Italy

The spread widening in the case of Italy is unprecedented since the start of the sovereign debt crisis. In addition to the pure ‘thematic contagion’ from the Greek problems and valuation questions over Italian bonds, there are also headwinds from the macro side (economic underperformance). Recent activity data from Italy, such as the weaker-than-expected manufacturing and services PMI readings in June and the larger-than-expected fall in industrial production of 0.6% MM in May, disappointed the market. While the cash deficit data for May continued to show a narrowing of the deficit, it remains elevated and the reduction of the central government deficit is less dynamic than in Spain — bearing in mind that in Spain the regional deficits are a source of concern. However, the recent economic news is unlikely to alter our outlook for Italy substantially. With huge structural problems we expect weak GDP growth of 0.8% in 2011 and 1.0% in 2012 in Italy. But we suspect that the government will be able to reduce the deficit from 4.6% of GDP in 2010 to around 4.1% in 2011, roughly in line with its target. However, we strongly doubt that the government will be able to present a balanced budget in 2014. According to Finance Minister Giulio Tremonti nonachievement of this target would be a “disaster”. We forecast a general government deficit of 3.8% of GDP in 2014. This suggests that the government has to increase its efforts regarding structural and fiscal reforms substantially. In this respect the implementation of the proposed austerity measures worth €40bn up to 2014 (around 0.7% of GDP on average per year) is crucial. So far the austerity package is only approved by the cabinet.

Low growth may start raising concerns about the medium-term sustainability of still-high public debt. Despite recent efforts to keep the public deficit contained, Italy requires a sizeably large primary surplus (of at least 3pp of GDP) in order to start seeing some meaningful declines in the debt ratio. Tighter fiscal policy will likely further compress trend growth in coming years, probably below 1% per annum.

Given the current fragility of the government after its political defeat in recent local elections, policy commitment towards a severe fiscal consolidation path may not be as strong as it has been in the recent past.