With the coronavirus having spread throughout Italy, and with the country’s already worrying debt profile, how will the ratings agencies view the sovereign that is hovering perilously close to junk status?
GDP growth in Italy has been broadly on a falling trajectory since the start of 2018, with growth falling into negative territory at the end of 2019. The manufacturing and services sectors followed the overall Eurozone picture of decline throughout the past two years, with signs of stabilisation more recently. Italy however, is obviously different to the average Eurozone market regarding the debt position, which is currently north of 135% of GDP. This level, while high on a relative basis, is more acute in Italy than other indebted nations like Greece or Portugal, given the level of yield spread that the government must pay to refinance, along with the large nominal amount of debt. Having said that, the debt profile is elongated enough such that the requirement to refinance is drawn out over a long period.
Much of the volatility in Italy in the past few years has been broadly a function of politics. It has been an evolving theme of populist, nationalist and socialist agendas involving a mixture of regional and national political parties. Generally, the widening of spreads is related to the success of the Lega and Five Star parties, which have sought to battle the EU for more expansionary fiscal policy than is acceptable under the stability and growth pact. More recently however, the tension has been reduced, as the vote of no confidence called by the Salvini-led Lega backfired and left them out of a new ruling coalition. As such, budget tensions are reduced for now and the danger for the Lega is that the conversation has now moved on.
So with the coronavirus worsening the fiscal position, how likely is it that we will see a downgrade to junk?
The issue with the Eurozone fiscal response is that Italy can’t afford it, despite the ECB pouring over €1 trillion worth of QE into Eurozone bond markets this year. The current government is more fiscally sensible than in the past and it is also aware that the market will punish it if it tries to push through irresponsible spending plans, however the macro data will be significantly hit by the virus. The government has also announced significant fiscal and liquidity measures in line with other Eurozone governments. The pandemic fiscal package will be waived under the stability and growth pact rules, but that doesn’t mean that Italy can afford it with debt to GDP of 135%. To be clear, debt sustainability is not the issue, with the term structure they have – it’s more of a market confidence issue.
On the plus side, the ECB’s Pandemic Emergency Purchase Programme (PEPP) package is significant, and affords the ECB the ability to support member countries as its sees fit, without worrying about breaching individual-country exposure limits. Furthermore, the ECB has been explicit within the PEPP programme (and through its external commentary) that they will not allow an isolated blow-out in Italy to potentially infect the wider Eurozone.
The ECB stimulus has been announced and is significant, but should now be broadly in the price. In the short term, the rating review by S&P on 24 April is a flash point (S&P already have a BBB rating / negative outlook, and Moody’s review follows on 8 May). Over the medium term, the overwhelming driver will be the horrific growth and debt trajectory. It seems increasingly likely that the ratings agencies will decide to downgrade the sovereign.