Italy 'BBB/A-2' Ratings Affirmed; Outlook Stable - Report by S&P Global Ratings about Italy, Italian rating and economy.
Overview about Italian Economy
- Economic growth will decelerate in 2023 on the back of high inflation and tightening credit conditions, before recovering in 2024, supported by EU investments and easing terms of trade.
- Fiscal consolidation is likely to be gradual and contingent upon growth outcomes or political pressures.
- The elaboration of the 2024 budget will be important in assessing the government's approach to economic and fiscal policy.
- We affirmed our unsolicited 'BBB/A-2' long- and short-term ratings on Italy and maintained the stable outlook.
On April 21, 2023, S&P Global Ratings affirmed its unsolicited 'BBB/A-2' long-and short-term foreign and local currency sovereign credit ratings on Italy. The outlook is stable.
Outlook for the Italian economy
The stable outlook reflects our expectation that Italy's government debt to GDP will decline in 2023-2026, as economic growth picks up next year, supported by EU investments, external demand, and stabilizing terms of trade. This assessment is balanced against the risk of a reversal in the delivery of critical reforms, including those embedded in Italy's National Recovery and Resilience Plan (PNRR), leading to a delay of EU support.
The rating could come under downward pressure should the government fail to put debt to GDP on a downward path due to persistent fiscal deviations, a prolonged interest rate shock, or as a consequence of weaker-than-expected growth. An only partial implementation of reforms, especially those attached to the disbursement of EU funds, would also pose risks to growth and public finances, and consequently put downward pressure on the rating.
We could raise the rating if economic growth were to outperform our forecast, leading to a sustainable improvement of real GDP per capita growth. A solid implementation of reforms and a continued path of budgetary consolidation addressing the government's high indebtedness would also foster ratings upside.
Rationale for the Italian economy
S&P Global Ratings continues to view economic growth rather than fiscal policy as the key driver of the sustainability of Italy's elevated stock of debt. For 2023, economic growth is set to decelerate as the government's energy support measures will only partially offset the adverse impact of high inflation and tightening monetary conditions on private consumption, which makes up 60% of Italian GDP. Real GDP growth will gradually pick up as terms of trade eases, and the disbursement of large EU funds stimulates investments.
A series of external shocks, including the 2020-2022 global pandemic and an energy price spike set off by Russia's February 2022 invasion of Ukraine, have consumed a large share of Italy's fiscal space. As of year-end 2022, net general government debt was at 136% of GDP (compared with 126% of GDP before the pandemic), with interest payments absorbing 9% of government revenue (versus 7% pre-pandemic).
Anchored by the reintroduction of EU fiscal rules next year, authorities are set to pursue a gradual pace of consolidation over the next few years, posting slight primary surpluses by 2024, putting debt to GDP on a slight downward path. Even assuming 5.2 percentage points of fiscal consolidation between year-end 2022 and year-end 2026, under our projections, in 2026 gross debt to GDP would still be around 136% of GDP, well above the current euro area average (93%), and the third-highest level of sovereign debt in the Organisation for Economic Co-operation and Development, after Japan and Greece.
Italy and PNRR
Political pressures or new external shocks could prevent the government from consolidating its fiscal position or delay the implementation of pro-growth reforms included in the PNRR. We understand that the Italian government wants to revisit some aspects of the PNRR, given the sharp rise in the cost of construction materials and services since its inception, but more importantly due to the urgency of building EU energy independence from Russian supply. The European Commission (EC) has asked member states to add a REPowerEU chapter to their Recovery and Resilience Plans to refocus investments into alternative energy sources and storage, and to encourage energy savings.
In our view, the 2024 budget will be important in assessing the government's commitment to fiscal prudence and the direction of policy, but so will be the annual updates of legislation on competition and other pro-growth reforms.
Institutional and economic profile: Economic activity to decelerate in 2023 and then recover, on the back of EU funds, easing terms of trade, and reducing inflation. Economic growth will decelerate in 2023 due to high inflation, tightening credit conditions, and subdued growth in Europe.
Abundant EU transfers until 2026 will provide a strong counter-cyclical boost to the economy, although risks to implementation of critical reforms persist.
EU governments, including Italy's, will implement their 2024 fiscal plans under resumed budgetary surveillance by the EC, as the general escape clause for the Stability and Growth Pact is deactivated at the end of this year.
Italian rating and economic projection
We project that Italy's economic growth will decelerate in 2023 to 0.4% from 3.7% in 2022.
Italy's moderate wage increases despite soaring inflation will erode real incomes, while households have drawn down most savings accumulated during the pandemic. In our view, the energy support package, estimated at 2% of GDP for the whole year, will only partially cushion the resulting hit to private consumption, which at roughly 60% of GDP is a key growth driver. In addition, recent changes to the Superbonus scheme, a tax credit for green investments by households that led to a construction boom in the past two years, will limit its uptake and dampen the sector's performance. The alterations include a reduction of the tax credit and the end of its transferability to third parties, which was central to its appeal. We also expect a slowdown in net exports, including tourism receipts, given stagnating eurozone growth, which S&P Global Ratings forecasts at 0.3% in 2023.
Economic activity will then gradually pick up, backed by the execution of significant EU funds, easing terms of trade, and the return of monetary policy to a neutral stance in 2025.
Economic project and Italian Rating
Italy has thus far received 35% of its Next Generation EU (NGEU) package, totaling €69 billion in grants and €123 billion in loans to be disbursed over 2021-2026. The third planned payment of €19 billion has been delayed, reportedly due to concerns over the licensing of port activities and two new urban renewal projects, but we expect the situation will be resolved before the third quarter. The government's intention to renegotiate parts of the recovery plan could, however, delay future disbursements, although we do not see it as likely to derail the program. The main risk is that it selectively implements the remaining targets, hampering the full disbursement of the funds, and denting economic performance. Given the sheer size of the recovery plan, we calculate that even half the funds available under the NGEU facility would boost growth by 2 percentage points by 2027. In addition, growth will benefit from monetary policy becoming neutral under our base case as inflation returns to target in 2025, but risks stemming from stagflation in Europe and the geopolitically fluid context persist.
Italy's energy resilience should strengthen under the EU's joint energy initiatives and funds geared toward the green transition.
Italy has managed to diversify away from Russian gas, which now constitutes 10% of its gas imports compared with 40% prior to the Russia-Ukraine war, thanks to new sources, particularly in North Africa. Still, around 70% of energy supply is imported and 20% is derived from renewables, a vulnerability the NGEU funds earmarked for the green transition (37% of the total envelope) will contribute to reduce. In addition, Europe is moving ahead with plans to buy gas jointly in a bid to leverage the bloc's purchasing power and secure lower prices from international suppliers. At the same time, Italy specializes in exports with relatively lower energy intensity than other European countries. Of all product categories greater than 5% weighting in Italy's export basket, only two (metal products and chemicals) are classified as energy intensive. In contrast, Italy's most competitive export sectors, machinery, processed food, fashion, automobiles, and pharma, have low or very low levels of energy intensity (on average 2.5 terajoules per euro versus the 9.6 terajoule average for all industrial output), according to the Banca d'Italia.
The labor market will remain resilient with unemployment ticking up slightly in 2023 and 2024, but a more severe economic slowdown or hastier monetary tightening could weaken the forecast.
At 8.1% on average during 2023-2026, unemployment will remain well below its peak of 12.9% in 2014, in the aftermath of that global financial crisis. Support measures during the pandemic and the energy crisis have contributed to protect employment while flexibility measures introduced as part of the Jobs Act in 2014 continue to bear fruit. Wage pressures are likely to remain moderate, perhaps slightly higher than the 3%-4% level seen in 2022. The lower wage pressure compared with European peers is mostly due to the nature of the Italian benchmark for wage indexation, which excludes energy prices, and the variations in the timing and size of wage increases due to multiyear contracts, especially as several collective agreements were reached in 2021.
Italian rating and the political scenario
The elaboration of the 2024 budget will be important in assessing the government's commitment to fiscal prudence.
Since the formation of the right-wing coalition government in September 2022, Prime Minister Giorgia Meloni has pursued a moderate and pragmatic approach in relation to Europe and to fiscal policy, exemplified by the approval of the 2023 budget, which maintained a degree of fiscal prudence, in line with her predecessor Mario Draghi. Her party, the Brothers of Italy, won the majority of votes in the regional elections in Lombardy and Lazio, ahead of Silvio Berlusconi's Forza Italia and Matteo Salvini's Lega, both part of the ruling coalition. This suggests she will be able to pursue her agenda without too many political hurdles. However, if this stance struggles to shore up domestic support, the government could be under pressure to deviate from a prudent budgetary policy. In this sense, the 2024 budget will be an important indication of the government's policy direction. We believe Silvio Berlusconi's current health concerns raise limited political risks, as the bulk of his party, Forza Italia, would likely join the ruling Brothers of Italy if the party was to splinter.
Flexibility and performance profile: Fiscal space remains constrained as monetary policy tightens amid high government indebtedness
Because our methodology focuses on debt accumulation rather than on accruals-based budgetary definitions, the substantial statistical revision to budgetary deficits in 2020-2022 has no impact on our fiscal assessment.
The limited fiscal space and reimplementation of EU fiscal rules by 2024 will lead to a gradual reduction of fiscal deficits, although external or political shocks could provoke slippages.
The European Central Bank and Italy
The European Central Bank (ECB) is set to continue to tighten its monetary policy until inflation returns to target by 2025. Because our methodology focuses on debt accumulation rather than on accruals-based budgetary definitions, the statistical revision of Italy's deficits for 2020-2022 has no impact on our fiscal assessment.
The national statistical agency ISTAT revised the budgetary deficit to 9.7% of GDP from 9.5% in 2020, to 9.0% from 7.2% in 2021, and to 8.0% from 5.6% in 2022. This reflects the reclassification of the Superbonus tax credit as a "payable tax credit", meaning it ought to be recorded on an accrual basis as an expenditure in the year in which it was incurred, instead of as a reduction in government tax revenue at the time of its utilization. When assessing a government's fiscal performance, S&P Global Ratings focuses on the government's net borrowing, which remains unchanged for 2020-2022 as a result of the ISTAT accounting decision. Considering the Superbonus was mostly responsible for the difference in budgetary deficits and assuming the latter would be evenly spread in 2023-2026, the change could reduce the target deficits for 2023-2026 by about 1 percentage point of GDP per year. The Superbonus will likely be treated as a reduction of government expenditure because the authorities have stopped its transferability to third parties, which was the key factor for its requalification. Although we believe Italy's fiscal space remains limited, the lower fiscal targets in 2023-2026 may prompt the government to ease spending.
Budgetary deficits will gradually decline, especially as EU fiscal constraints are set to be reestablished in 2024.
We forecast the budgetary deficit will narrow to 4.5% of GDP in 2023, owing to the statistical requalification of the Superbonus reducing the initial fiscal target, and to a phasing-out of energy support measures compared with 2022. The government did not fully spend the €22 billion energy package budgeted in 2022 and due to expire in March of this year, thanks to lower energy prices than anticipated, and will use the remaining funds to finance a new package of €5 billion, neutralizing the effect on the budgetary deficit. We estimate the package will be worth around 2% of GDP for the whole year. However, the economic downturn and slowdown in inflation will dent fiscal revenue and slow the consolidation.
Italian fiscal policy
The EC will begin to deactivate the general escape clause of the Stability and Growth Pact starting in 2024.
As a consequence, the EC will monitor Italy's fiscal plans for next year, with an expectation that most of the energy measures introduced in 2022 will be phased out, and that Italy will comply with its own stability and convergence targets of reaching a general government deficit of below 3% of GDP in 2025.We expect upward pressure on pension expenditure (in light of Italy's aging population) and interest spending to persist. In addition, the government's tax reform measures, which aim to simplify the tax system by limiting the number of tax brackets or cutting taxes for companies hiring new employees, are not likely to have an impact in the near term, especially given that its contours remain uncertain at this stage.
We project net general government debt to reach 130% of GDP, excluding the European Financial Stability Facility guarantee, at year-end 2026 versus 136% of GDP at year-end 2022.
Rising yields will continue to increase interest expenditure, which will reach 9.6% of government revenue by 2026 compared with 7.4% in 2021. The Transmission Protection Instrument (TPI) announced by the ECB should mitigate risks of financial fragmentation. Under the TPI, the ECB can purchase government bonds, including Italian ones, with a maturity of up to 10 years if it assesses that market pricing is disorderly or unwarranted. To determine whether a euro area member state's bonds are eligible for purchases, the ECB will consult a cumulative list of criteria. These include compliance with EU fiscal rules and an absence of severe macroeconomic imbalances.
Inflation is set to decline in 2023-2026 as monetary policy tightens and energy prices decline.
Headline inflation dropped to 7.6% in March 2023 from its peak in November 2022 (11.8%), as energy prices cooled. However, core inflation remains high at 6.3% in March 2023 compared with 2.4% in April 2022. We expect inflation to return to target by 2025 as the ECB pursues its monetary policy tightening. The ECB raised its policy rate across the eurozone by 0.5 basis points in March 2023 to 3.5% amid fears that higher borrowing costs could set off a domino effect across the European banking sector following a dent to confidence from the collapse of Credit Suisse, Switzerland's second-largest lender. However, at this stage financial stability concerns appear less binding to the ECB, given European banks' strong health metrics and the ECB's alternative tools in the event of financial turbulence, including the emergency funds like the Single Resolution Fund and the Common Backstop. The withdrawal of liquidity has so far been swift, with the Eurosystem's balance sheet having shrunk by 11% since its peak in June 2022, through the targeted longer-term refinancing operations.
Italian economy and EU
Alongside 19 other EU sovereigns, Italy is a member of the European Monetary Union.
This membership means the country cannot adjust its exchange rate relative to the currency of key trading partners or implement its own monetary policy. But it receives powerful liquidity support from one of the world's most credible central banks, the ECB, which issues the second-most widely held reserve currency, the euro.
Italy's external finances are a relative credit strength. We expect Italy's current account to return to surpluses in 2024 as energy prices decline and exports recover in line with the economy. Higher imports from the acceleration of projects under the NGEU will weigh on imports over 2023-2026 and reduce the current account surplus in the next few years in comparison with pre-pandemic levels.