Debt Looms over Revival Plan for Italy

Prime minister's pledge to settle all existing arrears draws praise, but 132.6 percent debt-to-GDP ratio remains cause for concern.

Lurking within Matteo Renzi’s plan to cut Italian taxes and pay state suppliers are dangers the largesse will hamper efforts to trim the 2.09 trillion-euro (US$2.9 trillion) public debt.

Italy’s newly installed prime minister won applause from labor unions with his March 12 blueprint to trim 10 billion euros from lower-income workers’ tax bills and a sigh of relief from commercial businesses promised 68 billion euros in arrears payments from the government.

Yet investors and economists say the shifts can’t be offset by this year’s budget cuts, with gross domestic product projected to grow less than 1 percent. Even though borrowing costs dropped to record lows this year, the tax and spending measures could pare Italy’s prized primary budget surplus and jeopardize a recovery after more than two years of recession.

“Italy’s debt-to-GDP ratio will continue to rise and thus peak later rather than sooner,” Marc Ostwald, a fixed-income strategist at Monument Securities Ltd. in London, said. “Given the rising tide of criticism leveled by the European Commission and the European Central Bank (ECB), higher debt means that Renzi’s plans may have to be revised.”

Italy’s debt load was 132.6 percent of gross domestic product last year, the second-highest in the 18-nation euro area, and it may still be growing.

Putting the debt on a downward trajectory is crucial for the 39-year-old premier to maintain credibility in financial markets and shore up the support of Germany, the largest and most influential economy in the European Union.

Italy should take the “necessary steps” to meet its fiscal targets, “particularly with regard to putting the debt-to-GDP ratio on a downward path,” the ECB said last week in its monthly bulletin. The Frankfurt-based bank said “no tangible progress” has been made on the EU’s recommendation to reduce the deficit, which last year was unchanged at 3 percent of GDP.

Renzi, who took office Feb. 22, said the ECB report did not take his plans into account. His finance minister, Pier Carlo Padoan, said on March 10 that the new government’s economic expansion forecast for this year is close to the EU’s 0.6 percent outlook.

 

Bonds Rallied

Italian bonds have rallied this year on optimism the euro-area economy is recovering from the sovereign-debt crisis. Italy’s 10-year yield fell 1 basis point, or 0.01 percentage point, to 3.35 percent as of 10:50 a.m. Rome time, the lowest level since October 2005. The additional yield that investors demand to hold Italian 10-year bonds over similar-maturity German bunds slid to 173 basis points on March 11, the least since June 2011.

Under Renzi’s plan, the personal income-tax reduction will be shared by 10 million Italians and will be accompanied by a 10 percent cut to the regional levy on companies. The government will pay for the measures with public spending cuts, an increase in some capital-gains rates, and lower debt-financing costs, he said. More value added tax revenue, tied to the state’s plan to repay its commercial debt arrears, will also help, he said.

Renzi’s pledge to settle all the existing arrears by Sept. 21 is “realistic,” state lender Cassa Depositi e Prestiti SpA Chairman Franco Bassanini told reporters in Rome March 17.

“Recognized debt will inevitably rise,” Bassanini said. Still, the alternative “would be not to repay the arrears, which would require the state to declare a default.”

The Italian public administration took an average 170 days last year to pay its debts, a report by artisans lobby Confartigianato showed earlier this year. That is almost three times the Eureopean Union average of 61 days, the report also said.

Italy’s plan to speed up the pace of paying off arrears “would have major implications for corporate liquidity and economic growth,” economists at JP Morgan Chase & Co. said last week in a note to investors.

Under the proposed measure, Italian banks would acquire the certified debt from the state that would guarantee it at the same time, according to a draft of the bill obtained by Bloomberg News.

“It remains far from clear how the European Commission will respond” to Renzi’s plan, JP Morgan’s Bruce Kasman, David Hensley and Joseph Lupton said in their March 14 note. “Although arrears are already incorporated into the liabilities of the government, they do not show up in the Eurostat measure used in the fiscal governance frameworkthus, paying off arrears pushes up government debt.”

 

‘Major Challenge’

8A deficit close to 3 percent of gross domestic product at year’s end, as the prime minister projected in presenting his plan last week, could deny him the chance to start reducing the country’s debt.

“High public debt puts a heavy burden on the economy, in particular in the context of chronically weak growth and subdued inflation,” the European Commission said in a March 5 report on the EU member countries’ economic imbalances. Reaching and sustaining high primary surpluses and robust GDP growth “for an extended period, both necessary to put the debt-to-GDP ratio on a firmly declining path, will be a major challenge” for Italy.

Italy’s primary surplus, the difference between revenues and spending net of debt-financing costs, fell last year to 2.2 percent of GDP from 2.5 percent in 2012.

“We don’t think the debt-to-GDP will reach a peak either in 2014 or 2015,” said Raffaella Tenconi, an economist at Bank of America Merrill Lynch in London. “The payment of arrears has a big one-off impact on the debt, and low growth and low inflation make it difficult to stabilize the debt-to-GDP ratio despite the fact that Italy has a meaningful primary surplus.”

The European Commission said last month it still expects Italy’s deficit to fall to 2.6 percent of GDP in 2014, matching the projection by the government of Enrico Letta, Renzi’s predecessor.

Italy’s debt-to-GDP ratio kept rising “despite a primary surplus and spending cuts, and that was due to our main problem, the lack of growth,” Renzi told reporters in Berlin after talks with German Chancellor Angela Merkel on March 17. Italy will meet its budget targets and keep reducing public spending, “but within this framework the government needs to revive domestic demand and growth.”

Investors are returning to the markets they shunned during the region’s sovereign-debt crisis, helping push the average yield to maturity on securities from Italy, Greece, Ireland, Portugal, and Spain to euro-era lows last week, according to Bank of America Merrill Lynch indexes.

Still, foreign ownership of Italy’s debt fell in December to 34 percent from 34.7 percent in November, the Bank of Italy said in a March 14 report.

Italian bond yields show “very clearly” that markets “are pinning hopes on the project” started by Renzi, Merkel told reporters after the March 17 talks in Berlin.

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