Short Insight – Italy’s debt only temporarily lower

by: Aline Schuiling

  • Italy’s government debt ratio is expected to decline in the next few years …
  • … thanks to the cyclical economic upswing and the drop in bond yields
  • Still, from a fundamental perspective, government finances have deteriorated in the past few years ….
  • … implying that the debt ratio will probably start rising again in a few years

1. Economic recovery has reduced the budget deficit

The Italian economy has gathered momentum in 2017. GDP growth rose from 1.3% yoy in Q1 to 1.7% in Q3; the highest rate since the start of the eurozone crisis. Although Italy’s growth rate remained well below that of the eurozone as a whole, it was above Italy’s own trend growth rate. The economic recovery has had a positive impact on the government’s budget balance, which improved from -2.9% in 2013 to an expected -2.1% in 2017. Recent calculations by the European Commission show that corrected for the cyclical economic upswing the budget balance in fact deteriorated from -0.5% in 2013 to -1.8% in 2017.

 

 

 

 

 

2. Drop in bond yields has reduced the deficit as well

Besides the higher level of economic growth, the government’s budget balance has also benefited from the drop in government bond yields. The ECB’s expansionary monetary policy stance (negative deposit rate and the extended asset purchase programme) has played a dominant role in this drop in yields. Indeed, the government interest payments (% GDP) have dropped from 4.8% in 2013 to an expected 3.7% in 2017. Meanwhile, the budget balance excluding interest payments (the primary budget balance) declined from a surplus of 1.9% in 2013 to around 1.7% in 2017.

 

 

 

 

 

3. More fundamentally, government finances have deteriorated

When we remove the impact of both the business cycle and the drop in bond yields, it turns out the underlying budget balance has deteriorated sharply in the past few years. Indeed, Italy’s structural primary budget surplus dropped from 4% in 2013 to 1.7% in 2017.

Looking forward, we do not expect this adjusted budget balance to improve noticeably in the coming years. The political landscape is fragmented and the upcoming general elections are unlikely to result in a stable coalition that is able to implement radical policy changes.

 

 

 

 

 

4. Debt ratio to fall in the next few years, but to rise thereafter

Our most likely scenario for Italy’s government debt ratio is that it will decline during the next two years. We expect this to be a combined result of a rise in the denominator of the ratio (nominal GDP), a somewhat further decline in interest payments and slight rise in the primary budget balance. We expect the debt ratio to fall from 132% GDP in 2017 to around 129% in 2019. However,  thereafter it is expected to start rising again (assuming no significant fiscal consolidation). Economic growth is expected to fall back to around the trend rate, while interest rates should start moving higher as the ECB is expected to gradually end its QE programme after September 2018 and start hiking rates as from September 2019 onwards.