By Alvise Lennkh-Yunus, Giulia Branz and Alessandra Poli, Sovereign Ratings

The resilience of the Italian economy has surprised on the upside, with quarter-on-quarter growth outperforming the euro area in six of the last eight quarters despite the marked slowdown since H2-2022. While growth in 2021 also reflected the rebound from the deeper recession during the Covid-19 pandemic, last year’s growth is remarkable, given Italy’s significant exposure to the energy and cost-of-living crises, with average inflation exceeding 8%, and limited spending for NGEU investments.

Last year’s growth of 3.9%, including the -0.1% contraction in Q4, was better than we expected (3.7% for the year and -0.5% for Q4). While the economy has slowed down, this mild contraction points to a greater-than-expected resilience to the energy and inflation shocks, which is mirrored across the euro area, which grew at 0.1% in Q4.

For 2023, we expect the Italian economy to avoid a recession and grow by at least 0.5%. The deceleration is due to the adverse impact of tightening financing conditions, with an expected ECB deposit rate of at least 3.0% by H2 2023, and persistent inflationary pressures, both curbing consumption and investment.

Still, the government’s fiscal support for more vulnerable households and the successful diversification of natural gas supplies away from Russia, which now constitutes only 10% of Italian gas compared with 43% before Russia’s war in Ukraine, should support the Italian economy’s resilience. In addition, we expect actual spending of NGEU funds to kick in this year, supporting investments, although implementation of EU disbursements into actual spending on the economy has been delayed vis-à-vis initial plans so far.

Figure 1 – Italy and euro area GDP growth, QoQ (%)

Note: seasonally adjusted, working day adjusted data
Source: Eurostat, Macrobond, Scope Ratings

The robust economic performance supports Italy’s public finances

Fiscal revenues grew more than 10% in the first eleven months of 2022 compared with the same period the previous year, driven by higher income from indirect taxes, benefitting from elevated inflation, and by the phasing-out of tax breaks enacted during the pandemic. Together with contained spending, this has supported the reduction in the fiscal deficit, which will likely have narrowed to 5.2% of GDP last year from 7.2% in 2021.

For 2023, we expect the new government’s fiscal stance to remain relatively cautious in light of rising policy rates and thus to maintain an overall prudent fiscal policy. The 2023 Budget Bill balances the need to consolidate public finances with providing temporary relief from higher energy costs of around EUR 21bn (1.1% of GDP) in 2023.

The fiscal deficit will narrow only modestly to 4.8% of GDP this year. The primary balance should, however, gradually improve and turn into a 1% of GDP surplus by 2026. A higher interest burden, set to exceed 4% of GDP over the coming years, should keep the headline deficit close or above 3% of GDP in the medium term.

Figure 2 – Public debt-to-GDP trajectories (%)

Source: Eurostat, Macrobond, Scope Ratings

Italy’s debt-to-GDP ratio is set to decline only modestly to around 142% by 2027, and thus remain around 10pp above its pre-Covid level, significantly above that of Portugal (BBB+/Positive; forecast debt-GDP of 97% by 2027) and Spain (A-/Stable; 107%).

Even with an expected primary surplus of 1% of GDP, which compares with an average primary surplus of 0.9% over the past 10 years excluding the Covid shock in 2020, it is hard to see how Italy’s public finances can be significantly consolidated further, not least due to rising fiscal pressures from the country’s ageing population.

For this reason, in the absence of higher growth, Italy will remain the second highest indebted country in the euro area after Greece (BB+/Positive). The country could even become the most indebted country in Europe by the end of the decade, should Greece sustain current growth and primary surpluses beyond 2027.

Higher growth needed to reduce public debt

Italy’s 2023 budget, while ensuring gradual fiscal consolidation, mostly includes one-off measures limited to a single fiscal year, rather than structural measures aimed at improving Italy’s economic and fiscal outcomes over multiple years. The forthcoming revision and re-implementation of the EU’s fiscal framework will likely maintain the 3% fiscal deficit rule, anchoring expectations for Italy’s medium-term fiscal trajectory.

Still, the swift implementation of growth-friendly NGEU-related reforms and the associated investment plan are critical to address Italy’s persistent structural problems, including stagnant productivity, low labour participation and employment rates, especially among women and the young, and rising pressures on pension and healthcare expenditure due to its ageing population.

These reforms and investments are critical to raising Italy’s growth potential to 1.25-1.50% from around 1%. This is needed to achieve steady debt reduction over this decade, which is a key driver to support Italy’s BBB+/Stable credit ratings.

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