Brexit: Preliminary Trade Deal avoids No-Deal, but “Slow Burn” of EU-Exit Costs Stresses British Economy

While the UK is expected to ultimately maintain significant access to the single market, the new customs border and uncertainties around the access to the single market for UK services sectors raise the economic consequences of Brexit.

We had expected that the UK would strike a free-trade agreement with the EU despite the market’s concern about a possible “no-deal”, so the last-minute accord in December was no surprise.

The rolling over of tariff- and quota-free trade in goods was largely in line with the roll-over of existing preferential trade arrangements that the UK has pursued with other trading partners outside the EU as an intermediate step in exiting first the customs union.

However, exit from customs union – to be itself phased in over three stages and in full force only from 1 July 2021 in the case of imports to the UK – has created trading friction and produced immediate economic losses as companies see longer delays, higher operating costs and lower productivity. This is even though grace periods granted – such as a one-year standstill on rules of origin documents – have eased disruption at the border.

UK gains sovereign privileges; trading regime to gradually reduce areas of long-run divergence

The trade and cooperation agreement has prevented a devolution to WTO-based trading rules with the EU. In addition, a principle of “managed divergence” implies either party reserves the right to retaliate in the case the other side is considered to have gained an unfair trading advantage.

The UK has secured greater sovereign privileges in determining its own laws, but cooperation with the EU on regulation under a new “partnership council” and capacity for the other side to impose tariffs – in the case deregulation is considered unfair – are expected over time to reduce disparities.

The mechanism should space out any areas of divergence and resulting trading frictions over a longer period. While December’s arrangement largely excludes services, this is consistent with the highly incremental and drawn-out Brexit that Scope has long anticipated, under which divergence with the EU is taking place over successive phases after extensions of Article 50, a transition state, lately an exit from the customs union with associated grace periods, and, in the end, agreements around additional, complementary trading agreements with the EU for sectors excluded from December’s preliminary arrangement.

New trade deal only initial step in shaping new long-term EU-UK economic partnership

December’s trade agreement, while thin, was never intended as a singular settlement. It is rather a first fundamental framework around which a more extensive set of trading agreements will ultimately be agreed to define the long-term EU-UK economic relationship.

As services were hardly discussed to date, with an agreement on goods trade the priority during the limited 10-month negotiating period in 2020, the focus will now be on reaching supplementary arrangements for critical services sectors including financial services.

The two sides are seeking a non-binding memorandum of understanding by March 2021 on the export of financial services, including services such as euro clearing currently operating with temporary access to EU markets as talks continue. However, more time is likely to be required than March before Brussels ultimately grants fuller EU access for UK financial firms even after a non-binding framework is in place.

We expect any such agreement or agreements around financial services to be “dynamic” – granting regulatory equivalence and thus full market access for select UK financial industries to “passport” to the single market, and vice versa, but with an understanding that such equivalence can be retracted should regulatory standards diverge – mirroring the agreement in goods.

A soft Brexit, but “slow-burn” from drawn-out exit process to incur further costs

Long term, we expect that the outcome of negotiations to reflect a “soft” Brexit. Non-regression clauses embedded in trade agreements and other limits on UK-EU trade divergence – such as the Irish Backstop that would reproduce any friction in trade with the EU with friction in trading inside the UK itself, damaging the UK’s internal market – will limit the degree of separation in the longer run. This will support preferential access to the single market for UK businesses long term.

The final EU-UK relationship could resemble something akin to a Swiss-like framework except with a faster-track negotiating process given support in accelerating talks from the series of self-imposed cliff-edge Brexit deadlines – and negotiated in reverse with the UK having started from fully-frictionless trade.

However, there will be persistent uncertainty due to the constant risk that changes in UK law could reduce access to the single market, so UK-based businesses are likely to continue to relocate activities to the continent – ensuring a steadily growing cost from a “slow-burn” Brexit even as the cliff-edge form of an abrupt no-deal exit has been repeatedly avoided.

City of London faces permanent damage after losing full single-market access

In addition, the City of London faces permanent damage in waiting for a definitive agreement on financial services in the months ahead during which select UK financial services have at least transitionally lost passporting rights, such as investment banking and securities trading on behalf of clients in those EU countries where national regulators have not as yet extended grace periods to UK firms. In the end, the UK has secured a deal for the trade in goods where it has a trading deficit with the EU, but not one as comprehensive to date in services where it stands to see losses to a trading surplus.

The UK enters this new Brexit phase amid the near-simultaneous introduction of a third national Covid-19 lockdown, which will add to stress on its public finances. We see upside pressure on government debt already estimated at more than 110% of GDP this year, up from 85% in 2019 in view of the double-dip economic contraction we have anticipated and the additional fiscal stimulus to address economic fallout from lockdown plus the economic and fiscal costs of the exit from the single market and customs union.

The latter costs, while more modest and much more spaced out by comparison with the sudden, severe cost of the Covid-19 crisis near term, might pose more significant long-term economic and institutional consequences.

Download the full Scope Ratings comment.

For a look at all of today’s economic events, check out our economic calendar.

Dennis Shen is a Director in Sovereign and Public Sector ratings at Scope Ratings GmbH.

Turkey: Central Bank Decision Calms Investor Nerves, But a Sustained Policy Reorientation Needed

The Turkish central bank backed up words with action in last week’s monetary policy decision – raising the key repo rate 475bps to 15% from 10.25%. In addition, the central bank indicated that commercial banks will have access to financing exclusively via the one-week repo auction window, with the repo rate henceforth the “only” indicator of monetary policy.

This ends for now a phase of “backdoor”, unorthodox rate increases via alternative tools that the central bank had employed to avoid any unwanted attention from President Recep Tayyip Erdoğan – who prefers low interest rates – and which had failed to assuage market concerns of too-easy central bank policy.

The central bank’s rate increase, both in its scale and in the consolidation of various policy instruments, was intended to address investors’ immediate concerns, ease pressures on the lira and stem a full-blown currency crisis. This has eased some concerns that central bank policy would remain behind the curve under new governance.

Shift near term to a more market-friendly, conventional monetary policy

The sizeable 30% depreciation in lira this year before ex-Central Bank Governor Murat Uysal’s dismissal appears to have been the final straw that forced this month’s reset of economic governance and the shift, at least near-term, towards a more market-friendly, more conventional monetary policy framework under Governor Naci Ağbal.

With this rate hike, Ağbal demonstrated that he holds enough influence and sway with the Turkish president to convince him to tolerate higher rates near term to fight inflation. Turkey’s real policy rates were negative before Thursday’s policy change with an annual rate of inflation of 11.9% in October. Real policy rates have since flipped to +2.8%

Complacency quickly returned after rate hike initially calmed investors’ nerves in 2018

That said, we have been here before. In 2018, the central bank raised rates by 625bps and similarly consolidated multiple policy instruments to reverse a sharp lira sell-off, only for complacency to speedily re-emerge by the following year as the lira stabilised and inflation receded.

The Turkish government’s underlying bias in favour of looser monetary policy has not dissipated overnight. Nor has Turkey’s executive presidency, in place since 2018 and which overtly subverts central bank independence, changed.

Possibility of greater near-term lira stability, but longer-term governance risks remain

While any sustained return to conventional monetary policies amid this year’s crisis could support greater lira stability in the short run and possibly help begin a process of rebuilding depleted foreign-exchange reserves, longer-term risks remain that significant institutional and governance deficits of the past re-emerge once the immediate crisis is in the rear-view mirror.

An important upcoming task is using this forthcoming window to rebuild Turkey’s official reserves, which stood at USD 82.4bn on 15 November, compared with USD 105.7 at year-end 2019 and USD 134.6bn at a 2013 peak. Official reserves cover around 61% of short-term external debt. Net reserves excluding short-run swaps with domestic banks stood at all-time lows of negative USD 47.5bn in September, cut sharply from (positive) USD 18.5bn at end-2019.

The government needs to tackle external-sector weaknesses

The risk that a longer-standing structural depletion of Turkey’s foreign-currency reserves poses to the economy’s external sector stability remains real and calls upon the near-term shift in policy frameworks to not only be maintained but strengthened. This will require tighter, more sustainable monetary, fiscal and structural economic policies over a longer period both in crisis and outside of crisis – something that has been lacking in the past – which prioritise lower but more sustainable economic growth.

In addition, Turkey needs to strengthen its flexible exchange rate regime – a traditional credit strength – and reduce severe external sector vulnerabilities, such as structural current account deficits, economic vulnerabilities to capital outflows and high FX exposures.

Scope downgraded Turkey’s foreign-currency long-term issuer and senior unsecured debt ratings to B from B+ on 6 November, while affirming Turkey’s long-term issuer and senior unsecured debt ratings in local currency at B+. Scope revised the Outlooks on Turkey’s long-term ratings in both foreign and local currency to Negative from Stable. Scope will next review Turkey’s sovereign ratings and Outlooks in H1-2021.

For a look at all of today’s economic events, check out our economic calendar.

Dennis Shen is a Director in Sovereign and Public Sector ratings at Scope Ratings GmbH.

Governments, Creditors Need DSSI+ Debt Relief Framework to Tackle Africa’s Solvency Crisis

We believe the Debt Service Suspension Initiative (DSSI) provides extra fiscal space in the near term to 29 participating African governments, but the programme can also accentuate medium-term debt distress by increasing future interest payments for some of the world’s most vulnerable sovereigns. African governments account for 38 of 73 countries eligible for the DSSI. Fine tuning the DSSI as well as the more recent Common Framework beyond the DSSI is essential to heading off future debt crises.

Download Scope Ratings’ full report on the need for a revamped debt relief framework for African countries.

Need for a DSSI+ architecture that differentiates between liquidity and solvency crises

A formal mechanism has been necessary to determine whether African countries face just a liquidity crisis or an underlying solvency issue given half of all sub-Saharan African sovereigns were at risk of or in debt distress at the start of 2020.

A framework that we call “DSSI+” is essential for enhancing the transparency and consistency of China’s participation under the programme, ensuring creditors are treated equally including mandating the participation of private-sector creditors, and, importantly, bringing to the fore debt forgiveness as an option to address solvency crises.

China’s involvement in DSSI has been crucial for the programme’s efficacy

China is the largest player in African infrastructure finance. Between 2000 and 2018, China lent USD 148bn to 50 African countries, contributing to a near doubling of the region’s external debt from 19% in 2008 to about 34% of GDP in 2018.

With almost a third of Africa’s sovereign external debt service over 2020-24 due to be paid to China, the country’s involvement in the G20’s DSSI has been crucial. With the extension of DSSI beyond 2020, Angola and Djibouti could see total debt-service savings on loans from China of above 4.5% of 2019 GDP over 2020-21. Potential savings under any case of their DSSI participation are estimated as well at over 1.5% of GDP for countries such as Mozambique, the Republic of the Congo, Kenya, Guinea and Zambia.

Debt-service suspension can address short-run liquidity shortages but could accentuate medium-term debt distress

Debt-service suspension is the right remedy for certain countries such as Burkina Faso, Central African Republic, and the Democratic Republic of the Congo with low debt and limited debt sustainability concerns. Suspension of debt service addresses a short-run liquidity shortfall and provides the required fiscal space. However, for countries such as Angola, Burundi or Ghana, a participation under existing DSSI terms could compound medium-run debt distress.

Angola, Djibouti and Mozambique could each see increases in their debt servicing requirements over 2022-24 of over 1% of GDP on average per year due to participation in debt-service suspension on existing programme terms, due to the shifting of payments to later years on NPV-neutral bases.

G20’s Common Framework beyond the DSSI does not go far enough to address solvency crises

In October, Paris Club creditors agreed on a “Common Framework for Debt Treatments beyond the DSSI”, approved at a 13 November extraordinary meeting of G20 Finance Ministers and Central Bank Governors.

While the Framework represents a positive step, the emphasis on reductions in short-run debt service and NPV reductions of debt risks not going far enough. According to the Framework, debt treatments will generally not be conducted in the form of debt write-off or cancellation except in the most difficult cases.

While the G20 Framework is a positive extension of DSSI’s core tenets with a progression from a principle of NPV neutrality in the direction of NPV haircuts in certain cases of solvency risk, the stated preference against outright principal haircuts even in more severe cases may not go far enough for vulnerable borrowers. In addition, the lack of a specified mechanism to compel equitable participation across creditor groups including from the private sector remains a weakness.

An evolution to a DSSI+ architecture could support stronger credit profiles for African issuers after a restructuring

The evolution of DSSI to a proposed DSSI+ architecture of orderly debt treatments could embed enhanced collective-action clauses in bonds, mandate rather than seek the involvement of private-sector creditors, ensure consistency in the adoption of debt measures across participating creditors, and provide the option of ambitious debt restructuring – including outright principal write-down were this needed. Such a proposed DSSI+ architecture could support stronger credit profiles for African issuers after any more comprehensive debt restructuring.

An evolution to a DSSI+ framework for sovereign debt restructuring could be similarly managed with debt sustainability analyses determining if a solvency issue exists. A hypothetical 25% principal write-down for only distressed African borrowers could alone bring targeted savings of nearly USD 29bn with the largest savings coming on bilateral loans from China (USD 11bn).

In this respect, clearly not all DSSI-eligible countries, however, would or should qualify for debt forgiveness under a suggested DSSI+ framework. In addition, the form and extent of any principal write-downs for a sovereign government with underlying solvency risks under such a mechanism need to be tailored to the specific debt sustainability situation of the borrower.

For a look at all of today’s economic events, check out our economic calendar.

Dennis Shen is a Director in Sovereign and Public Sector ratings at Scope Ratings GmbH. Thibault Vasse, Sovereign Ratings Analyst of Scope, co-authored this article.

Italy’s Debt Sustainability Remains a Challenge, Despite Low Interest Costs and Pro-Growth Agenda

Scope Ratings believes Prime Minister Giuseppe Conte’s coalition government has an opportunity to raise Italy’s rate of recovery exiting this Covid-19 crisis with its pro-growth agenda. However, given the Italian economy’s historically low-growth potential with modest inflation expectations (of 0.8% 12-months ahead according to the latest Banca d’Italia survey), public debt is unlikely to be curtailed significantly post-crisis – even recognising the boon from near-record-low borrowing rates as well as support from the EU’s EUR 750bn recovery fund.

The government’s latest budgetary plan contained in the Documento di Economia e Finanza (NADEF) envisages discretionary measures in 2021 amounting to a fiscal expansion of 1.4% of GDP, including measures for southern regions, business support and funding for ministries. This proposed fiscal stimulus will support growth, but longer-term plans premised on a compilation of reforms to ensure elevated growth medium term, to return the public debt ratio to pre-crisis levels by 2031, face challenges, including in policy implementation.

Government projections for public debt trajectory seem optimistic

We consider Italian Ministry of Finance projections for a reduction in Italy’s public debt ratio of more than 23pps over the next decade as optimistic. The forecasts assume significant primary surpluses equivalent to 2.5% of GDP by 2026, representing a very significant consolidation from the primary deficit of 7.2% of GDP we estimate in 2020. In addition, the government does assume a significant hike in trend growth, averaging 1.6% by 2024-26. This compares with our estimate of the economy’s medium-term growth potential of 0.7%, and pre-crisis output growth that averaged just 0.2% over 2010-19.

In view of the current fiscal stimulus to tackle the economic and public health consequences of the pandemic, alongside still accommodative financial conditions supported by the extraordinary interventions of the ECB, we do not consider the government being able to achieve pre-crisis levels of primary surpluses of near 1.5% of GDP over forthcoming years of recovery as a given. On that basis, achievement of a higher primary surplus of 2.5% of GDP seems optimistic.

Yields nonetheless hit record lows, also fostering risk of budgetary moral hazard longer term

Nevertheless, the yield on the 10-year Italian BTP touched an all-time low of just above 0.6% last week compared with 2.4% at crisis peaks of March, underpinned by a declining disparity in borrowing costs between European nations. Ten-year BTPs have been trading around a spread of only 130bps above German Bunds. Earlier this month, Italy issued a three-year BTP with a zero coupon – the first such issuance on record – which was priced with a negative yield. Over recent months, unlike during past crises, as debt and deficits have risen, yields have declined. There is a risk of moral hazard, nonetheless, linked to this in governments’ spending behaviours longer term even if, short term, counter-cyclical spending amid the crisis is appropriate.

Italy has exercised, however, greater fiscal restraint during this crisis than many other economies of the region such as Germany or the United Kingdom, and authorities are targeting an ambitious longer-term consolidation.

Italy’s debt ratio seen to be on a structurally rising long-term trajectory

Nevertheless, instead of a sustained declining trajectory of public debt beginning in 2021 as assumed under the government or the latest IMF projections, we expect a comparatively flat trajectory of public debt in the years immediately after this crisis, currently projected around a 160% of GDP level, with this ratio potentially displaying a short-run moderate decline during initial 2021 recovery phases. Similar to our opinion before this crisis, we consider Italy’s debt ratio long term to be on a structurally rising trajectory, displaying modest changes during years of positive economic growth but seeing large increases during years of recession such as in 2020.

This pattern had seen Italy’s public debt ratio steadily increase entering this crisis, across multiple business cycles, from 104% of GDP as of end-2001, reaching 135% by end-2019, and around 160% in 2020 under Scope baseline expectations. As we move ahead in this decade, there remains the likelihood of additional adverse shocks that could impact the debt trajectory abruptly. This questions long-run debt sustainability.

Scope’s baseline is for a Q4 economic contraction amid fresh economic restrictions

Scope’s baseline scenario, which assumes a fresh round of economic restrictions in Q4 amid a significant second wave of coronavirus and a return to negative Q/Q growth in Q4 but with a second recovery phase beginning by the spring of 2021, foresees the Italian economy will contract by around 9% in 2020 before rebounding with growth of 6.1% in 2021. The fiscal deficit widens to 10.9% of GDP in 2020 from 1.6% in 2019, before easing to a nonetheless elevated 6.9% of GDP next year.

Alternatively, under a stressed scenario of a return to full national lockdown of the same scale of that of spring 2020 alongside an uneven 2021 recovery due to virus relapses, Scope estimates growth of -13.7% in 2020 before +4.3% in 2021. This stressed scenario could see not only higher explicit public debt but greater risk of crystallisation of contingent liabilities that impact the government balance sheet.

Unprecedented EU institutional support continues to support low-cost refinancing, although poor record of EU fund absorption a risk for sustained recovery

Nevertheless, Italy and other euro area economies are set to receive unprecedented support from EU institutions, including the recovery fund’s EUR 77bn in grants and EUR 128bn in loans to Italy over 2021-26. Italy’s poor record of absorption of EU investment funds poses the risk, however, that Italy’s fiscal response tied to EU funds may not be effective in supporting recovery longer term.

Favourable funding conditions due to ECB interventions have also been critical considering Italy’s elevated gross financing needs (GFNs). In 2020, Scope projects GFNs of about 33% of GDP, well above an IMF threshold of 20%, above which a mature economy is considered by the IMF as being under “high scrutiny”, with GFNs remaining well above a 20% of GDP level through 2025.

We estimate the share of Italy’s government debt held by the Eurosystem to rise to about 25% by end-year, and about 30% in 2021. As such, the nominal stock of public debt held by the private sector will indeed decrease by 2021 compared with 2019 levels even despite the significant debt accumulated in this crisis. This is credit positive near term.

Scope revised the Outlook on Italy’s BBB+ sovereign ratings from Stable to Negative in May.

For a look at all of today’s economic events, check out our economic calendar.

Dennis Shen is a Director in Sovereign and Public Sector ratings at Scope Ratings GmbH.

 

Coronavirus, Job Market and Brexit Stresses Darken the Outlook for the British Economic Recovery

The United Kingdom faces a challenging fourth quarter with crises that stretch from fresh corona lockdowns to an expectation of sharply higher unemployment to prolonged negotiations still to come before a Brexit year-end deadline.

“We anticipated renewed partial lockdown and more intensive restrictions in the United Kingdom to arrive by Q3 and Q4 under our baseline scenario in July’s Q3 2020 Sovereign Update,” says Dennis Shen, primary analyst for the UK at Scope. “Here, we anticipated a deceleration in the UK’s recovery in the 2H 2020 with moderate economic contraction by Q4 GDP relative to Q3 in following the rapid economic gains between April and July.”

“As economies reopen, coronavirus cases rearise, and fresh restrictions follow – even though governments and public health sectors are considerably better prepared during this second wave.”

Scope currently projects for the UK an economic contraction of 10.4% in 2020 before recovery growth of 8.8% in 2021.

“Lockdown lite” thus far in response to a significant second wave

Although mortality ratios are lower during the second wave, UK daily confirmed cases have now reached record rates. Most concerningly, confirmed cases have been spreading to older demographics ahead of the winter.

So far, the UK is trying to contain the breakout with “lockdown lite” actions taken at sectoral and local levels such as limiting the number of people in a social group, as well as stricter local measures in virus hotspots.

Transition out of furlough scheme to abet market-based adjustment but raise unemployment

Rules that restrict economic activity – most critically within the UK services sector – and thus adversely impact demand and labour markets are occurring while the UK is phasing out current furlough wage support policies by end-October to be replaced with a six-month “Job Support Scheme” to subsidise wages for short-time work.

“The premise to this change in policies to abet market-based economic adjustment and arrest the sharp increase in public debt is understandable given many of the jobs may not come back and in view of a public debt ratio we see rising past 110% of GDP in 2020, after 85% in 2019,” says Shen. “However, there will be, in following, a significant increase in unemployment due to this policy transition, with the effects to reverberate across the economy in the fourth quarter and into 2021 as lost subsidised income and resulting curtailed private final demand interact with economic losses from renewed economic and social restriction.”

A year-end no-deal Brexit is unlikely; an agreement of some kind late in the year more probable

The public health and unemployment crises gather as Brexit negotiations enter a critical three-month stretch, including this week’s nominal final round of formal negotiation, before the transition state ends in December.

“We have considered a year-end no-deal Brexit as unlikely, especially amid a global health emergency that’s elevated the need for just-in-time supply chains and given political sensitivities of any Brexit disorder around the end-year Christmas period,” says Shen. “Instead, a last-minute agreement late in the year of some kind that avoids no-deal, announces progress made since March in free trade talks and gives the UK and the EU potentially additional time by extending standstill conditions for most if not all goods trade temporarily into 2021 to allow continued negotiation, give any time needed for Treaty ratification and/or support necessary preparations around customs infrastructure appears more likely.”

“No-deal remains unlikely from multiple vantage points – whether due to the significant economic, financial market, social and political dislocations that’d ensue – including probable loss of life amid the pandemic, the succour no-deal could give nationalists in Scotland surrounding independence, the frictions to trade no-deal facilitates within the UK itself between Great Britain and Northern Ireland or between the county of Kent and the rest of England in travel to Dover, the fact the UK is unprepared currently to replace arrangements with many global trading partners it benefits from preferential trade within the EU customs union, or the damage a no-deal scenario could deal to EU-UK relations longer term for both counterparties in key strategic areas.”

Things on Brexit could get worse before they get better

“The Internal Market Bill detailed earlier this month was likely designed to add pressure in trade negotiations – similar to the tactical use of parliamentary prorogation in 2019 – with the intention that such pressure could force the EU to back down on some negotiation red lines,” adds Shen.

“As such, things on Brexit could easily still get worse before they get better – with uncertainty looming around how much progress will have been made before a self-imposed 15-16 October European Council deadline. However, we maintain the view that even were the UK to agree on terms with the EU ultimately, there’s an ongoing cost of Brexit uncertainties as future relationship negotiations drag on into 2021. Entering 2020, we estimated this Brexit cumulative cost in lost output had already totalled to over 1.5% of UK GDP.”

“With protests against coronavirus restriction, higher short-run unemployment and banks relocating operations to Europe, economic output is foreseen contracting in the fourth quarter and the robust recovery foreseen in 2021 will take some hit,” says Shen. “This holds important credit implications for the United Kingdom’s AA/Negative ratings were economic uncertainty and rising public debt to not be firmly addressed.”

For a look at all of today’s economic events, check out our economic calendar.

Dennis Shen is a Director in Sovereign and Public Sector ratings at Scope Ratings GmbH.

Multilateral Fiscal Support for African Governments Addresses Liquidity More than Solvency Risk

Download Scope Ratings’ full report on Africa’s debt crisis and multilateral initiatives.

Fiscal vulnerabilities among African sovereigns were building in the years even before this year’s pandemic. This reflected challenging economic conditions, unfavourable exchange-rate and commodity-price changes, alongside significant new borrowing – including loans from Africa’s largest bilateral lender, China, and increased bond issuance.

Covid-19 has pushed most African economies into recession, driven, among other factors, by lost tourism revenues, falls in commodity prices and a decline in remittances. Real GDP in 2020 is set to contract by 2.3% on average across the continent, tax revenues will shrink and pressures to increase expenditure have risen.

An emphatic policy response needed in Africa, however fiscal constraints prevail

“This calls for an emphatic policy response,” says Dennis Shen, director at Scope. “Reinforcing public health systems, providing emergency food where necessary, offering income relief to vulnerable persons and supporting strategic economic sectors and small and medium-sized enterprises are short-term priorities alongside the long-term need to bolster economic development.”

However, in addition to overcoming weak governance structures and administrative capacities for the policies’ effective implementation, such measures also come with considerable price tags. Many African governments lack the fiscal space to implement such relief programmes without jeopardising the sustainability of their public debt.

African countries’ average public debt ratio increased from a 2011 low of 38.5% of GDP to 62.3% in 2019, while debt ratios more than doubled in that period in one third of the 53 economies on which there’s data. The burden of servicing debt has risen in parallel: regional average interest payments doubled from 5% to just under 10% of government revenues over the same period.

Multilateral institutions have increased emergency lending and debt service suspension

Multilateral organisations have ramped up emergency support in the form of loans and grants of around 0.6% of Africa’s 2019 GDP to-date, while the G20 has agreed on a Debt Service Suspension Initiative (DSSI) with average savings of 0.6% of 2019 GDP.

“International initiatives can support African sovereign creditworthiness, though, critically, DSSI debt relief has led to suspension rather than outright debt forgiveness,” according to Shen. “The international support programmes primarily address short-run liquidity rather than long-run solvency issues.”

“In addition, any private sector involvement in DSSI could be tied to a temporary (selective) default credit rating – potentially restricting market access near-term,” Shen says. “However, such a default credit rating in a scenario of private sector involvement would likely be transitory and, longer term, involvement of private sector creditors in debt relief could be viewed as positive for creditworthiness especially were underlying solvency issues addressed.”

DSSI elements such as enhanced debt transparency, multilateral monitoring and borrowing ceilings are considered by the rating agency as positive for the region’s sovereign ratings.

Governments will need to independently weigh the benefits vs costs of debt suspension participation

“Governments will need to judge the benefits of participation in DSSI – especially of any element of private debt bail-in – against the costs,” Shen says. “If a suspension of 2020 bond coupon and principal payments leads to a significant debt service hump in future years, this could be considered a significant risk even after a debt suspension – given potential for renewed debt distress over future years.”

“Conversely, if an economy’s debt sustainability is adequately enhanced by momentary suspension of debt payments to official and/or private sector lenders and repayment schedules are subsequently smoothened, this could support stronger market access and lower borrowing rates long term, and with this, bring a potentially stronger sovereign credit rating long term.”

The ongoing shift in African governments’ funding source in the direction of markets and China

Rising public debt burdens have coincided with a shift in African governments’ reliance on multilateral institutions and bilateral lenders towards capital markets. There has been a parallel longer-term shift to non-Paris Club bilateral creditors, predominantly China. The proportion of private funding has risen, up at almost 40% of public and publicly guaranteed debt in 2018.

Increased issuance of sovereign bonds can diversify a country’s investor base and subject a government to market discipline especially in crises, but it comes with higher borrowing costs than concessional multilateral and bilateral loans and increases exposure to volatility in investor sentiment.

Multilateral and bilateral financial support alongside debt relief initiatives, such as the DSSI, support African governments’ capacities to cope with the economic and public-health crises – they mitigate economic and financial damage, ease immediate liquidity risk, and can improve sovereign creditworthiness over time.

For a look at all of today’s economic events, check out our economic calendar.

Dennis Shen is a Director in Sovereign and Public Sector ratings at Scope Ratings GmbH. Thibault Vasse, Sovereign Ratings Analyst of Scope, co-authored this article.

Turkish Lira’s Plunge Throws Institutional, Economic Challenges Into Sharp Focus

Scope Ratings has ranked Turkey as among its “Risky-3” out of a sample of 63 economies most at risk of a balance of payments crisis, given the lira’s history of significant volatility and the high proportion of government and private sector debt denominated in foreign currencies.

The rating agency downgraded Turkey’s credit ratings to B+ from BB- on 10 July to reflect growing risks to external sector stability and deterioration in the governance framework including risks stemming from long-run foreign-exchange reserve depletion. The lira trades presently 33% below an August 2019 peak against the dollar. The Turkish currency also hit fresh all-time lows against the euro this past week, before making up some losses after evidence of policy tightening.

Early signs of reversal in the direction of policy tightening, but unlikely enough

Friday’s closure of the one-week repo financing window forces central bank funding of banks to the costlier overnight window – an effective 150bp hike. Next, regulators are expected to ease an unorthodox “asset ratio”, effective since 1 May, which has compelled lenders to raise lending activities unsustainably. Lira lending from the consolidated banking system rose 45.9% YoY as of July. The banking supervisor this week, moreover, announced easing of some rules that restrict foreign banks from access to lira liquidity, under strict conditions in regard to the use of such liquidity.

“So, we’ve now sort of returned to the 2018 lira crisis response playbook of backdoor rate hikes via shifting funding between central bank windows, to avoid unwanted attention for central bankers from President Recep Tayyip Erdoğan were policy rates themselves hiked, whilst, moreover, easing foreign exchange reserves deficits via funding from foreign sources like Qatar,” says Dennis Shen, lead analyst on Turkey at Scope. “Unfortunately, what ultimately eased the crisis in 2018 more tangibly was a return towards conventional policymaking and a significant hike in the policy rate itself.”

“In consideration of elevated inflation of 11.8% in July, Turkey’s real policy rates remain among the world’s lowest. However, a rate hike will not be straight-forward given politicisation of the central bank and interventions from the President, who has a stated preference for low rates. A significant rate hike would be helpful in stabilising current exchange rate devaluations; however, tightening would also come at some price to Turkey’s fledgling economic recovery.”

The lira’s recent weakness against the dollar and other major currencies comes even as global risk sentiment has improved since a March ebb, which should otherwise support emerging market currencies.

Lira’s decline exacerbates macro imbalances

“Deterioration in the value of the lira not only raises inflation, but also undermines debt sustainability given 50% of Turkey’s central government debt denominated in foreign currency, up from 27% in mid-2013,” says Shen.

“Any sustained deterioration in the exchange rate can spiral increasingly easily into a problem for the government’s future servicing capacity of its public debt,” Shen says.

Turkish general government debt is set to rise to more than 40% of GDP this year, up from a comparatively low 28% in 2017. Non-financial companies have a significant net foreign currency debt position of USD 165bn as of May 2020.

The impact of the Covid-19 pandemic in curtailing Turkey’s income from travel and tourism receipts impairs private sector foreign exchange reserve liquidity as well as the current account – the latter which returned to a deficit of just above 1% of GDP in the year to May 2020.

Inadequate foreign exchange reserves have been diminished further

Ankara has diminished what were already inadequate foreign currency reserves this year in trying to defend the exchange rate. Gross official reserves (including gold) fell to USD 90.2bn as of 31 July, compared with USD 105.7bn at the start of 2020.

“However, we need to net out central bank foreign-exchange liabilities to domestic banks and, importantly, bilateral short-term foreign-exchange swap liabilities.”

FX swaps stood at a record high USD 54.4bn at end-June as the central bank has entered such arrangements with domestic financial institutions, including state-owned banks, to artificially elevate gross reserve levels. Swap-corrected net reserves declined to a record low of negative USD 32.5bn in June, a turnaround from positive USD 18.8bn at end-2019 and USD 56.0bn at a 2011 peak.

“Absent the roll-over of such swap arrangements, the country’s reserves are negative – in other words, Turkey’s balance of payments is precarious unless the country’s underlying economic and external sector weaknesses are swiftly corrected,” says Shen.

For a look at all of today’s economic events, check out our economic calendar.

Dennis Shen is a Director in Sovereign and Public Sector ratings at Scope Ratings GmbH. Matthew Curtin, Senior Editor of Economic Research at Scope, was a contributing writer for this comment.

Ireland: Covid-19 Crisis Weighs upon Growth and Fiscal Metrics, but Robust Recovery Expected

Ireland has experienced severe health and economic crisis but has responded forcefully, including prompt and stringent restrictions of economic activity from 27 March followed by a staggered re-opening of its economy. The formation of Ireland’s first grand coalition government – between Fianna Fáil and Fine Gael after the February elections – has created a more predictable political climate.

“The political breakthrough should help Ireland navigate through this severe global health crisis, including the risk of a second wave of coronavirus incidence in Europe in the 2H-20, and engineer a robust economic rebound,” says Dennis Shen, lead analyst at Scope Ratings for Ireland.

Significant economic contraction in 2020, but robust 2021 rebound

The Irish economy grew by 1.2% QoQ in Q1 2020, although the true economic barometer for 2020 is Q2, a quarter during which output is expected to have contracted significantly. Scope Ratings forecasts a real output contraction of around 7% for the full-year 2020, as the Irish economy entered recovery after April troughs, a milder forecast than European Commission expectations for a 7.9% contraction in 2020.

“The coronavirus-related demand and supply shock has curtailed output in Ireland’s domestic consumer-oriented sectors such as retail, real estate, construction, entertainment, transport and hospitality, while the financial sector, industry – including the important pharmaceuticals sector – and the information and communications technology sector have been more resilient,” says Shen.

In 2021, Scope forecasts a sturdy economic rebound of around 7.5%.

Debt ratios to rise significantly this year, but resume a downward trajectory post-crisis

The government has announced fiscal support of about EUR 18.5bn, equivalent to 5.5% of GDP, since the start of the crisis, including income support, healthcare and investment spending, grants for small and medium-sized enterprises, tax cuts and payment holidays, and credit-guarantee schemes. After the announcement of the July stimulus package, the Irish National Treasury Management Treasury estimates total bond funding activity this year will be at the upper end of a range of EUR 20bn to EUR 24bn, over 80% of which has been financed via long-term bond issuance already, with an average issuance maturity of above 11 years.

“We expect Ireland’s public debt stock to rise to around 70% of GDP this year, having declined to less than 58% of GDP in 2019,” says Shen. “The rise in debt this year does return Ireland to ratios of debt per 2016 or 2017.”

“However, we expect the debt ratio to return on a sustained downward trajectory post-crisis, reaching 66% of GDP by 2024, given the economy’s strong growth potential, supported by increases in the working-age population of an estimated 0.9% a year alongside steady improvements in productivity,” says Shen. The current government is, moreover, expected to take action to reduce budget deficits post-crisis.

“However, public debt compared with the underlying Irish economy – as measured by debt to modified GNI – is significantly more elevated. Under this alternative metric, public debt is expected to increase in 2020 to around 120% of modified GNI – justifying the government’s continued attention on ensuring fiscal consolidation after the crisis.”

Highly accommodative financing rates continue to support Ireland’s capacity to lower public debt over the medium run. Ireland can borrow at a 10-year yield of -0.12% at time of writing – equal to a spread of 39 bps over Germany.

In addition to coronavirus risk, legal and tax certainty and Brexit are risks

“The recent ruling of the EU General Court against the earlier European Commission decision to make Apple pay to Ireland EUR 14.3bn or 4.4% of GDP in back taxes and interest does impact government assets and, as such, net debt levels, pending the outcome of any Commission appeal to the European Court of Justice,” says Shen. “At the same time, the ruling may hold medium-run consequences as well including greater tax certainty for US multi-nationals with operations in Ireland.”

“Brexit remains another risk,” says Shen. “The impact of a year-end no-deal UK exit from the EU single market and customs union, even though it is not an outcome that we’d expect, would weigh upon Ireland’s economic performance.”

In late June, Ireland’s political parties agreed on a three-way grand coalition, made up of the centre-right parties, Fianna Fáil and Fine Gael, alongside the Green Party, the first such coalition since the Irish independent state’s founding in 1922. The coalition government’s priorities include the addressal of a housing shortage and homelessness, an overhaul of healthcare, and achievement of ambitious climate-change objectives.

For a look at all of today’s economic events, check out our economic calendar.

Dennis Shen is a Director in Sovereign and Public Sector ratings at Scope Ratings GmbH.

Nordic Economies: Covid-19 Impairs 2020 Growth but Rising Public Debt Levels Still Manageable

The economic cost of the Covid-19 crisis will be significant across the Nordic region. Economies have been impaired by disruptions to production and supply chains alongside significant declines in internal as well as in foreign demand. Labour market dynamics, the speed of 2021 economic recoveries and fiscal and monetary interventions will vary across the region.

“Finland will see public finances deteriorate materially, with debt reaching around 70% of its GDP, presenting challenges in terms of required future fiscal consolidation,” said Dennis Shen, a director in the sovereign ratings team of Scope Ratings and co-author of a new report on the Nordic region.

“Denmark and Norway, having managed the crisis commendably to date and now re-opening, will nonetheless see significant economic contraction in 2020. Sweden has shown signs of greater resilience and is set to experience a comparatively moderate 2020 GDP contraction, due to less restrictive virus containment but this has come at the cost of higher loss of life alongside an impeded recovery as the health crisis remains unresolved. In general, the 2020 contraction in the Nordic region is expected to be somewhat more moderate, however, than that in the euro area aggregate.”

Denmark: significant 2020 recession but public finances remain robust

The extensive and speedy lockdown implemented by Denmark will weigh on 2020 economic performance. Scope expects a gradual, uneven recovery but with public finances still in a comparatively strong position. “Denmark’s strong fiscal fundamentals entering this crisis enable the government to run a wide 2020 public sector deficit of around 8.1% of GDP, its widest deficit since the early 1980s, without endangering debt sustainability. The government debt-to-GDP ratio is expected to increase from 33.2% in 2019 to a still moderate 42.5% in 2020.”

Norway: pandemic and oil price crisis bring material recession, but gradual rebound expected

The Covid-19 economic shock and turbulence in global oil markets will push the Norwegian economy into significant recession. “After -3.75% growth in 2020, we anticipate 2.5% in 2021, supported by an uneven recovery in global aggregate demand and a gradual increase in external demand for Norwegian oil and gas exports – the latter accounting for 15% of Norwegian GDP and 35% of exports of goods and services in 2019. This is even though effects of the crisis will still be wearing on wage growth, and, as such, on domestic consumption patterns,” Shen said.

Sweden: moderate 2020 economic contraction but at significant cost to lives in a health crisis

A comparatively moderate economic contraction in Sweden in 2020 is foreseen, due to less stringent economic restrictions. However, with the virus having reached peak case counts in June, recovery will be impeded so long as the virus is not brought under control. “We expect a fiscal deficit of 6.2% of GDP, after five consecutive years of general government budgets in balance or in surplus entering 2020,” said Shen. The debt-to-GDP ratio is expected to rise from 35% in 2019 to a still moderate 42% in 2020.

Finland: rising debt during 2020 crisis requires fiscal consolidation steps after the crisis

Economic contraction, government stimulus and economic weaknesses that pre-date the pandemic have pushed up government debt in Finland significantly and this could present risks to longer-run debt sustainability if a swift response to stabilise the debt trajectory is not acted upon. “We expect a general government deficit of 8.5% of GDP in 2020. As a result, debt-to-GDP is seen increasing to about 70% in 2020 (from 59% in 2019) – rising back above an EU 60% threshold – requiring fiscal consolidation steps after the crisis to re-strengthen Finnish debt sustainability,” Shen said.

For a look at all of today’s economic events, check out our economic calendar.

Download Scope’s full report

Dennis Shen is a Director in Public Finance at Scope Ratings GmbH.

UK Faces Historic Dual Coronavirus, Brexit Challenges, Though Counterbalancing Economic Strengths Remain

Scope Ratings says the heavy impact of Covid-19 and Brexit is testing the resilience of the UK’s economy and public finances, although the UK (rated AA/Negative by Scope) retains important, counterbalancing fiscal strengths.

“Prime Minister Boris Johnson’s government faces a delicate balancing act of gradually re-opening the economy and easing physical distancing while avoiding a significant second wave of infection, as is the case for many other governments around the world,” says Dennis Shen, lead sovereign analyst for the UK.

The UK has experienced a disproportionately heavy toll from the pandemic due in significant part to government mismanagement in the crisis, accounting for near 10% of global Covid-19 confirmed fatalities (according to Johns Hopkins University data) with 0.9% of the world’s population. “The economy and health trade-off in this crisis is not such an obvious trade-off in the final analysis – as long as the virus is not brought under control, there cannot be a true normalisation of economic conditions,” says Shen.

Brexit represents a second potential risk

The UK faces a second potential crisis: the looming end-June deadline in the Brexit process on whether to extend the standstill implementation period in the EU’s single market and customs union beyond 2020 – a deadline that UK negotiators are likely to let pass by.

“If so, the UK would technically lose its option under the 2019 Withdrawal Agreement to avoid a disruptive no deal exit on 1 January 2021,” says Shen. “However, even if the deadline is ignored, we expect an agreement late in 2020 to extend the transition state and avoid hard Brexit. Such an extension would mean that the UK continues payments to the EU budget for the EU’s 2021-27 financial period.”

“Beneath the rhetoric and Brexit posturing, we believe there is little real appetite from general publics for a no-deal exit on either side of the Channel in the middle of a severe health and economic crisis,” says Shen. “UK proposals for a temporary light-touch customs regime, in the case no trade deal is struck, are also unrealistic – as stated by the EU.”

Deep recession alongside fiscal deterioration

The UK economy is expected to be in a very deep recession in 2020. “A significant weakening of the UK’s public finances is foreseen with the budget deficit set to increase to above 10% of GDP in 2020 with public debt to climb above 100% of GDP from 85% in 2019,” says Shen. “Potential no-deal Brexit contingency planning late in 2020 is expected to add additional budget costs – as it did in 2019. Economic uncertainties tied to Brexit will damage investment and impede the recovery later in 2020 as well as in future years.”

Public debt will likely continue to rise over the medium run toward 115% by 2024, as the UK economy recovers with the support of accommodative fiscal and monetary policies but deficits remain high as the Conservative government seeks to avoid a fresh round of austerity cuts, in line with a potentially more lax fiscal consolidation response globally after this crisis compared with after 2008-09. “This also links to a weakened UK fiscal framework after attrition from the Brexit process.”

“With Labour gaining on the Conservatives in opinion polls, the government will want to provide fiscal support for households and business – likely forgoing significant tax increases and spending reductions for the foreseeable future,” he says. “The government has discussed treating debt accrued in 2020 as ‘war debt’, justifying a higher public debt ratio. Central bank QE has moreover granted governments greater fiscal space. Unfortunately, debts accrued during this crisis will, nonetheless, have to be repaid one day,” says Shen.

However, the UK maintains economic and fiscal strengths

However, the UK has counterbalancing economic and fiscal strengths. As one of three economies with a “Big Four” central bank alongside an independent monetary policy – the others being the United States and Japan – the UK can issue gilts and raise borrowing with limited immediate concern regarding debt sustainability. UK yields are near historic lows: at or under 0% on the short to medium end and only 0.2% to borrow for 10 years (compared with near 5% at 2008 crisis heights). Similarly, UK interest payments are at their lowest since World War II, with debt interest to revenues of around 3.5%, well under a new fiscal rule set in case this ratio were to rise above 6%.

The 2020 public debt ratio remains well below that of similarly rated sovereigns such as France (AA/Stable) (at around 115% of GDP at end-2020) and the US (AA/Stable) (135-140%) despite the increase in the UK government’s debt stock. Government annual gross financing needs are also significantly below those of such sovereigns, with the UK’s long average maturity of public debt of 15.2 years contrasting with 7.8 years in the case of France, 5.8 years for the US, and a weighted average of 7 years for G7 countries.

“Moreover, the Bank of England has been buying gilts in the secondary market,” says Shen. “With the expansion of QE to GBP 645bn as announced in March, the central bank should at minimum approach holding 30% of outstanding UK debt securities in 2020, up from 24% at end-2019, with the significant possibility that QE is further enlarged. Even if purchases represent only the momentary transfer of UK debt to the central bank, this goes some way in curtailing the 2020 increase in UK government debt owed to the private sector – the segment of sovereign debt rated by Scope.”

For a look at all of today’s economic events, check out our economic calendar.

Dennis Shen is a Director in Public Finance at Scope Ratings GmbH.

Italy’s Debt Sustainability Challenge is Increasing, Though ECB Support Mitigates Liquidity Risk

Concerns about Italy’s debt burden are underscored in Scope Ratings’ revision of the Outlook for Italy’s BBB+ long-term ratings to Negative on 15 May.

Elevated public debt

Italy’s general government debt is set to increase to more than 155% of GDP from 135% at end-2019. Risks to this baseline projection are heavily skewed to the upside. The increase in debt this year could be much greater if the Italian economy contracts more severely and/or the government activates additional resources to cushion a vulnerable economy. Italy has the second highest public debt-to-GDP ratio in the euro area and the highest ratio to GDP with regards to debt owed to the private sector – the segment of sovereign debt rated by Scope.

“We expect that a significant amount of public debt accrued during this crisis will be of permanent nature considering the Italian economy’s weak nominal growth and the government’s track record of pro-cyclical loosening of fiscal policy during phases of recovery after economic crises,” says Dennis Shen, lead analyst at Scope for Italy’s sovereign ratings. “Though the public debt ratio might stabilise or decline moderately immediately after the crisis, we expect the ratio to continue to increase longer term. Debts accrued in past crises have not been reversed in full before the next downturn hit.”

Italy’s record of insufficient debt reduction is in significant part the result of modest nominal growth. Over 2010 to 2019, nominal growth averaged 1.3% – with average real growth of 0.2% per year – which was the weakest in the euro area after Greece. Scope estimates Italy’s real economic growth potential at just 0.7% – the second lowest after Japan’s among sovereigns rated by Scope.

The EU recovery fund helps, but not game-changer alone

“Debt sustainability is challenging even with the assumption of the inception of an EU recovery fund by 2021,” says Shen.

The exact details of the proposed recovery fund have yet to be fully finalised; however, even under an assumption that Italy receives EUR 82bn (4-5% of Italian GDP) per the proposal of the European Commission, through grant monies spread across 2021-24, this significant amount would nonetheless remain insufficient to significantly dent the country’s high public debt burden. Here, this in part recognises that the ultimate economic impact of grants, loans and guarantees disbursed depends on long-run growth multipliers of projects undertaken.

“In addition, challenges relate to higher contingent liabilities from the EU’s joint financing of the fund alongside uncertain implementation of projects in the green and digital economies given Italy’s record of not fully utilising EU funds,” Shen says.

“That said, should EU recovery fund allocations arrive with associated conditionality, including the assurance of enhanced fiscal discipline post-crisis in reversing a significant 2020 deficit estimated at above 10% of GDP, this would make the fund more supportive to Italy’s credit ratings,” says Shen.

“This could partially address a risk we see on the horizon relevant across EU sovereign issuers,” says Shen. “Namely, that after European fiscal rules have been relaxed over this crisis in response to exceptional conditions, re-activation of the pre-crisis budget rulebook and a steering of governments away from any new normal of more elevated spending – especially under an environment of continued ECB support and low financing rates – may prove challenging.”

A more permanent role for the ECB to ensure debt sustainability

Structurally more elevated debt alongside increased government gross financing needs of above 25% of GDP a year over the medium run indicate a more permanent role for the ECB might be required to support the continuous roll-over of Italian debt at sustainable rates.

The Eurosystem now holds more than 20% of Italian medium- to long-term government securities – with this share increasing – representing a transfer of Italy’s marketable debts from the private sector to the ECB balance sheet. This has helped to slow what otherwise would be a sharper increase in the government debt stock owed to the private sector. Here, the extraordinary support from the ECB and EU for Italy as a systemically relevant issuer is slowing the speed of deterioration in the sovereign’s creditworthiness even as gross debt levels increase.

“We expect that the ECB balance sheet will continue expanding over time. While this supposed ‘temporary’ transfer of an increasing share of Italian debt to the Eurosystem books does not itself resolve debt sustainability, it does kick the need to have an answer to the solvency question down the road,” says Shen. “Similar to the case of Greece, Europe will expect Italy’s public debt can be brought down to more sustainable thresholds via reforms to raise growth potential whilst holding interest rates low. However, this strategy is likely to face challenges.”

For now, domestic demand for Italian government bonds supports the nation’s financing at accommodative rates. In May, the Italian Treasury raised more than EUR 22bn from an issuance in the BTP Italia series. The spread to Germany on 10-year Italian government bonds has declined to under 200 basis points, from 281bps mid-March.

Scope’s next scheduled calendar review date on Italy’s sovereign ratings is 30 October.

Dennis Shen is a Director in Public Finance at Scope Ratings GmbH.

Italy: Debt Sustainability Supported by ECB as Covid-19 Crisis Brings Rise in Debt and Funding Needs

In a new report, Scope Ratings outlines a severe decline in nominal GDP in Italy (rated BBB+/Stable) this year from the Covid-19 crisis, with real economic output set to contract by 7.5% – and downside risk to this estimate. Italy’s budget deficit could widen to more than 10% of GDP while public debt is expected to rise above 155% of GDP from 135% at end-2019.

The ECB’s bond-buying programmes are crucial in ensuring Italy benefits from low interest rates, so a future move to wind down net purchases could increase longer-term financing risks given structurally higher yearly funding demands.

“We expect public debt to rise above a 155% of GDP level in 2020 with this debt ratio maintaining an upward trajectory longer term – remaining relatively unchanged in years of positive growth but adjusting significantly upwards in years of recession,” says Dennis Shen, lead analyst on Italy’s sovereign rating at Scope and co-author of the report. “This unfavourable long-term trajectory reflects in significant part weak nominal growth dynamics.”

Short- and longer-term debt sustainability risk

“In addition, with concern to short-term debt sustainability, we expect 2020 gross financing needs for Italy to rise above 30% of GDP under a baseline and then to fall somewhat, as fiscal deficits are trimmed after the crisis, but remain above 25% of GDP a year through 2024,” says Shen. “As such, financing needs are significantly above an IMF gross financing needs threshold of 20% of GDP, above which an advanced economy is categorised as under ‘high scrutiny’.”

In addition to its baseline debt projection, Scope sets out in the report a stressed scenario in which public debt levels rise more significantly.

Although government debt is increasing, budget stimulus of 4.5% of GDP in 2020 alongside 40% of GDP in public guarantees on bank loans are key components of the government’s counter-cyclical fiscal response, similar to that announced by countries like France and Germany.

ECB actions mitigate immediate liquidity risks

For now, the ECB’s forceful actions have helped to avoid a liquidity crisis in the euro area and eased concern to an extent about Italy’s medium- to long-run debt sustainability.

Yields on 10-year Italian government bonds are below 2%, comparatively low when viewed against the above 7% reached during euro area sovereign crisis peaks of 2011-2012.

ECB intervention remains vital for the preservation of Italy’s market access and facilitating sustainable funding rates for the government to cover elevated financing needs.

We estimate the ECB could indirectly cover additional gross funding needs Italy has during this 2020 crisis beyond pre-crisis financing requirements of 2019 in full.”

This acknowledges the flexibility the ECB has – specifically with concern to the Pandemic Emergency Purchase Programme – to deviate from capital key purchase targets for a period of time and acquire more or less of a specific country’s bonds if it chooses. “This includes higher purchases for a while for those governments most exposed to the crisis, including Italy.”

Any winding down of ECB interventions presents challenges

“Nevertheless, our new analysis shows that Italy is likely to experience structurally higher debt post-crisis, alongside structurally higher annual funding needs, raising longer term questions over the sustainability of Italian debt especially under any scenario of greater reduction in intervention post-crisis from the ECB,” Shen says.

Future winding down in ECB crisis-era net purchases and any movement, in the long run, towards reducing the size of the ECB balance sheet – including, for example, any non-re-investment of maturing Italian government bonds – could present significant challenges for Italy and result in the more likely materialisation of debt sustainability concerns.

“Significant market assistance from Italian banks and Italian savers through so-called home bias – with 65% of Italian government debt held by domestic investors ensuring a stable local buyer base in moments of crisis – would only partially compensate in this scenario,” Shen concludes.

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Dennis Shen is a Director in Public Finance at Scope Ratings GmbH.

Covid-19 in Italy: What is the Budget Deficit, Sovereign Debt and Credit Rating Outlook?

Dennis Shen, a Director in sovereign ratings at Scope Ratings, answers five pressing questions that policymakers and investors are asking amid worries about the country’s credit ratings (BBB+/Stable):

Italy is at the centre of Europe’s health care and economic crisis. Should the government in Rome be worrying more about growth or about the budget deficit to protect the country’s credit ratings?

The strength of the economic recovery and expectations for deficit levels in 2020 and in years beyond will both ultimately be critical in determining our long-term sovereign ratings. In the near term, the speed and shape of a future economic recovery will be more important for policy makers and financial markets than the level of the deficit.

The priority right now is rightfully on stemming this unprecedented public health crisis that has cost over 10,000 lives in Italy, protecting households and businesses, and then getting the wheels of the economy rolling again before a deeper financial crisis manifests itself.

Italy’s high public debt levels have been a consistent area of concern for investors, alongside tensions in recent years between Rome and Brussels and breaches of EU fiscal rules.

For now, however, we see no risk of those fears materialising into an EU Excessive Deficit Procedure immediately nor do we see an outsized increase in yields on Italian government bonds (of the scale of that at sovereign debt crisis heights).

First, the EU has suspended its budgetary rules as Europe grapples with the pandemic. Secondly, European institutions such as the ECB and European Stability Mechanism are coming to Italy’s aid with hefty monetary and contingent fiscal support for euro area member states.

What are Scope’s latest GDP, budget-deficit and debt-to-GDP forecasts for Italy?

The reality is that Italy faces a very steep economic contraction of 5% to 10% this year, with risk even as regards this range skewed to the downside. Moreover, a much wider deficit will be a result of the economic decline and emergency fiscal responses to the pandemic, together pushing public debt well above the 135% of GDP level at which it stood at end-2019.

We expect a budget deficit of over 6% of GDP this year, widening after Italy’s budget result was better than anticipated in 2019 at only -1.6% of GDP. The much increased 2020 deficit accounts for an increase in Italy’s cyclical deficit alongside well over EUR 50bn in “shock therapy” fiscal support actions that alone raise the deficit by over 2% of GDP. Italy’s debt ratio could easily breach a 145% of GDP threshold within the next year.

What about the longer-term fiscal and economic consequences of a severe recession this year?

We recognise that “cyclical” deterioration in growth or “cyclical” weakening in budgets during a crisis have sometimes more structural consequences than one thinks: the weakening of Italian companies, banks and government balance sheets over 2020 could reduce investment even in 2021 or 2022, and higher “extraordinary”, one-off deficits may not be so completely unwound in 2021 or even by 2022.

The severity of this economic shock, the durability and strength of the recovery after it as well as greater fiscal imbalances do matter as they have effects on investor confidence and the longer-run risk of liquidity crises.

Should Italy instead be adopting a “whatever it takes” fiscal approach in view of its budgetary constraints?

In today’s exceptional circumstances, a “whatever it takes” approach is what is required on the part of national governments and central banks to address the pandemic and its economic consequences. But there is no escaping the observation that there are immediate and later-day credit implications depending on the scale of the decline in the economy and in debt sustainability.

Authorities ought to direct targeted policies such as to minimise the build-up of longer-run fiscal and economic imbalances. At the same time, the more that other euro area countries with greater fiscal space, such as Germany, can do to bolster their economies, the more there will be positive knock-on benefits for Italy – and the less Italy needs to do alone.

In what circumstances might Italy’s sovereign rating be downgraded?

Scope’s next scheduled sovereign review date on Italy’s credit ratings is on 15 May 2020. There has undoubtedly been a weakening of public- and private-sector balance sheets from this unprecedented economic shock. One consequence of a weakened balance sheet is that the private sector and the central government are now more vulnerable to shocks in the future, even assuming a gradual recovery does take place later in the second quarter and into the third.

In other words, Italy’s fundamentals will look different after this crisis than they looked entering it. But the crisis has also demonstrated one core rationale underpinning Scope’s investment-grade rating for Italy compared to a more pessimistic view of market participants: Italy’s systemic importance in the euro area and the extraordinary support from European institutions available to Italy under worst-case scenarios.

The ECB has provided ample evidence of European institutions’ extraordinary support for Italy over recent weeks: new long-term refinancing operations, more accommodative targeted long-term refinancing operations and a tolerance for front-loading new quantitative-easing purchases to potentially support vulnerable governments like Italy’s – more or less a backdoor activation of Outright Monetary Transactions – alongside considerations of ESM credit lines under curtailed conditionality.

The major question now will be whether the fundamental deterioration that has occurred and is still ongoing, acknowledging the extraordinary support and Italy’s multiple other credit strengths, is still reflected in a BBB+ credit rating or if an alternative assignment is warranted.

Dennis Shen is a Director in Public Finance at Scope Ratings GmbH.

Italy’s Economy Proves Extremely Vulnerable to Coronavirus Epidemic

Governments around the world are in a quandary over Covid-19: how to counter the economic disruption caused by the outbreak when public-health measures to contain the disease require often severe restrictions on people’s ability to travel and work.

Italy has reported the largest number of cases of coronavirus in Europe, standing at more than 9,100 now, with at least 463 deaths to date, leading the government to take drastic measures to slow the spread of the disease. Schools closed on 5 March for a minimum 10 days and sporting matches will be played behind closed doors for the next month, if they haven’t already been cancelled. The authorities have expanded a quarantine to all of Italy, restricting public gatherings and encouraging “social distancing”.

The public health challenge the Italian government faces is very serious. But on top of the disruption to millions of ordinary people’s lives and the distress for those worst affected, the Italian economy is experiencing a triple shock.

Export Sector Risks

First, Italy’s export-oriented industry is relatively heavily exposed to the disruption to global supply chains caused by the initial outbreak of the disease in China. As Europe’s most-important manufacturing powerhouse after Germany, Italy is the EU’s third biggest exporter of goods to China and third biggest importer from China after Germany and France.

The particularly virulent outbreak of the disease in Italy is taking place in the country’s northern industrial heartland. The region of Lombardy alone counts for around 27% of exports and 22% of Italy’s GDP, with the total share of the economy attributed to severely impacted regions rising to 40% once Veneto and Emilia-Romagna are included.

Significant Impact on Tourism Industry

Secondly, the impact on Italy’s treasured tourism sector is significant. The international spread of the virus is discouraging visitors to some of Europe’s most popular holiday destinations such as Milan, Venice and Florence. Tourism accounts for 13% of Italy’s economic output by itself. Even after the global and Italian manufacturing sectors start to recover, Italy’s tourism exports might well lag behind should travellers remain reluctant about voyaging too far from home.

Vulnerable Economy and Public Finances

Thirdly, the Italian economy and public finances were already in a vulnerable position in comparison with those of other European countries even before the coronavirus struck. GDP shrank in the fourth quarter. Public debt remains high. We expect gradually rising debt to GDP in the future. In addition, we undertook an exercise a month ago to stress test the public finances of EU countries. Italy scored weakly in terms of its fiscal vulnerability to a severe economic shock and capacity to weather such a crisis without significant increases in public debt.

Conclusion

Our conclusion is that Italy is facing a very difficult year as the epidemic has brought widespread disruption to many communities in addition to the distress they are suffering as the death toll has mounted. We estimate that the economy may shrink in 2020 by at least 0.3%; we had previously forecasted growth of 0.25%. The sometimes-shaky coalition government of Prime Minister Giuseppe Conte has limited room for fiscal manoeuvre to offset the economic shock absent endangering debt sustainability.

The government has opened up its fiscal first-aid kit amid the public health emergency to help businesses, workers and those on the front-line dealing with the health crisis. Measures include doubling a “shock therapy” fiscal stimulus package to EUR 7.5bn (0.4% of GDP) on 5 March, including tax credits for companies hardest hit, bolstering a national wage-supplement fund and extra cash for health services and the civil protection and security forces. There are now discussions about further raising the size of the stimulus.

Weaker-than-expected growth and extra-governmental spending suggest that Italy’s budget deficit will widen significantly this year, if only temporarily, after narrowing to 1.6% of GDP last year. The government recently estimated a deficit of 2.5% of GDP in 2020.

In normal times, that would put Rome at loggerheads with Brussels as Italy has repeatedly brushed up against EU fiscal limits. However, this time is different: in recognition of the gravity of the situation in Italy and in the rest of Europe, the European Commission has indicated maximum flexibility around its fiscal rules in 2020 if spending is clearly linked to the epidemic mitigation. Still, Rome’s approach needs to recognise the government’s budgetary constraints and still-elevated public debt of 135% of GDP at end-2019, second highest in the EU after Greece’s.

There are concerns that public debt may rise towards 140% of GDP in coming years, which could adversely impact on investor confidence particularly as a pronounced slowdown in global growth now appears definite this year. After all, an economic downturn can increase debt via multiple channels.

One is by curtailing tax revenue flows and raising counter-cyclical spending by governments, both driving budget balances downwards. Another is the reduction in nominal economic output, raising debt-to-GDP ratios via a denominator effect. Yet another is the possibility that the cost of servicing the debt rises as investors lose faith in governments with greater fiscal vulnerabilities.

One metric of investor concerns is the widening in the spread in yields between Italian and benchmark 10-year German government bonds to around 200 basis points, up from 130bps in mid-February. The last thing Italy needs presently is any deeper market sell-off and financial instability.

Even so, we recognise that Italy has significant institutional and financial strengths, among them a large and diversified economy, a long record of primary fiscal surpluses and moderate levels of non-financial private sector debt. Moreover, the government’s success in raising revenues supported the lower-than-anticipated budget deficit in 2019, which has given Rome greater leeway to release funds in responding to the crisis.

Crucially, Italy is a main beneficiary of the euro area’s ultra-accommodative monetary policy and lender-of-last-resort facilities. Italy can borrow over 10 years at very low rates still of just over 1%. Indeed, the BBB+ sovereign ratings we assign to Italy – itself 1-2 notches above the assessment from US credit rating agencies – reflects our unchanged view of Italy’s systemic importance within the euro area and associated likelihood of receiving multilateral support in worst-case scenarios.

Dennis Shen is a Director in Public Finance at Scope Ratings GmbH.