Fitch Ratings: New Italy Deficit Targets Underscore Fiscal Risks
Italy’s new deficit targets confirm the coalition government’s more expansionary fiscal stance, which was a key driver of our revision of the Outlook on the country’s ‘BBB’ sovereign rating to Negative at the end of August, says Fitch Ratings.
The budget process has highlighted policy tensions within the coalition government, and we see sizeable risks to the targets, particularly beyond 2019. It is also consistent with our view that those elements of the government hostile towards the EU and euro would focus their antipathy on challenging the Stability and Growth Pact (SGP) fiscal rules.
The Update to the Economic and Finance Document (NADEF) for 2018 is the first major fiscal policy document produced under the Lega-Five Star Movement (M5S) coalition government formed in May. It targets a deficit of 2.4% of GDP in 2019, compared to our 2.2% forecast at our August sovereign rating review, with a structural deterioration of 0.8pp relative to 2018.
This would be 1.4pp outside the current EU Preventive Arm structural deficit target and could lead to Italy being brought within the Excessive Deficit Procedure, potentially through a reassessment of the mitigants for breaching the SGP debt rule, although this remains uncertain. In any case, we do not expect this prospect to lead the government to substantially change its 2019 deficit target.
The confrontational response from Lega and M5S leaders to the European Commission’s concern over the new targets indicates that the government sees political opportunities in attacking the EU’s fiscal rules, especially in the run-up to European Parliamentary elections next May. The lengthy SGP corrective action processes and the lack of previous EU fines for non-compliance may also influence the government’s political calculations. As in our 31 August review, we believe that the risk of heightened financial market volatility will act as the main constraint on the degree of fiscal expansion.
The NADEF targets a moderate reduction in the 2020 deficit to 2.1% of GDP. We expect an outturn closer to the 2.6% we forecast in August, which contributes to our higher public debt/GDP projections (129.8% by end-2021, versus 126.7% in the NADEF).
A number of factors explain the difference. We forecast lower GDP growth (1.2% in 2019 and 0.9% in 2020 versus 1.5% and 1.6% in the NADEF). Unlike the government, we do not assume VAT increases via the activation of safeguard clauses in 2020. We expect additional measures on universal basic income, pension reform, and a “flat tax” for small business to be phased in, with only partial offsetting measures.
The NADEF contains little detail on individual measures, notably the potential cost of “dual flat tax” proposals, where political pressure for at least partial implementation is likely to grow after 2019. Structural bottlenecks could hinder the NADEF target of increasing public investment to 3% of GDP from the current 1.9% by the end of the current parliament, and represent a further challenge to the government’s forecasts.
The lack of detail means it is still unclear how differing fiscal policy priorities within the coalition, and the overall inconsistency between the high cost of implementing core policy pledges and the objective to reduce public debt, will be resolved. These tensions were reflected in the disorderly build-up to the NADEF. Publication was delayed, and the fiscal objective articulated by Finance Minister Giovanni Tria (who is not a member of Lega or M5S) not to weaken the structural fiscal position was dropped very late in the process.
Policy differences within the coalition also present a challenge to implementation of a number of NADEF measures. For example, M5S has previously opposed some large infrastructure projects, while the parameters of Universal Income (a flagship M5S policy, which Lega thinks should be more narrowly targeted) are still being discussed.
Fiscal policy detail and implementation remain a key element of our Italian sovereign rating assessment. Our next scheduled sovereign rating review is due in 1Q19.
Source: Fitch Ratings