Scenarios for Italian debt sustainability
Peripheral spreads have been widening recently despite the launch of the European Central Bank (ECB)’s Pandemic Emergency Purchase Programme (PEPP), as the covid-19-led recession looks set to have a severe impact on public finances. While Europe contains to await the terms and conditions of an eventual recovery fund, the market has been expressing a number of concerns about Italian debt in particular. These include:
1. The absence of an effective pan-euro area response to covid-19
2. Euroscepticism and increasing political noise in Italy
3. Concerns over Italy’s sovereign debt sustainability
4. Worries about Italy’s sovereign rating
5. Doubts about the length and scale of the ECB’s sovereign bonds purchase programme.
In our view, to have an impact, the EU’s recovery fund, when it is agreed will need to meet several criteria: (1) it will have to be approved and rolled out quickly; (2) it must be substantial, with risks shared; and (3) it will need to stay off individual countries’ balance sheets. So funding should be considered grants, not loans. The risk is that we end up with a fund that is too small and comes too late for Italy.
However, in our central scenario (55% probability), we are keeping our 10-year Italian government bond spread forecast at 180 bps for end June and 130 bps at year-end. In our central scenario, we expect the following: no early elections in Italy; Italy’s debt to remain sustainable thanks to low borrowing costs and some pan-euro fiscal support; Italy’ rating to remain safely in investment grade; and the ECB’s PEPP to be increased in size and extended in time.
In our positive scenario (10% probability), the 10-year Italian spreads would tighten even more thanks to a very strong economic recovery.
In our negative scenario (35% probability), we could see the 10-year Italian spread shooting back above 300 bps in the coming months but falling back towards 200 bps by year’s end as the prospects of an ‘Italexit’ fade. This scenario foresees a deep recession in Italy that reduces potential output and places a question mark over Italy’s sovereign debt sustainability. This would trigger rating downgrades, perhaps closer to high yield. While we could see a further rise in euroscepticism, we expect the euro area to come through intact, making compromises as needed.
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