward trajectory in the coming years.
The first key driver of today’s decision to place the rating on review is Moody’s concern that the new government’s fiscal plans suggest that the latter will indeed be the case.
Far from offering the prospect of further fiscal consolidation, the “contract” for government signed by the two parties includes potentially costly tax and spending measures, without any clear proposals on how to fund those. While Moody’s notes that some of the coalition parties’ original proposals have been modified in the final coalition agreement, they would still lead to a weaker, not a stronger, fiscal position going forward. So far, Moody’s has assumed a gradual deficit reduction over the coming years, which in turn would allow for a very gradual decline in the public debt ratio.
The review will allow Moody’s to seek more clarity on the new government’s plans in this regard, and in particular on the scope of the tax and spending pledges, specifically the “flat tax” and “citizen income” proposals, as well as their potential financing sources and the timeline for their implementation. The parties have also stated their intention to avoid the legislated increase in the VAT rate for next year, which would bring additional revenues worth around 0.7% of GDP. Higher budget deficits would hamper any reduction in Italy’s very high public debt ratio of over 130% of GDP.
At the time of the last rating action, Moody’s also noted that the outlook could be stabilized if a more ambitious programme of structural reforms were to be implemented, which would result in a sustainably stronger growth performance of the Italian economy. Conversely, a failure to articulate and present a credible structural reform agenda would put downward pressure on the rating.
A second driver of today’s action is Moody’s concern that, again, the latter will in fact be the case, and indeed that some important past reforms might be reversed. The rating agency will therefore also use the review period to assess some of the new government’s other pledges contained in the coalition agreement. The agency will explore what – if any – plans the government has to continue, in some form, the reform effort of the previous governments with further growth-enhancing economic and fiscal reforms.
A particular focus will be on the possible reversal of earlier reforms, such as the 2011 “Fornero” pension reform. In that particular case, marginal corrections with limited impact are not a source of concern. But a more generalized reduction in the retirement age would have a more material impact on the sustainability of the pension system. Moody’s notes that Italy already spends close to 16% of GDP on pensions, one of the highest ratios in advanced economies. While current long-term estimates forecast relatively stable pension spending as a share of GDP over the coming decades — in contrast to some other EU countries — those estimates rely on optimistic assumptions for population growth and employment trends. Rather than a reduction in the retirement age, Italy will probably require additional measures to maintain pension spending at a broadly stable ratio.
RATIONALE FOR NOT LOWERING ITALY’S Baa2 RATING AT THIS TIME
Moody’s recognizes that there inevitably exists substantial uncertainty whenever a new government is formed regarding that government’s intentions and capacity. Italy has maintained reasonably solid public finances for a long period of time and under different governments. Moody’s notes that the parties forming the new government seem to have accepted the need to maintain small budget deficits, given the limited fiscal space due to the very high debt ratio. It is also noteworthy that the new government’s “contract” does not include previous proposals that raised questions about the government’s commitment to Italy’s euro membership. More time is needed to assess what policies the new government is in fact likely and able to pursue.
The rating is also supported, for now at least, by the very low risk of a severe deterioration in Italy’s credit profile, such as could result from a far more confrontational stance vis-à-vis the euro area. Strong checks and balances and constitutional constraints exist which would impede any government from seeking to achieve fundamental changes to its role in, or obligations towards, the euro area in a way that would damage Italy’s credit profile. The Italian president holds significant power in ensuring that any Italian government honours its international commitments including those assumed by dint of membership of the euro area. Accordingly, while some of the above mentioned spending and tax plans place further doubt over Italy’s willingness and ability to meet its obligations under the EU fiscal compact and balanced budget rules, the risk of much more credit negative outcomes, up to and including exit from the euro area, remains very low.
The risk of a government liquidity crisis is also low, in Moody’s view. The government’s outstanding debt has a reasonably long average maturity (around seven years), debt management is very prudent and experienced, and while borrowing needs are substantial for this year and next (at around 22% of GDP), even significantly higher interest rates for newly issued debt would take a number of years to be reflected in materially higher government spending on debt interest. Monetary policy will remain an important support for government bond yields in all the euro area countries, including Italy.
Moody’s also notes that the Italian economy maintains significant underlying strengths and has been recovering from a prolonged period of very low growth. Italy’s economy is the third-largest in the euro area and its export and manufacturing sectors have experienced a solid recovery in recent quarters. While the public sector is highly indebted, the private sector generally has a much stronger balance sheet position. Leverage is low and households in particular have significant wealth and high levels of savings, an important buffer in a situation of stress.
WHAT COULD CHANGE THE RATING DOWN/UP
Rating drivers are essentially unchanged from the time of the previous action. Moody’s would likely downgrade the rating if, having assessed the new government’s proposed policies during the review, it were to conclude that its policies will be insufficient to place the public debt ratio on a sustainable, downward trajectory in the coming years. A failure to articulate and present a credible structural reform agenda which would enhance Italy’s economic growth prospects on a sustained basis, would be similarly negative for the rating.
Given the review, an upgrade is highly unlikely in the near future. Moody’s would consider confirming the Baa2 rating if, following the review, it had a high level of confidence that the debt ratio would be put onto a sustained downward trend. As before, this would require a reorientation of fiscal policy towards achieving higher primary surpluses on a sustained basis. The rating could also be confirmed if an ambitious programme of structural reforms were to be implemented by the new government, which would result in a sustainably stronger growth performance of the Italian economy.
The committee was called outside of the sovereign calendar dates for EU sovereign ratings, based on the event of the nomination of a new Italian government with a decidedly credit-negative fiscal and economic policy platform.
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