Following the EU Commission's rejection of the Italian coalition government's 2019 Draft Budgetary Plan, we explore what the proposed measures mean for the country's credit ratings and the outlook for Italian Bonds.
Italian/German 10y Government Bond Yield Spread
The Italian coalition government submitted their 2019 Draft Budgetary Plan to the EC. The populous budget includes scrapping the VAT hike planned for next year, the introduction of a minimum citizenship income, tax cut for the self-employed and rowing back on some of the 2012 pension reform. The inclusion of these measures have meant next year’s budget deficit has risen to 2.4% of GDP. This is likely to place Italy in conflict with the EC, which recommended a fiscal tightening of 0.6pp of GDP, as opposed to the 2019 budget’s 0.8pp fiscal expansion, hence potentially instigating a reopening of the Excessive Deficit Procedure (EDP).
Why does a 2.4% Deficit matter so much?
Indeed, the Italian Finance Minister, Tria, said ’2.4% was normal for western countries.’ However, Italy’s economic settings means it is not a ‘normal’ western country.
Italy Public Debt/GDP Ratio
1. Italy’s public debt/GDP ratio is a troubling 45ppt higher than the Eurozone’s average. It has been on a declining trajectory since 2016, but any fiscal slippage or GDP growth disappointment in 2019 could reverse this trend.
Italian nominal GDP growth has consistently underperformed the EU average
2. Italy’s challenging fiscal arithmetic has suffered from the country’s poor economic growth record. The coalition government have argued that the extra fiscal spending is necessary to boost growth through investment and hence reduce the public debt. However, there is relatively little on investment in the budget, with the majority of money being spent on social transfers.
Italian government deficit forecasts and outcomes
3. Italy’s deficit forecasts are generally revised higher and 2019 is likely to be no exception. The coalition have ambitious nominal GDP growth forecasts (expecting 3.1% nominal growth for 2019, which would be the fastest rate since 2011) and their reluctance to instigate large expenditure cuts ahead of next May’s European elections.
Source: Eurostat and Ministero dell ‘Economia e delle Finanze
With the 2019 Draft Budgetary Plan lodged with the European Central Bank (ECB), European government bond investors have turned their attention to how the rating agencies react, how the EC responds and most importantly how the Italian coalition responds to the EC’s assessment?
The EC has a week to request clarification on the budget and a further week to reject if it sees a ‘serious non-compliance’ with EU rules. The Italian government would then have to amend it or, should they refuse to, the EC could propose a reopening of the EDP. Having been warned already by EC’s Vice-president Dombrovskis that Italy’s fiscal targets are a ‘source of serious concern,’ if the Italian government were not to change their 2019 Budget the EC may eventually impose financial penalties of 0.2-0.5% of GDP. Clearly this would anger the coalition and investors will be alert to any anti-EU rhetoric and threats to leave the Euro.
Rating agency response
S&P will update their Italian sovereign debt rating on 26 October. Currently, Italy is rated BBB (stable outlook) by S&P. Investor expectations are for a one notch downgrade, however, markets are still nervous that the negative outlook will be maintained.
A one notch downgrade will still leave Italy one notch above investment grade, hence no requirement for force selling as a result of BTPs (Italian government bonds) falling out of any of the major bond indices. However, being just one notch above investment grade will mean that the risk of a further downgrade in 2019 is meaningful. It is impossible to know how many BTP holders are indexed investors (the ECB and most domestic investors are unlikely to be indexed as well as non-domestic banks and pension funds). However, the sheer fact that there are €1.3trn of eligible Italian bonds in the Bloomberg Barclays government index, would mean that the downgrading of BTPs below investment grade would be a seismic event.
Back to 2011/12?
One scenario would be that the EC accepts the Italian government’s 2019 budget and propose a fiscal adjustment process that is not too dissimilar to what is currently outlined by the coalition. BTP yields would react very positively, narrowing the BTP/Bund spread towards 220bp.
Another is that the combination of rating agency downgrades and a rapid escalation of anti-EU rhetoric could send the current BTP/bund yield spread spiralling wider. Such a move could then become self-fulfilling as the rise in yields means investors question the sovereign’s solvency, pushing BTP yields even higher and possibly to the 2011/12 levels.
However, Tria has expressed concern with Italy’s rising and identified a BTP/Bund spread of 400bp at which the Italian government will take action. Bond markets may have to test his resolve.
10y BTP/Bund Spread: Back to 2011/12? Or something more benign?
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