David Roberts

Italy in the lap of the rating gods

David Roberts

All major ratings agencies adopt a “rate through the cycle” approach. All agencies have also given implicit/explicit credit to euro issuers for being part of the EU and, to a greater or lesser extent, operated in the expectation that the EU will work to help any member state as long as that state tries to help itself. Recent EU debt crises have shown that to be the case.

None of this removes the possibility of a downgrade, but it reduces the probability of default.

Italy: current versus prospective fiscal situation

If we look at Italy, for example, the fiscal situation had actually started to improve. The budget deficit for 2019 was around 1.6%, much better than most had forecast and well below the 3% “limit”. This was one of the best readings for a decade and showed that, despite all the political angst, progress was being made.

Of course, the stock of debt was still close to 135% of GDP but not increasing significantly given low debt service costs (in absolute terms) and small positive nominal GDP growth. Even at that level, however, ratings agencies have been nervous and, without EU support, Italy may well have been junked already.

The Italian response to Coronavirus has been one of the smallest (in terms of GDP spend) in Europe: our best guess is that spending of around 2% of GDP will be incurred. Obviously, at the other end, the lockdown has been more aggressive and, given the state of public finances, this is probably the right balance. Also, importantly, it should give Prime Minister Giuseppe Conte a big bargaining chip with the EU – despite all the noise, Italy is clearly trying to keep to the rules. At some point, I think Germany and Holland will understand this (more below).

However, the flipside is the strict lockdown. Consensus is for a 7% year-on-year economic contraction, although, at present, a 4% to 5% positive year in 2021 is also expected. If this is accompanied by a little inflation, then over the two-year period, in nominal terms, the economy may be around flat. I would be nervous of undershoot but this is the consensus for now.

With a better 2021 predicted and a strong 2019 behind us, there is some hope Italy will retain its BBB rating. But there is still the likelihood that, during this period, debt to GDP could increase above 150%, and then you are in the lap of the ratings gods and there is a possibility one or more will decide to cut. If they do “look through the cycle”, it is possible we see BBB-watch/outlook negative – if not, then junk it is.

Unless…

Deeper union and EU bonds?

I am an EU believer and continue to believe the lack of coordinated fiscal policy is a major problem even after 50 years for Europe, especially in competition with China and the US.

I believe “northern” economies should use this as an opportunity to increase fiscal discipline and start to push for integration across the bloc. The “south” will resist but it may be a price worth paying if it is sold as a “USA mark 2” to the populous – Federal versus “state” powers, retention of most at state level and Federal tax gathering and disbursement (in reality, the same as happens in most EU countries at a localised level anyway).

It guarantees debt is raised at a unified level (which would be great for Italy) and market access. And similar to the US municipals market, we have a second tier where states/cities/provinces can raise additional finance but with credit risk attached. So, the northern states continue to benefit from cheaper finance and a politically and economically more stable south.

Europe currently has a big flaw: the Americans believe they are competing against the rest of the world, while Italians and Germans think they are competing against other EU states – German and Dutch people do not realise that what is good for Italy can be good for Holland and Germany.

What do I think will happen? Conte will get some form of watered-down version, probably “unity/crisis bonds” with an EU GDP per capita guarantee. This will create a contingent off-balance sheet liability for Italy but probably allow the ratings agencies to look through it.

As above, I think his message is simple – Italy is in a mess but was improving and, even though at the epicentre of the virus, has retained discipline as far as humanely possible. I think this works but don’t think it leads to deeper integration and an opportunity is missed.

When it comes to Germany, these bonds have not performed well: yields were too low and the European Central Bank couldn’t really cut further. However, I believe many people in the market are expecting some form of central issuance with negative impacts for Germany – not least as the centrally issued bonds will be cheap to where bund yields are currently.

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Thursday, April 23, 2020, 10:26 AM