And so it begins.
After a week of budget wrangling and amid relentless pressure on Italian assets, Moody’s downgraded Italy on Friday to Baa3 from Baa2. Mercifully, the outlook is Stable.
Moody’s cites the obvious when explaining their decision. Key drivers include “a material weakening in Italy’s fiscal strength”, the expectation that Italy’s public debt ratio “will stabilize close to the current 130% of GDP in the coming years, rather than start trending down as previously expected” and the country’s vulnerability to “weaker economic growth prospects, which would see the public debt ratio rise further from its already elevated level.”
The next hurdle is obviously S&P, which will render its judgement later this month.
A bit of conciliatory rhetoric from both sides on Friday notwithstanding, there’s no end in sight to the tension between Italy’s populists and Brussels. Absent last minute concessions, it’s likely the E.U. will reject Italy’s budget, setting the stage for more pain in BTP land and more losses in Italian equities.
The fear is that more selling pressure (if it materializes) could become a self-fulfilling prophecy, as higher yields further imperil the country’s debt dynamics.
“Once ratings are updated, and should Italy be downgraded by one notch by Moody’s and potentially S&P by the end of October, we would consider any potential positive market response to be transitory”, Goldman wrote earlier this week, before warning that if you look at the “broader picture, Italy would be only one mark above ‘speculative’ grade and would still be exposed to meaningful fiscal, macro and political risks.”
Full rationale from Moody’s
London, 19 October 2018 — Moody’s Investors Service has today downgraded the Government of Italy’s local and foreign-currency issuer ratings to Baa3 from Baa2. The outlook on the rating has been changed to stable. This concludes the review initiated on 25 May.
Moody’s also downgraded to Baa3 from Baa2 the local and foreign-currency senior unsecured bond ratings. The foreign-currency senior unsecured shelf and MTN ratings were downgraded to (P)Baa3 from (P)Baa2. Italy’s local-currency commercial paper rating and foreign-currency other short-term rating were downgraded to P-3/(P)P-3 from P-2/(P)P-2. The rating outlook is stable.
The key drivers for today’s downgrade of Italy’s ratings to Baa3 are as follows:
- A material weakening in Italy’s fiscal strength, with the government targeting higher budget deficits for the coming years than Moody’s previously assumed. Italy’s public debt ratio will likely stabilize close to the current 130% of GDP in the coming years, rather than start trending down as previously expected by Moody’s. Moreover, the public debt trend is vulnerable to weaker economic growth prospects, which would see the public debt ratio rise further from its already elevated level.
- The negative implications for medium-term growth of the stalling of plans for structural economic and fiscal reforms. In Moody’s view, the government’s fiscal and economic policy plans do not comprise a coherent agenda of reforms that will address Italy’s sub-par growth performance on a sustained basis. Following a temporary lift to growth due to the expansionary fiscal policy, the rating agency expects growth to fall back to its trend rate of around 1%. Even in the near term, Moody’s believes that the fiscal stimulus will provide a more limited boost to growth than the government assumes.
The stable outlook reflects the broadly balanced risk at the Baa3 rating level. In Moody’s view, Italy still exhibits important credit strengths that balance the weakening fiscal prospects. These strengths include a very large and diversified economy, a solid external position with substantial current account surpluses and a near balanced international investment position. Italian households have high wealth levels, an important buffer against future shocks and also a potentially substantial source of funding for the government.
The foreign and local currency bond and deposit ceilings were lowered to Aa3 from the previous Aa2. The short-term foreign-currency bond and deposit ceilings were unchanged at Prime-1.
RATIONALE FOR THE DOWNGRADE TO Baa3
FIRST DRIVER: WEAKENING FISCAL STRENGTH, WITH HIGHER BUDGET DEFICITS IN COMING YEARS IMPLYING THAT THE PUBLIC DEBT RATIO WILL REMAIN ELEVATED
The first driver of today’s downgrade to Baa3 is the recently announced material shift in fiscal strategy, with significantly higher budget deficits planned for the coming three years compared to earlier expectations. The shift towards an expansionary fiscal policy suggests that, rather than falling over the coming years as was projected under the previous government’s fiscal stance, Italy’s public debt will instead remain around the current 130% of GDP, a level that makes Italy vulnerable to future domestic or externally-sourced shocks, in particular to weaker economic growth. Moody’s has previously stated that addressing this vulnerability by engineering a clear downward trend in the public debt ratio was important if Italy’s rating was to be maintained at the Baa2 level.
The government targets a general government budget deficit of 2.4% of GDP for next year, higher than this year’s likely outturn of around 1.9% and materially higher than Italy’s commitments under the EU’s fiscal rules. It projects budget deficits for 2020 and 2021 of 2.1% and 1.8% of GDP respectively, compared to a balanced position targeted before.
Most of the government’s spending increases are structural in nature, implying that they will be difficult to reverse. The material upward deficit revision reflects in particular the implementation of the Five Star Movement’s flagship measure, the so-called citizen’s income, as well as higher spending on employment centers and new routes for early retirement, which the government estimates will together cost 0.8% of GDP per year on average over the next three years. The decision not to activate a pre-legislated increase in the VAT rate implies foregone revenues of 0.7% of GDP in 2019. Increased public investment will absorb a further 0.2% of GDP in 2019, rising to 0.3% of GDP by 2021. The early retirement option is ostensibly intended to be a one-off measure, available next year only, and as such would be more limited in scope than Moody’s first assumed. However, in Moody’s view there is a material risk that the measure will be extended into future years given the likely political pressure to offer similar avenues for early retirement again in the future. And even if time-limited as the government intends, it will still have a material and ongoing fiscal cost (estimated at close to 0.4% of GDP).
Moody’s expects higher budget deficits than the government, at around 2.5% of GDP in each of the coming three years. This reflects (a) the coalition parties’ stated intention to implement their election campaign pledges over the coming years, including potentially costly tax cuts for both corporates and households (under the so-called “flat tax” proposal), and (b) Moody’s more conservative growth forecasts for the coming years. The rating agency raised its growth forecasts slightly in both 2019 and 2020 as the fiscal stimulus should indeed provide some uplift to private and public consumption, while the public investment programme should support (construction) investment. But Moody’s considers the government’s projections to be optimistic, and higher interest rates will likely dampen the positive impact from the fiscal easing. Italy’s independent fiscal council, the parliamentary budget office, has not endorsed the government’s macroeconomic assumptions, also judging them overly optimistic.
Under Moody’s baseline assumptions for the fiscal trajectory and economic growth, Italy’s public debt ratio will not materially decline in the coming years. It will remain broadly stable at its current 130% of GDP, one of the highest ratios among Moody’s rated sovereigns. The debt trend is relatively insensitive to an isolated interest rate shock, but more vulnerable to a growth shock. Italy’s high debt level severely limits the authorities’ ability to use fiscal policy to cushion any future economic downturn, which will inevitably come. Accordingly, the risks to Moody’s debt forecast are broadly balanced at the moment, with the risk that a shock causes the debt burden to rise no less material than the potential that it falls further than expected.
SECOND DRIVER: LACK OF COHERENT AGENDA FOR GROWTH-ENHANCING REFORMS IMPLIES CONTINUED WEAK GROWTH OVER THE MEDIUM TERM
The second driver for today’s downgrade is Moody’s view that the economic plans of the government — while supportive of growth in the near term — do not amount to a coherent programme of reforms that will lift Italy’s mediocre growth performance on a sustained basis. Moody’s therefore assumes that real GDP growth will return to rates of 1% per annum at best in the years beyond the temporary fiscal stimulus.
The rating agency recognizes that the government’s plans contain positive elements — the public investment programme has the potential to support higher productivity growth in the economy. But it remains to be seen whether the planned new tools and procedures to accelerate the selection of projects and ensure proper design, evaluation and implementation will be sufficient to materially improve Italy’s weak track record on public investment delivery. Similarly, Moody’s believes that a tax reform could be positive for economic growth and job creation; currently Italy combines high tax rates with low revenue collection (due to many deductions and exemptions), high complexity and evasion. The government’s first small instalment of its “flat tax” proposal is a step in this direction. However, as pointed out by the IMF, the OECD and also the Italian employers’ association, a reduction in direct taxes needs to be compensated for by increases in other, preferably consumption-linked, taxes so as to be seen as durable and credible in a highly-indebted country such as Italy.
Other areas — where previous governments have implemented some reforms and independent institutions such as the OECD and the IMF have long urged a significant acceleration in implementation — are at best continued at a slow pace (such as measures under way to speed up the judicial system and improve efficiency in the public administration) or not addressed at all. Those include measures to improve the quality of the education system, reduce extensive skill mismatches in the labour market, increase participation rates and more closely link wage developments to productivity growth. Increasing competition in domestic product and services markets would also be credit positive, but does not form part of the government’s programme. The above mentioned early retirement option is a step backward with regards to the long-term sustainability of the Italian pension system.
RATIONALE FOR STABLE OUTLOOK
The stable outlook reflects the broadly balanced risks at the Baa3 rating level. In Moody’s view, Italy still exhibits important credit strengths that balance the weakening fiscal prospects. These strengths include a very large and diversified economy with some highly competitive industries, a solid external position with substantial current account surpluses of above 2% of GDP and a near balanced international investment position. Italy’s households have high wealth levels, which represent an important buffer against future shocks and could also be a potentially substantial source of funding for the government. Moody’s base case is that the public debt ratio will remain stable, albeit at high levels. While Italy’s institutional strength is lower than most of its euro area peers and Italian politics have often been volatile, overall institutional quality is broadly in line with global peers. In addition, the country’s president has a strong role in providing stability to the political system.
WHAT COULD CHANGE THE RATING DOWN
The rating would come under renewed downward pressure if the Italian government were to pursue a fiscal strategy that would lead to a rising debt trend in the coming years, possibly as a result of a weaker growth performance than expected. Aside from the direct implications for Italy’s fiscal strength, Moody’s would likely consider the willingness to pursue such a strategy and/or the inability to address the fiscal consequences of a growth shock as indicative of a weakening of Italy’s institutional strength.
Such an outcome could also undermine investor confidence in the sovereign’s credit profile. The rating would also come under pressure if Moody’s were to conclude that the affordability of Italy’s elevated public debt were likely to worsen materially and in a sustained way, particularly if that signaled some increased risk of the government losing market access. The Italian government has large refinancing needs (with around €200 billion in medium to long-term bonds maturing in 2019) and will need to maintain the confidence of both foreign and domestic investors to refinance its upcoming debt maturities at affordable rates. Moody’s would assess whether any increase in the government’s funding costs signaled a sustained reduction in the government’s debt affordability, or put the banking sector and potentially the wider economy under significant stress.
Given the government’s confrontational stance towards the EU and the risk of further escalation, Moody’s now assumes a higher susceptibility to political event risk than before. Relatedly, the rating would likely also be downgraded if Moody’s were to conclude that the risk of Italy exiting the euro area were to rise materially. While currently very low, the likelihood of such a scenario could rise if tensions between the Italian government and the European authorities over Italy’s fiscal stance and its commitment to the fiscal rules were to escalate further, particularly if accompanied by a rise in support for confrontation within the Italian electorate and/or measures which signaled preparation for a parallel currency.
WHAT COULD CHANGE THE RATING UP
Given the downgrade, a positive rating action is currently unlikely. Positive rating pressure could emerge if a coherent programme of structural reforms were to be introduced, including for example measures which increased the efficiency of the public administration, improved the functioning of the labour market and the education system and strengthened competition, all with the ultimate goal of raising productivity growth in the Italian economy. A change in the fiscal stance that would result in a declining debt trend would also be credit positive.