S&P Delivers a Downgrade, Italian-Style
On Oct. 19, Standard & Poor's Ratings Services lowered its long-term sovereign credit rating on the Republic of Italy to A+ from AA-, on poor prospects for a sustained fiscal consolidation program. At the same time, the A-1+ short-term sovereign credit rating on Italy was affirmed. The outlook is stable.
"The downgrade reflects the new government's inadequate response to Italy's structural economic and fiscal challenges," says Standard & Poor's credit analyst Moritz Kraemer. "The [recently passed] budget bill does little to drive forward on meaningful supply-side reforms and will actually lead to net increases in spending as a share of [gross domestic product (GDP)], instead of curtailing high current expenditure, which is the root cause of Italy's fiscal imbalance."
The targeted reduction of the deficit to 2.8% of GDP in 2007 (from 3.6% in 2006, net of one-off items) is to be achieved through tax increases. In practice, the budget outrun in 2007 is unlikely to come in below 3% of GDP, as certain of the proposed measures may be optimistic, namely the assumed success in rolling back tax evasion and the savings that can be generated by making the civil service more efficient.
More important than the expected mild slippage on fiscal targets in 2007 is the fact that the budget may have undermined the prospects for meaningful reform aimed at curtailing current expenditure in the areas of pensions, health care, public administration, and fiscal federalism. The up front tax-and-spend concessions to the reform-skeptical members of the center-left coalition have effectively reduced the bargaining power of the modernizers in the Cabinet.
In this context, the prospects have receded for structural measures needed to ensure the resumption of a clear, significant, and sustainable downward trend of the government debt-to-GDP ratio, which Standard & Poor's had repeatedly indicated would be essential to avoid a lowering of the rating. As a consequence, Standard & Poor's assumes that the primary balance will recover from the current low level (less than 1% of GDP in 2005 and 2006) but is unlikely to significantly surpass 2% during the rest of the current decade.
Consequently, the debt ratio will hardly decline at all. It will drop to 105.7% of GDP by 2010 (vs. the government's 100.7% target), from 107.6% in 2006. In the light of Italy's low potential GDP growth rate (1.3% per year) and the onset of spending pressures in the next decade associated with a rapidly aging society, the implied slight improvement in the debt ratio is insufficient to sustain Italy in the AA rating category.
"If the debt ratio were to rise significantly from current levels, the long- and short-term ratings would come under renewed downward pressure," says Kraemer. "Conversely, the rating could be raised if structural measures were implemented that would ensure the resumption of an unambiguous, significant, and sustainable downward trend of the government debt ratio."