Italy: Public debt affordability issues loom

8 December 2022 13:50

Italy’s new government has the thankless task to balance fiscal support amid the energy crisis and keeping public finances in check. Unless energy prices and bond yields come down significantly, debt affordability challenges could materialise soon.

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At first sight, a rather conservative budget

Last week, the Italian cabinet headed by the far-right Giorgia Meloni presented its 2023 budget. Parliament still has to approve the proposal before the end of the year, but that is unlikely to pose a major problem. At first sight the budget seems to be fairly conservative, only more so when taking into account the major challenge posed by the energy crisis and the numerous hobbyhorses among coalition parties. The government has proposed a deficit target of 4.5% next year, after 5.6% this year (Figure 1). The primary balance is projected to decline from -1.5% this year to -0.4% next year, before returning to a surplus in 2024. According to the government, these budget projections would support a gradual reduction in the debt ratio (Figure 2). But the headline budget figures that were presented do not tell the entire story.

Figure 1: Government projects the budget deficit to gradually improve…

Source: Budget 2023, Italian government, RaboResearch

Figure 2: … and the debt-to-GDP ratio to gradually decline

Note: Risk scenario includes extension of energy support measures until early '24, i.e. a slower return to a primary surplus, lower growth rate and current forward rates - Source: Budget 2023, Italian government, RaboResearch

The government plans to increase spending by some EUR 35bn, of which EUR 21.6bn is budgeted to help households and businesses pay their energy bills. The rest is used to, among other things, increase welfare payments to families with children; slightly increase the maximum income of self-employed who are eligible for a low flat tax; cut the social security contributions for low-income employees; start the construction of a bridge to connect Sicily to the mainland; support early retirement at 62 for people with 41 years of contribution; and to increase minimum pensions to compensate for the high inflation. Part of the increased spending is funded through a higher windfall tax on the profits of energy companies. The 50% tax is expected to raise some EUR 2.5bn in revenues. The government will also start to curb payments within the citizens’ income scheme, before it intends to overhaul the welfare system altogether in 2024. So, it seems that everybody in the coalition got a bit of something it wished for – with emphasis on a bit, though.

Zooming in on support related to the energy crisis, the budget mainly extends, and sometimes broadens the scope of, current measures through the first quarter of 2023. These measures include tax cuts on fuel, electricity and gas; energy bill subsidy schemes for low-income households; and tax credits for companies that are confronted with very large energy cost increases. According to ISTAT, the measures subtracted 2 percentage points from headline inflation in August and as such have already had quite some impact so far – even though the measures were not able to bring inflation back down to more comforting levels. In October, inflation still amounted to 12.6%. Combined with the money already dedicated to fight the energy crisis in 2021 and 2022, total energy cost support will mount to some EUR 90bn, or a cumulative 4.6% of GDP. As mentioned, however, the devil is in the details.

The devil is in the details

The government forecasts the Italian economy to grow by 0.6% next year and 1.9% in 2024. It has calculated that the budget supports next year’s growth by 0.3pp. This compares to our own projections of a contraction of -0.8% this year and +0.8% in 2023. Moreover, the government’s budget only include the costs of extending support measures until 2023Q1. They will wait and see what will be necessary thereafter. And one thing is certain, with electricity and gas prices staying high, more support will be required. Gas prices have come down from their August peak, but they are still far above what they used to be. Moreover, we expect prices to veer back up from their current levels once winter really kicks in. There simply aren’t enough alternatives to substitute the lack of Russian gas and competition is fierce. Joint EU gas purchases could certainly help to prevent peaks as seen in August, but would not magically increase the availability of gas. Taking into account our lower growth projections, and assuming that tax cuts and subsidies will be extended throughout the rest of 2023, the budget deficit is more likely to come in at close to 7% rather than the projected 4.5% by the government (Figure 1).

Debt sustainability

From a debt sustainability point of view this matters. Based on the points raised above, debt-to-GDP would increase rather than decrease next year (from 146% to 148% - Figure 2). Looking a bit further ahead, based on the current maturity profile of public debt and forward rates, the government would have to run serious primary surpluses to prevent the debt ratio to move back up in the second half of this decade and thereafter. Our simulations show primary surpluses of around 2.5% would be required; the average between 2002 and 2019 was 1.3% (Figure 3). Another important indicator when assessing government finances is debt affordability. In July, we have already assessed the impact of the increase in bond yields on the affordability of debt, i.e. the share of government revenues that has to be used to pay interest. If that share exceeds 10%, debt affordability is said to be weak. The rise in yields since the start of the year has seriously increased the pace with which Italy is approaching this threshold. In fact, Italy looks set to breach the threshold in 2024 already if yields remain this high and the government does not find a way to substantially lift economic growth – or disproportionally increase its revenues (Figure 4).

Figure 3: Debt ratio projections with varying primary balances

Source: Macrobond, Bloomberg, RaboResearch

Figure 4: Debt affordability threshold set to be breached in 2024

Source: Macrobond, Bloomberg, RaboResearch

To conclude

All in all, it is certainly comforting that the new government has been able to draw a budget in such a short amount of time. But, government finances are very likely to come in worse than projected next year. Looking a bit further ahead, tensions between coalition parties will probably grow again. It will become ever more difficult to cater to the wishes of coalition partners and hand out widescale financial support to soften the blow of the energy crisis, while at the same time safeguarding the sustainability and affordability of government finances against the backdrop of higher yields. That said, the large bag of EU money can certainly help to guide policymaking and in time also alleviate sustainability challenges by lifting the growth potential.