May 22, 2011 / 6:24 PM / 8 years ago

Analysis - S&P warning heralds tough times ahead for Italy

ROME (Reuters) - Standard & Poor’s surprising decision to revise downward its outlook for Italy could mark the start of increased market scrutiny on the euro zone’s third-largest economy, which faces tough challenges that it is probably unable to meet.

The Palace of the Consulta (constitutional court palace) is seen in downtown Rome January 13, 2011. REUTERS/Max Rossi

Italy has escaped the brunt of the euro zone debt crisis that has engulfed Greece, Ireland and Portugal, due largely to a prudent fiscal policy and low levels of private debt.

But if markets begin to focus more on the country’s appalling growth record, weak reform prospects and the grim implications for reducing its mountain of public debt, then Italian bond yields will rise and its situation could become untenable.

Those were precisely the weaknesses cited by S&P when it announced on Saturday it was revising its rating outlook for Italy to “negative” from “stable,” while maintaining its A+ rating.

S&P’s move will not precipitate any immediate debt crisis for Italy, analysts said, but with euro zone developments so unpredictable it does make the country more vulnerable.

Analysts said yields on Italian government bonds would probably widen initially, and while this may prove short-lived, increased scrutiny on Italy’s economic performance would be a more threatening problem in the medium term.

“I’m afraid the reaction will be negative because this was a big surprise and it comes after a bad week for euro zone peripherals,” said Banca BSI analyst Gianluigi Mandruzzato. “Monday won’t be an easy day for Italian government bonds.”

Raj Badiani, an economist with IHS Global Insight in London, said he expects “a moderate widening of spreads” on Italian bonds, and markets will hope to see in a second phase some sign of a policy response from the government.


But there is unlikely to be a long-lasting sell-off, considering S&P has not put Italy on a negative credit watch, implying a likely downgrade in the next three months, and its peer agencies Moody’s Investors Service and Fitch Ratings are unlikely to follow suit.

Judging by recent history, Moody’s, which has taken a far more benign view of Italy than its peers, is likely on Monday to repeat its basic confidence in the country’s economy.

“In our view, Italy’s current growth prospects are weak, and the political commitment for productivity-enhancing reforms appears to be faltering,” S&P said in its statement.

It also said the fragility of Prime Minister Silvio Berlusconi’s centre-right coalition government meant such reforms were unlikely to be pushed through anytime soon.

“Potential political gridlock could contribute to fiscal slippage. As a result, we believe Italy’s prospects for reducing its general government debt have diminished,” it said.

Italy’s public debt stood at 119 percent of gross domestic product at the end of 2010 — second only to Greece in the euro zone. The government last month said it would remain above that level both this year and next.

But the real and interlinked problem for Italy is growth. For well over a decade, when the rest of the euro zone goes into recession, Italy has gone into a deeper one, but when the rest of the euro zone recovers, Italy’s rebound is weaker.

And the dismal story is not only in comparison with its European peers.

According to International Monetary Fund data, Italy was the world’s fourth most sluggish economy between 2000 and 2010, ahead of only Zimbabwe, Eritrea and Haiti.


Italy has avoided the acute financial woes of Greece, Portugal and Ireland, but it is afflicted by a sort of long-term wasting disease which could eventually prove just as damaging.

In the last 10 years, it has been the only advanced economy to see a contraction of per-capita GDP, and Italians’ real purchasing power has fallen by 4 percent.

All this risks becoming a growing problem for markets and not just for Italy’s hard-pressed citizens. If the economy does not grow then tax revenues are low and it is increasingly hard to reduce the national debt as a proportion of GDP.

And as long as public debt remains high, huge resources are used up in interest payments, meaning taxes must stay high and nothing can be spent on stimulating the economy.

“To some extent it’s a vicious circle, you can’t cut the debt if the economy doesn’t grow and the economy can’t grow if you don’t cut the debt,” said Banca BSI’s Mandruzzato.

Fiscal austerity cannot be maintained indefinitely and only by adopting radical reforms to improve its growth potential can Italy put its finances on a sustainably sound footing.

And on this front the outlook is grimmer than ever.

Some commentators, as well as Italy’s Treasury, expressed surprise at S&P’s move, saying nothing had changed in Italy’s situation to warrant a change of outlook.

Yet that is precisely the problem. Nothing has changed it Italy for far too long.

“When you look at what’s been happening in Spain over the last year and a half, we’ve seen quite a full timetable of reform, but in Italy we’ve seen virtually nothing,” said Badiani.

For years economists and international bodies like the IMF and the Organisation for Economic Research and Development have issued the same recipes for Italy, including liberalization of markets, a less rigid labour market, less red tape, lower spending on the public administration and more investment on research and infrastructures.

Yet the response has been too slow or non-existent as successive governments have lacked the courage or political strength to take on trade unions or numerous vested interests.

And now, as S&P noted, reform hopes could hardly be weaker. An increasingly unpopular Berlusconi commands only a tiny and fragile majority in parliament and seems far more absorbed with his many legal problems than with any economic reform agenda.

“I think the prospects for meaningful reform before the next election in 2013 are virtually zero,” said Mandruzzato.

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