Turkey Nears Tipping Point: Capital Controls, Use of Reserves Unlikely to Prevent Lira Depreciation

The government in Ankara has few options available so long as President Recep Tayyip Erdoğan remains committed to lowering borrowing rates to accelerate economic growth and raise exports even under conditions of inflation running above 20% – eroding ordinary citizens’ disposable income.

Either the currency crisis gets bad enough for President Erdoğan’s advisors to say “enough is enough”, at which stage the central bank changes personnel and belatedly hikes rates – even if temporarily – to ease current selling pressure on lira and check inflation.

Or, as an alternative, the central bank resorts to “de-globalising” the currency – reintroducing capital controls, limiting access to foreign currency within the economy, seeking foreign currency from domestic banks and foreign allies, and going through reserves in defence of the currency – in line with what occurred between 2018 and 2020 when Erdoğan’s son-in-law Berat Albayrak ran economic policy.

The government’s exchange-rate pain threshold appears higher than in the past

Any decision to cut rates again, even as global central banks are generally tightening, at the monetary policy committee of 16 December could place even further pressure on lira, already having lost around half its value since February.

Inflation rose to 21.3% YoY in November, sending real policy rates to -5.2%, among the lowest in emerging markets.

Stemming this lira slump is critical but the government’s exchange-rate pain threshold appears higher than it was in 2018 or late 2020 when the central bank last hiked rates sharply to circuit break a currency rout.

Erdoğan has significantly consolidated his influence over economic decision-making by this stage, including monetary policy. The president appears much more “dug in” during this crisis with loyalists running the central bank and treasury and repeated mantra of how falling interest rates support growth and employment. In addition, the political stakes are much higher ahead of centenary elections due by 2023. Erdoğan and his Justice and Development Party are trailing in polling, so any public admission of failure on the economy such as vis-à-vis a rates reversal is likely to be seen by Erdoğan as damaging to credibility.

Observing steps of use of forex reserves and capital controls in slowing lira losses

We are already observing the government pursuing a “de-globalisation” strategy in using forex reserves to intervene in exchange-rate markets – after having previously committed not to do so – and adopting specific forms of capital controls to discourage depositing in foreign currency and selling of lira, to allow for lower rates while slowing currency losses. The catch is that defending lira via such a strategy is unsustainable long run.

The policy is expensive, and only buys time. Turkey racked up foreign-exchange reserve losses of over USD 100bn over 2018-20. Net reserves ex-swaps, standing at negative USD 42.3bn as of October, represent a lasting testament to consequences of this policy framework, which would be risky to attempt again with the domestic sector losing confidence in value of lira, precipitating further capital outflows.

Risk of political crisis with elections looming, on top of economic and lira crises

Instead of helping Erdoğan’s political cause, a lower interest rate policy to engineer higher economic growth appears to be aggravating his likelihood of re-election. The weak currency is instead exacerbating high inflation and loss of consumer purchasing power, which are central causes of popular discontent. Moreover, rate cuts are resulting in much higher long-end rates, tightening monetary conditions and exacerbating economic instability – hitting the poorest the hardest.

Should Erdoğan not alter course and electoral defeat were to appear inevitable, political tensions are likely to grow over 2022 and 2023 if the president turns to less democratic routes to hold to power. Risk of a political crisis, in addition to economic and lira crises, represents a vulnerability with bearing on B/Negative Outlook foreign-currency credit ratings we assign to Turkey.

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.

 

African Nations’ Shock Resistance, Debt Sustainability Varies Widely Despite Shared Vulnerabilities

Explainer video: Scope Ratings introduces its 2021 external vulnerabilities and resilience report

Our annual external risk-ranking report reflected this year 12, mostly larger African economies, comprising those with sufficiently transparent data for metrics assessed under the report, although 2021 findings attest to the continent’s mixed economic performance through the Covid-19 crisis.

Algeria, Botswana and South Africa stand out for comparatively stronger resilience in the region

Botswana stands out with respect to external-sector resilience, supported by stronger public finances and a comparatively stable crawling-band exchange-rate policy. Neighbouring South Africa’s recovering economy has shock absorbers during external crises in a long average maturity of government debt of around 12 years of which a lesser proportion (10%) is denominated in foreign currency, plus a flexible exchange rate.

Algeria owes its external-sector resilience to adequate holdings of official reserves and limited outstanding foreign currency debt or debt held by foreign creditors, reflecting longer-standing government reluctance to borrow internationally. These factors partially compensate for persistently wide current-account deficits.

Zambia, Angola and Gabon are Africa’s three riskiest economies under 2021’s ranking

On the other hand, features common to Africa’s more fragile economies include net capital outflows, volatile, less-globally traded domestic currencies, large net international liability positions, inadequate reserves and high foreign ownership and foreign-currency-denomination of their government debt – this being most significantly true as regards Zambia, Angola and Gabon.

Zambia, Angola and Gabon compose the Africa region’s “risky-3” under this year’s Scope ranking, which embeds a special concentration on Africa.

Zambia and Angola are participating in the G20 debt service suspension initiative (DSSI). Zambia has sought more comprehensive debt restructuring under an associated G20 Common Framework for Debt Treatments beyond the DSSI, after defaulting on debt late in 2020.

G20 debt-relief programmes risk not going far enough in addressing Africa’s solvency crisis

The G20 Common Framework’s continued concentration upon extension of debt maturity and, only where applicable, debt reduction on NPV terms, risks achieving overly little in improving debt sustainability as regards many heavily indebted sovereign states. The DSSI and the Common Framework also target low-income countries, leaving many middle-income countries vulnerable to debt crisis.

Many African governments are poorly placed in dealing with their heavier medium-run debt servicing requirements due to DSSI payment postponements. Half of all sub-Saharan African sovereigns were at high risk of or in debt distress already prior to the Covid-19 crisis.

A more comprehensive debt restructuring involving debt forgiveness could enhance credit profiles of many poorer countries of the Africa region significantly after restructuring. We have titled such a framework more comprehensively embedding debt forgiveness: DSSI+.

Instead, by postponing today’s problems to tomorrow under DSSI, interest and principal payments may come due during periods when there is less international support for multilateral debt relief than there is today.

Zambia’s default has elevated concern around African debt owed to China

Zambia’s 2020 default has elevated concern surrounding repayment risk associated with other highly indebted countries with borrowing from China, such as Angola or Uganda, as the latter furthermore seeks amendment of loan clauses.

Among other African markets, Nigeria’s comparatively lesser dependence upon financing in foreign currency plus liquid domestic debt markets support external resilience. However, persistent high inflation has resulted in overvaluation of the naira.

Meanwhile, Kenya’s outstanding external risks are mitigated by IMF extended arrangements as well as relief provided via DSSI, which Kenya made a U-turn concerning and participates under this year.

Our annual external vulnerability and resilience rankings evaluate nations on 1) underlying vulnerabilities to a potential balance of payment crisis; and 2) economies’ degree of underlying resilience when exposed to such external crisis. This year’s ranking expanded the Africa sample to 12 nations of the region, from two in 2020.

Download the 2021 external vulnerabilities and resilience report and rankings (pages 11-15 for Africa).

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. Levon Kameryan, Senior Analyst at Scope Ratings and co-author of the report, co-wrote this article.

 

Poland: row with the EU could have negative impact on outlooks for growth, public finances

Investment premised on future EU funding will prove essential for determining the potential for long-run growth in Poland (rated A+/Stable). The government would have limited room for fiscal manoeuvre should EU financing continue to be withheld considering the nation’s sizeable allocation under the EU Recovery and Resilience Facility of EUR 58.7bn. The funding is made up of EUR 23.9bn in grants and EUR 34.8bn in loans – together equivalent to more than 10% of 2021 GDP – though Poland does not plan on making full use of available loans.

The row between Warsaw and Brussels follows the recently introduced ‘Rule of Law Conditionality Regulation’, which allows the EU to suspend payments to member states where violations of the rule of law “affect or seriously risk affecting” the management of EU funds. The European Commission has delayed approval of national recovery and resilience plans of Hungary and Poland over concerns around the rule of law and judicial independence.

Tensions between Poland and the EU are unlikely to subside soon

Tensions between Poland and the EU surrounding rule of law are unlikely to subside soon, and a recent ruling of Poland’s Constitutional Tribunal has only deepened divisions.

On 7 October 2021, Poland’s Constitutional Tribunal ruled some areas of EU treaties as being incompatible with the Polish Constitution, challenging the primacy of EU law. A group of 26 former judges of the Tribunal, including some former presidents, have criticised the ruling under a joint statement.

The ruling leaves the EU between a rock and a hard place. The strategic importance of Poland in the central and eastern Europe region and pressure on the EU to accelerate sustainability-linked financing in transport and energy sectors underscore a determination to punish Poland for transgressions but without pushing the point overly far. However, it is hard to see at this stage what room there is for compromise given the Tribunal’s ruling and another unresolved conflict around the independence of the Polish Supreme Court.

The European Court of Justice ruled last week that Poland will be required to forfeit EUR 1m per day until the government suspends a disciplinary chamber of the Supreme Court. Poland has responded it will not pay this fine.

The risk is that disagreements result in more prolonged suspension of EU funding for Poland

The government’s want to update fundamental provisions of EU law – on the basis of the Tribunal’s assessment of incompatibility with the Polish Constitution – is not realistic. Meanwhile, an exit of the European Union – ‘Polexit’ – remains highly unlikely. According to recent opinion polling, 9 of every 10 Poles support Poland’s membership of the EU.

Aside from added monetary penalties and an escalating row with the EU potentially adversely impacting foreign direct investment, the risk Poland faces is that current disagreements result in a more significant and prolonged suspension of EU funding. This could adversely impact the growth and public-finance outlook, the latter especially should the government use own resources to compensate for suspended EU financing.

For now, Poland’s economy remains resilient, weathering the Covid-19 crisis comparatively robustly. The government’s budgetary and monetary response has complemented unprecedented EU support in response to the crisis. Poland’s output will grow by around 5.6% in 2021, having returned to pre-crisis levels of output in Q2, and 4.6% next year.

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. Levon Kameryan, Senior Analyst at Scope Ratings, contributed to writing this commentary.

Greece: High Government Debt, Sovereign-Bank Nexus, Weak Growth Potential Remain Economic Challenges

Greece (rated BB+/Stable)’s government debt ratio is second only to that of Japan (A/Stable) among 36 nations whose debt is rated publicly by Scope. While we anticipate general government debt of Greece to moderate to 199.1% of GDP by end-2021, from a 205.6% peak last year, this remains significantly above a pre-crisis 180.5% level in 2019.

The high stock of Greece’s debt leaves the government vulnerable to any reappraisal in markets after this crisis concerning sustainability of government debt and deficits accrued in crisis, especially as ECB support is gradually scaled back. This vulnerability to market correction remains a core sovereign credit rating constraint.

After 2021, Greece’s public debt ratio is foreseen declining to around 186% of GDP by 2026 as growth stays above potential and budget deficits narrow, assuming no interruption to the economic recovery.

Sustained recovery remains contingent upon addressing structural bottlenecks

Nevertheless, sustained economic recovery remains contingent upon Athens addressing residual structural economic bottlenecks, such as the continued reduction of non-performing loans (NPLs) on domestic bank balance sheets, even recognising recent significant progress achieved in this area. Elevated NPLs (21.3% of total loans as of June but reduced from 40% as of end-2019) affect banking-system profitability and capacity to finance recovery. Piraeus Bank, Alpha Bank and the National Bank of Greece have taken on capital-enhancing actions to cover cost of forthcoming non-performing loan securitisations and the gradual phasing out of transitional prudential arrangements.

System-wide tier 1 capital ratios dropped to 13.0% of risk-weighted assets in Q2 2021 from 16.4% in Q4 2019, a reflection of poor profitability and asset quality. In this respect, under an adverse scenario of the European Banking Authority’s 2021 stress examination, core capital ratios of three of the four systemic banks observed decline to 8% or under – speaking to remaining vulnerabilities in the financial system.

Sovereign-bank nexus represents an increasing risk under adverse scenarios for the financial system

Crucially, a high share of deferred tax credits in bank capital, banks’ increasing domestic government bond holdings, state equity stakes in Greek banks and guarantees under the Hercules scheme infer a stronger sovereign-bank nexus – increasing risk for the sovereign borrower under contingent scenarios impacting banking-system resilience.

The government has focused upon addressing outstanding challenges

The government has focused on addressing outstanding bottlenecks in the real economy such as rigidities in the labour market, low investment and elevated private-sector arrears. Unemployment remains high, of 14.2% as of July, although having sharply been reduced from 17.2% in April. Tax compliance remains a weakness, although having similarly been improved, while spending on pensions and public-sector wages is above a euro-area average, limiting fiscal space for growth-enhancing expenditure.

Further progress required to enhance confidence in Greece’s long-run growth potential

Progress is important on some aforementioned areas to enhance confidence in Greece’s long-run growth potential, which remains among the lowest of the euro area, as well as to raise confidence in stability of the Greek economy under future crisis scenarios.

Scope upgraded Greece’s long-term sovereign ratings one notch to BB+, from BB, on 10 September.

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 and primary analyst for Greece’s sovereign credit rating.

Debt Ceiling Crisis Serves as Reminder Why the United States No Longer Has a AAA Credit Rating

Each debt-ceiling crisis imposes costs and damages the US’ reputation as a ‘risk-free’ borrower.

On Monday, a vote on a stopgap spending measure, packaged together with suspension of the debt ceiling, was blocked in the Senate. So, the US enters a critical phase of debt repayment risk entering October as the federal government’s cash resources diminish, and with federal deficits significantly higher than normal in 2021. Wider deficits curtail the time the US Treasury has for emergency action in meeting government spending obligations. Treasury’s cash balance stood at USD 0.3trn on 20 September, down from USD 1.6trn in February.

Expectation debt ceiling to be raised or suspended under party-line vote at the last moment

We expect the US government to raise or suspend the debt ceiling under a party-line vote in the end, thereby avoiding a sovereign credit default.

Nevertheless, the last-minute nature of any legislation sidestepping temporary default would remind investors of the significant, recurring risk to the willingness and capacity of the US to meet its debt obligations due to the debt ceiling.

Scope does not rate the United States as a AAA, risk-free sovereign issuer

Not only does Scope Ratings – the European rating agency I represent – not rate the US as a AAA, risk-free sovereign borrower, but the debt ceiling represents the most relevant near- to medium-run downside risk to current AA credit ratings we assign.

To resolve the latest debt-ceiling crisis, congressional Democrats could first seek to delink the debt ceiling and pass a separate continuing resolution for the US government to be open (confronting a potential government shutdown on 1 October). Thereafter, the Democratic Party, holding a technical majority in both houses of Congress, could consider budget reconciliation as final recourse to delay the debt ceiling until after 2022 midterm elections – although the complex reconciliation process similarly presents a set of risks due to nearly two weeks’ time this may demand.

Should not assume debt-ceiling political stand-offs are inevitably resolved just in nick of time

This latest episode is a fresh reminder that debt-ceiling crises of 2011 or 2013 are anything but things of the past.

We ought, moreover, not simply assume debt-ceiling political stand-offs are inevitably resolved in the nick of time. After all, the only technical US government debt default of the post-war era occurred in 1979 precisely due to partisan use of the debt ceiling.

The frequency of such US debt-ceiling stand-offs and recurring possibility of temporary non-repayment – even if driven by a so-called ‘accidental’ credit event – weigh on the US credit ratings. No other sovereign rated AA by Scope experiences such frequent crises during which default is a real scenario, barring last-minute legislative action, or has experienced a post-war credit event.

Each debt-ceiling crisis brings avoidable market instability, damage to Treasury market

Alongside risk of technical default, each debt-ceiling crisis brings otherwise avoidable financial-market instability, raising operational expenses for markets and resulting in some degree of damage to the market for US debt. This is even accounting for likelihood the debt ceiling has some impact in limiting ambition of incumbent governments’ spending policies.

According to the Government Accountability Office, delays in raising the debt ceiling in 2011 raised funding rates, hiking borrowing costs by USD 1.3bn over the fiscal year. The Bipartisan Policy Center estimated that the 2011 crisis, over a lengthier 10-year period, raised borrowing costs an aggregate USD 18.9bn.

Even a ‘temporary’ default on treasury bills – similar to that of 1979 – could result in structural damage to treasuries’ status as the global benchmark ‘risk-free asset’. The reputation of the US may require time to recover from any credit-event scenario, even if extra interest costs incurred might ultimately prove manageable.

Debt-ceiling crises occur as status of the US as issuer of the global benchmark safe asset is attenuating

US debt-ceiling crises are also taking place while the status of the US as issuer of the global reserve currency and benchmark risk-free asset is slowly attenuating. Avoiding debt crises is crucial to avoid any acceleration of this process.

This is leaving aside short-run repercussions of any credit-event scenario as regards undermining economic sentiment and growth – the latter which we estimate at a robust 6.2% for 2021 before 4.8% for 2022.

Debt-ceiling risks could further increase after 2022 midterm congressional elections

Risk associating with the debt ceiling could, furthermore, further elevate over the future, such as after midterm elections – should Democrats lose control of Congress. The experiences of 2011 and 2013 debt-ceiling crises demonstrate that risks were near heights when a Democrat President faced instead a divided Congress – and was, as such, absent recourse to a party-line congressional vote to raise (the debt ceiling), instead requiring a fraught bipartisan solution.

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.

 

Poland: Minority PiS Government Restricts Capacity for Reform, Raises Early Election Risk

We expect Poland to help lead the economic recovery in central and eastern Europe this year. Polish output should grow 5.6% in 2021 – revised up from a 4.9% forecast Scope Ratings held as of June – before 4.6% growth next year, having reached pre-crisis output levels by Q2 2021.

However, the governing Law and Justice (PiS) party’s loss of one of its junior coalition partners represents, nevertheless, an increase in policy and economic uncertainty, not least by raising likelihood of early elections before the autumn 2023 deadline.

Institutional erosion has increased political instability and tested Poland’s institutional relationships

PiS’s loss of its slim majority in the lower house (Sejm) shows the consequences of institutional erosion since PiS entered government in 2015 – a factor that has weighed on Poland’s A+ sovereign credit ratings. The recent bill introduced in Parliament seeking to bar companies outside the European Economic Area from holding majority stakes in Polish media firms has brought government instability after the coalition partner’s exit while potentially further testing Poland’s institutional relationship with the EU and the United States.

The bill under question is seen as a manner to compel US media group Discovery to sell a controlling stake in TVN, Poland’s main independent broadcaster, which has been critical of the government. At this stage, it remains unclear whether the bill will be signed into law.

A silver lining to Law and Justice losing its governing majority

There’s a silver lining, however, to PiS’s loss of its governing majority, which, while making the passage of important reforms such as those required for critical EU funding more difficult, may also bring a more balanced near-term legislative agenda, reducing the risk of further weakening of judicial independence and the free media. The government may temper certain policy objectives in return for support of smaller parliamentary groupings and independent MPs to pass legislation.

Over recent weeks, the government has passed a bill reducing the room for property restitution claims and was forced by the European Court of Justice into an about-face over a disciplinary chamber for Supreme Court judges. Since PiS entered government, other actions that have buffeted democratic norms include politicisation of the Constitutional Tribunal, attempted removal of Supreme Court judges, and limitations of media freedoms.

Checks and balances prevail restraining pace of institutional weakening

Checks and balances restricting pace of institutional backsliding still hold, including the government’s lack of a Sejm majority at this stage and opposition control of the Senate. More importantly, Poland’s dependence on EUR 58.1bn in EU monies, equivalent to more than 10% of 2021 GDP as part of the Recovery and Resilience Facility, alongside on further 2021-27 EU multiannual budget financing, constrain the government’s room for manoeuvre.

Dependence on EU funds encourages PiS observation of ECJ rulings and EU decisions on the rule of law ultimately, after frequently a phase of acrimonious back and forth talks.

A minority government may be difficult to sustain

Looking ahead, the PiS party will be eager to put off elections for as long as possible, although a current minority government may be difficult to sustain. Should PiS lose a parliamentary vote of confidence, an early election scenario could raise possibility of a hung parliament and associated heightened political uncertainty, but, moreover, might bring change of government favouring centrist groups.

Delays of fiscal consolidation and impediments to economic programme

This aside, the minority PiS government may seek to delay stringent fiscal consolidation reform over the coming period, with looser spending policies driven by political considerations. A recent outsized 60% pay hike for legislators – which goes into effect on 1 September – is only one example of how this may look. The lack of a governing majority may, moreover, impede the government’s capacity to fully implement its economic programme – even the flagship Polish New Deal in the existing form.

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. Levon Kameryan, Senior Analyst at Scope Ratings, contributed to writing this commentary.

Italy: Strong Rebound is Underway; EU Funds to Help Raise Medium-Run Growth Potential

We forecast a robust Italian rebound this year and next, with the rating agency I represent raising a 2021 growth estimate to 6.1% from an already above-consensus estimate of 5.6% we had forecasted previously since December 2020, while we kept for the present an estimate of growth in 2022 of 3.8%. The Italian economy shrank by 8.9% in 2020.

However, the medium-run growth potential of Italy as the EU’s third biggest economy remains modest given domestic bottlenecks in part relating to an ageing population, tepid productivity growth alongside risk that sizeable EU funding is absorbed only incompletely or ineffectively.

Here, we see after 2022 a gentle moderation of Italy’s annual growth in direction of a potential rate of around 0.8%, the latter revised modestly up from an estimate of the economy’s medium-run growth potential of 0.7% we had held prior to the Covid-19 crisis.

Public investment and economic adaptation to the virus support economic growth potential

The expected growth-enhancing effects of extra public investment post-crisis and economic adaptation to coexisting with the SARS-CoV-2 virus, curtailing some associated longer-term economic scarring effects, support the more optimistic assessment of the economy’s medium-run potential.

But any more significant increase in Italy’s growth potential might hinge upon Prime Minister Mario Draghi maintaining current momentum in deep-rooted structural reforms – in competition policies, enhancing fiscal and social safety nets, labour market reform, after a first set of judicial reform was achieved. Maintaining the cohesion of this government of national unity remains crucial after such actions had for decades eluded policy makers amid frequent changes in government.

Continued robust growth expected over the second half of this year although risks have settled on the horizon

We should see continued robust growth over the second half of this year if Italian households continue spending some of the forced savings accrued during successive lockdowns, further progress is achieved with vaccination of residents and investment stimulus from the Next Generation EU recovery programme begins flowing in over coming months.

However, we also acknowledge that there are downside risks to the economic outlook moving ahead as Covid-19 cases have climbed due to transmission of the Delta variant, potentially restricting some economic activities, plus the possibility of a harsher winter flu season.

Nonetheless, Italy’s Q2 GDP came in at double consensus estimates at an elevated 2.7% on quarter, largely in line, however, with our estimate for the quarter.

A large beneficiary of EU funds

For the medium-run outlook, Italy is one the largest beneficiaries from the Next Generation EU plan, particularly important given low levels of investment since the global financial crisis.

Inflation is another factor. Italy’s inflation rate, at 0.9% YoY in July, is running well under the euro area’s (2.2%) and is likely to continue underperformance even though we might consider much of current low inflation of Italy to associate with transitory factors and Italy’s inflation medium run is likely to rest above a 0.7% pre-crisis rate.

Higher but still comparatively modest levels of medium-run nominal growth

Higher real and nominal growth for Italy is anticipated as compared with rates from before the Covid-19 crisis, but the nominal medium-term trend will nonetheless remain comparatively modest at around 2%, representing an ongoing constraint for debt sustainability.

After all, real growth averaged only 0.3% over a 2010-19 decade (with nominal growth of 1.3% on average over this period), while an expected 0.5% annual decline in the working-age population over 2021-26 remains a significant economic headwind.

Italy’s 10-year yield level trades currently near its historic lows, at below 0.6%, helped by ECB support, despite the significant increase in the country’s government debt by the equivalent of nearly 25% of GDP since the crisis started.

The next review of Scope Ratings’ BBB+/Negative Outlook sovereign ratings of Italy is on 20 August.

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. Giulia Branz, Analyst at Scope Ratings, contributed to writing this commentary.

US Recovery Plan Will Support Recovery and Raise Long-Run Economic Growth Potential From 1.9%

Since the USD 1.9trn American Rescue Plan was signed into law in March, the Biden administration is pursuing two complementary pillars of its three-pillar “Build Back Better” agenda: i) the American Jobs Plan (with an earlier bipartisan compromise around a curtailed USD 1.2trn over eight years before recent setbacks), and ii) the American Families Plan (proposed USD 1.8trn).

The American Jobs Plan channels public funding towards enhancing physical and digital infrastructure, investing in research and development, shoring up supply chains and strengthening care systems. The American Families Plan aims to significantly raise federal spending in priority areas such as childcare, paid leave, pre-kindergarten, community college and healthcare.

The recovery plan is important not only for economic recovery but also for addressing structural bottlenecks

The administration’s programme is critical not only to provide near-term support for the economic recovery but also to address long-standing structural bottlenecks in the US economy. By enhancing the economy’s productive capacity, supporting domestic demand and tackling infrastructure deficits as well as structural weaknesses with respect to the social safety net, the programme supports a more inclusive and sustainable economic rebound and raises economic growth potential.

In our June 2021 Sovereign Interim Outlook, Scope Ratings projected the US economy to recover robustly, with 6.2% growth in 2021 (raised 2.2pps from our December 2020 projections) before 4.8% in 2022. After the 3.5% economic contraction of 2020, GDP is expected to have exceeded pre-crisis output as of Q2 2021, well ahead of the pace of recoveries in most European economies, including that of France and the United Kingdom. On the basis of the public investment programme, there is upside risk to our department’s prevailing US growth potential estimate of 1.9% – with potential output growth having otherwise seen secular decline since the turn of the century.

The spending programme comes at significant fiscal cost

The spending programme comes at a significant fiscal cost, however. The Committee for a Responsible Federal Budget estimates that the comprehensive package may amount to an aggregate of USD 6.7trn over 10 years. The US government has proposed offsetting measures such as an increase in the corporate income tax rate from 21% to 28%, enhanced tax enforcement and higher taxation of high-income households. These measures might generate savings of USD 3.3trn, leaving USD 3.5trn of unfunded costs, absent further revenue-raising measures.

In addition, mandatory expenditure linked to the healthcare system is likely to increase given the increase in federal spending on Medicaid and Medicare due to the Covid-19 health crisis and as more Americans seek benefits under programmes, barring reforms of the system.

US public debt to rise further, but accommodative financing conditions manage costs of borrowing

Presently, we expect US public debt to rise to above 135% of GDP in forthcoming years, from 108% in 2019 and only 65% as of 2007, exacerbating public finance weaknesses and stressing the United States’ AA credit ratings. Gross government financing requirements are estimated to stay around or above an elevated 40% of GDP per year through 2026. At the same time, prevailing accommodative financing conditions mitigate costs of borrowing, with 10-year government yields having backtracked to around 1.2% amid concern of a slowdown in the global recovery, from March highs of nearly 1.8%.

While benefits of a well-tailored investment programme at this stage are high and the cost of debt is low, it is critical that additional debt incurred nonetheless translates to tangible improvements of growth potential and addresses structural bottlenecks such as rising social inequality and problems of social mobility.

A return to a more balanced budget position remains crucial to ensuring benign funding costs and as the debt ceiling looms

While the United States still has meaningful fiscal space due to the dollar-based global financial system and the unparalleled status of US treasuries as the international risk-free asset, a return to a more balanced budget position after this crisis and reduction of contingent liabilities are nonetheless crucial to ensuring continued benign funding costs, especially as the Federal Reserve considers its exit strategies from crisis policies and as elevated deficits present risks after coming reinstatement of the US debt ceiling.

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, Senior Analyst at Scope Ratings, contributed to writing this commentary.

China’s Economic Outlook Stabilises as Beijing Addresses Financial Risks to Enhance Resilience

The Chinese state’s commitment to reining in credit growth, deflating asset bubbles, and cutting off state support for unproductive firms while also encouraging the development of Chinese financial markets and opening the capital account support the sustainability of China’s growth model.

Reduced financial-stability risk is partially a function of a noticeably reduced concentration of the state on meeting inflated ‘hard’ growth objectives. The latest Five-Year Plan target of doubling the size of the economy between 2020 and 2035 implies a more manageable average annual growth of 4.5% over 2022-35 assuming growth in GDP of 8.6% (our updated forecast) this year.

Such structural reforms ease still significant economy-wide debt risks and increase likelihood of a ‘soft’ rather than ‘hard’ landing after the significant private- and public-sector debt accumulated since the global financial crisis. As economic growth recovered slightly to 1.3% Q/Q in the second quarter, we expect Chinese authorities to balance management of financial stability risk with a parallel need to support recovery over the second half of this year.

Trend growth of China’s economy still compares favorably with that of most economies

Even as growth cooled since the initial rebound from Q1 2020 troughs, trend growth of China’s large and diversified economy remains very high compared with that of most economies around the world even if the former moderates towards a 5% rate over the medium run.

The Agency I represent affirmed China’s long-term local- and foreign-currency issuer and senior unsecured debt ratings at A+ on 9 July and revised the Outlooks to Stable from Negative. We also affirmed China’s short-term issuer ratings at S-1+ in local- and foreign-currency and revised the Outlooks to Stable from Negative.

Extensive financial-stability reform and progress of renminbi as reserve currency underscore improved outlook

Extensive supervisory and regulatory changes have intensified since the Covid-19 economic crisis with the People’s Bank of China laying out defined priorities in the period to 2025 that include improvement of the macro-prudential assessment framework and strengthening supervision of systemically important institutions, businesses and infrastructure.

Further anchoring China’s improved outlook is gradual progress in establishing the renminbi as a global reserve currency, which in turn reinforces the country’s economic resilience on top of existing external-sector buffers relating to high foreign-exchange reserves and low external debt.

Budget deficits and rising public debt remain credit challenges

Structural public-sector fiscal deficits as well as an increasing public-sector debt stock over the long run remain prevailing credit challenges, exacerbated by the fiscal and monetary easing adopted to cushion China’s economy against repeated macroeconomic shocks.

China’s general government deficit increased to 11.4% of GDP in 2020 despite relatively moderate pandemic-related fiscal stimulus, from 6.3% in 2019 and only 0.9% of GDP in 2014. The general government deficit will remain a sizeable 9.5% of GDP this year before narrowing to 8.6% next year.

High and rising levels of total non-financial sector debt since 2008 remain a core credit challenge, although authorities have taken important steps to easing this trajectory of rising debt.

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.

US: Debt Ceiling Deadline Highlights Risks to Sovereign Ratings, Need to Reform Fiscal Framework

The debt limit is a drag on the US ratings without a better-designed alternative instrument enforcing budget discipline.

Scope Ratings says the US debt ceiling is the most relevant near- to medium-term risk to the US sovereign credit ratings (of AA/Stable Outlook) – one that is likely to increase after the 2022 midterm elections if they should lead to a divided or Republican-controlled Congress.

The only technical US government debt default of the post-war era took place in 1979 in a crisis related to the debt ceiling, a reminder that one should not simply assume debt-related political standoffs are inevitably resolved.

The debt ceiling today increases rather than decreases the likelihood of a US credit event.

Risk of another technical default remain a relevant consideration for the US credit ratings

In the period since 1979, while another debt ceiling-related default has been prevented – risks of another technical default remain a rating-relevant consideration when the US government gets so close to severe payment difficulty every year or few years. Risks relating to the debt ceiling have also increased since 1979 due to the intensification of domestic political brinkmanship, including the use of the debt limit in partisan grandstanding.

In today’s political context in Washington, we expect the most likely compromise will be for the Joseph R. Biden administration and Democrat-controlled Congress to again raise the debt ceiling or, alternatively, suspend the ceiling once more later on in the year, sidestepping debt default.

Such a move will become even less straight-forward, however, in the future should Democrats lose control of Congress in 2022 if the experiences of the 2011 and 2013 debt-ceiling crises are anything to go by when President Barack Obama faced a divided Congress.

Scope’s AA credit assessment of the US recognises risks associated with the debt limit and impact on the likelihood of a credit event, even an ‘accidental’ one such as in 1979. No other sovereign credit rated AA by Scope either experiences such frequent crises during which default is a real scenario barring last-minute legislative action or has experienced a post-war credit event.

Higher US budget deficits reduce room for manoeuvre during debt-ceiling crises

We see pressures building seeking resolution of the debt ceiling before Congress’s recess in August.

For one, federal deficits are now much higher – meaning the fiscal largess of past and present US administrations is presenting shorter-run credit risk via curtailing the duration during which Treasury can mobilise extraordinary measures to meet spending obligations after debt ceilings are reinstated.

The Congressional Budget Office projects a federal deficit of USD 2.3trn in 2021, the second largest since 1945 and USD 1.3trn more than the deficit the US recorded when it last suspended the debt limit. Treasury faces growing pressures to slash T-bill supply ahead of the coming debt deadline. Any credit event affecting US treasury bonds impacts the US and global financial systems given treasuries are the global risk-free asset of choice and vital for inter-bank liquidity as collateral.

Treasury warnings are exaggerated, but government has likely only until the autumn prior to acute payment stress

Treasury’s warnings about the US running out of available funds by August are likely exaggerated, partially designed to focus minds in Congress. Nevertheless, the US government likely has until the autumn for the debt limit to be resolved before it encounters acute debt payment problems.

The expected resolution over the coming period of the debt ceiling could come via packaging a debt-limit suspension within the infrastructure spending legislation or the American Families Plan or alongside stopgap funding to avert a partial government shutdown after the fiscal year ends on 30 September – bills with more substantive congressional backing. If this does not work, Democrats, currently controlling technical majorities in both houses of Congress, could hold the option, at this stage, of using budget reconciliation to push back the limit – although there’s a view among experts that the reconciliation process may require raising the ceiling rather than suspending.

Acrimonious negotiations could serve as reminder of a longer-standing crisis of governance

Even assuming the debt ceiling issue is resolved in the end this go around, the likely acrimonious negotiations surrounding any agreement will be a reminder of a crisis of governance in the US’s divided political and social landscape. Governance risk has not disappeared with the new US administration. Republican members of Congress, mindful of primary challengers in 2022, will be under pressure to extract concessions from a Democrat-controlled White House and Congress and push for deep budget cuts.

Frequent debt crises underscore the need to reform the US’s fiscal framework

Frequent debt crises in the United States underscore deficiencies of the fiscal framework in the world’s largest economy, with the debt limit requiring reform in an age of political obstructionism.

Here, the US credit outlook would benefit from the replacement of the debt limit with an alternative credible and better-designed fiscal instrument that more effectively enforces budgetary discipline, particularly given the US government’s otherwise unparalleled capacity to raise funds and refinance debt.

On 2 July 2021, Scope took no rating action on the US but noted the debt ceiling as a credit constraint.

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, Senior Analyst at Scope Ratings, contributed to writing this commentary.

 

UK Outlook: Brexit Drag On Sovereign Rating Eases; Risks to City, Trade Balance Remain

We have consistently argued through the Brexit period that “no deal” was the least likely outcome. In this respect, the entering into force of the Trade and Cooperation Agreement with the EU in May 2021 was a crucial development behind an improved credit outlook for the United Kingdom.

The reduction of ‘no-deal’ adverse Brexit risk has significantly curtailed contingent downside risks that affect economic, fiscal, external-sector and institutional outlooks relevant for the UK’s sovereign credit ratings.

While the important UK services sector was mostly excluded from the trade deal, the additional Memorandum of Understanding agreed by the two sides in March represents a further important step for any more substantive access rights granted to the UK financial industry medium run, contingent on equivalence rulings.

Scope revised the UK’s sovereign rating Outlook to Stable on 25 June

The rating agency I represent revised the United Kingdom’s rating Outlook to Stable from Negative, affirming the ratings at AA on 25 June. In part, this Outlook change also reflected an exhibited resilience since the referendum in sterling’s status as a reserve currency.

The diminished risk of severe no-deal complications from Brexit has coincided with comparative resilience of the British economy through both a tense phase of domestic politics and frequently fraught relations with the EU after the June 2016 referendum and the Covid-19 crisis.

Sharp contraction in UK output in 2020, but strong recovery expected over 2021-22

UK economic output contracted sharply by 9.8% in 2020 with strict sequential lockdowns and heavy disruption of the domestic economy as the government struggled to contain the SARS-CoV-2 virus.

However, supported by large-scale fiscal and monetary stimulus, we expect a strong, but uneven, economic rebound of 6.6% this year and 5.4% next. In the medium term, we anticipate the UK’s growth potential to remain around 1.5%, capped by soft estimated productivity growth of just 0.6% a year.

True, that is below our 2% potential growth estimate should the UK have stayed in the EU, but it is nonetheless still comparable to that of similarly-AA rated countries such as the US, at 1.9%, and France, at 1.4%.

Revision of UK credit Outlook does not imply Brexit risks have passed

The revision of the UK rating Outlook does not imply Brexit risk and associated economic and institutional consequences have passed. The City of London is facing permanent damage in awaiting definitive agreements with the EU on financial services. UK-based businesses may continue to relocate some activities to the continent. Domestic politics remain volatile, from the growing pressure for a second referendum on independence for Scotland and the fall-out in Northern Ireland from the new UK-EU trading arrangements.

The external sector represents one constant credit challenge. The current account deficit amounted to 3.5% of GDP in 2020, slightly up from 3.1% of GDP in 2019 although significantly below a 6.1% of GDP peak in the four quarters to Q3 2016. The UK ultimately secured an EU deal for trade in goods where it has a trading deficit with the EU, but not one as comprehensive in services where it stands to see a diminished trading surplus. This holds longer-term adverse consequences for the UK’s current account balance.

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. Eiko Sievert, Director at Scope Ratings, contributed to writing this commentary.

G7 Corporate Tax-reform Poses a Moderate Risk to Ireland’s High-growth Economic Model

The G7 agreement to clamp down on global tax avoidance by multinational corporations (MNCs) aims to ensure that a larger share of corporation taxation is paid in countries where they operate. This included G7 backing for a global minimum corporation tax rate of at least 15%. This agreement may form the basis for a global deal.

The 15% minimum rate is nearer Ireland’s prevailing 12.5% rate than an original US proposal of 21% was, but still represents a gap.

However, the tax rate is only one factor that investors consider when deciding where to put their money. Ireland is no exception.

Ireland has multiple attractions for international businesses

Ireland holds multiple factors attractive to international business, among them the English language, a well-educated workforce, membership of the EU single market and favourable business conditions. As long as the tax ‘top-up’ does not widen significantly beyond current expectations, it is unlikely that most MNCs opt out of Ireland. The G7 agreement is only the starting point for future discussion at the G20 before any final deal is struck, likely to contain exemptions to ensure as many countries sign up as possible.

The full domestic impact of global tax reform will also hinge upon Ireland’s policy response, which may involve new measures to attract foreign capital and support local businesses. This could include advancing innovation backing such as campus incubators that abet firms with access to venture capital.

Any corporate tax increase is important, given MNCs’ role in Irish economy

Any increase of the tax rate is nonetheless important, considering Ireland’s dependence on pharmaceutical, computer services and other MNCs sectors, visible in the economy’s resilience amid the Covid-19 crisis.

Ireland’s 3.4% GDP growth was the highest in the EU in 2020 as MNCs benefitted from pandemic-associated trends such as more remote working and demand for immunological drugs. However, Ireland’s underlying economy – measured by real modified domestic demand – contracted 5.4% amid comparatively stringent lockdown, more akin to a 6.7% aggregate drop of euro-area aggregate GDP. The pharmaceutical and technology MNCs’ performance during this crisis may also carry into a post-Covid age, with these companies potentially benefitting longer term from structural economic changes.

Putting some of the government’s tax take at risk

Changes in global tax rules could put some of the government’s tax take at risk, ranging from 0.6-1% of GDP, or 1.1-1.8% of modified GNI in 2018, according to the IMF. The Irish government estimates that it might lose EUR 2bn (0.9% of estimated 2021 modified GNI) of corporation tax receipts longer term due to OECD proposals related to changes in the geographical domicile of corporate taxation.

Ireland’s small, open economy and the size and complexity of its financial and corporate sectors leave it vulnerable to shifts in international regulation around cross-border trade and investment.

Upgraded credit rating; 2021 growth forecast revised higher

Scope upgraded Ireland’s credit ratings one notch to AA- on 21 May, with the Outlook revised to Stable. Scope expects GDP growth of 9% in 2021 (revised sharply up from 5%) – supported by pent-up demand, strong monetary and fiscal policy support, and recoveries in Ireland’s main trading partners – followed by 4% growth in 2022.

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.

Ireland’s Debt Ratio Could Fall to Pre-covid Levels After 2026 on Deficit Reduction, Strong Growth

The consolidation in Irish public debt when measured as a percentage of modified gross national income (GNI*) – an indicator of the underlying output of Ireland’s globalised economy – will be slower than that in debt-to-nominal GDP, the latter metric set to fall to pre-crisis levels by 2025 absent significant adverse shock. The GNI* benchmark excludes the economic contribution of multinational pharmaceutical, technology and other companies with operations in Ireland that have performed strongly amid the crisis and may benefit longer term from structural economic changes owing to the pandemic.

Ireland is among the euro area member states with the greatest capacity to reverse the significant debt build-up from the crisis.

Comparatively resilient economic performance

Ireland’s comparatively resilient economic performance, with 3.4% growth in 2020 followed by an elevated 7.8% QoQ over the first quarter of 2021, plus robust growth expected after the crisis, gives the government substantive room to consolidate excess budget deficits. We upgraded Ireland’s sovereign credit ratings to AA- on 21 May, with the Outlook revised to Stable.

The Irish government’s significant fiscal response to the Covid-19 global crisis – equivalent to EUR 38bn or 18% of GNI* in 2020 and 2021 – will nonetheless see a budget deficit of around 9% of GNI* this year, approximately the same as last year’s deficit. The correction in Ireland’s budget is seen starting thereafter more significantly from 2022 on.

A further modest increase in the public debt ratio in 2021, before reductions medium term

Scope expects a further modest increase in the public debt ratio to 110% of GNI* (62% of GDP) this year as government support for business and households remains in place during the early stages of economic recovery. Public debt rose to nearly 106% of GNI* (60% of GDP) in 2020 from 95% in 2019 (57% of GDP).

As recovery takes hold, our expectation of robust growth underpins a forecast of post-crisis reductions of government debt: we estimate Ireland’s potential annual growth at 4% under real GDP terms and at 3% under a real modified domestic demand definition. Output growth should accelerate this year, with growth of 5% under GDP terms and 3% in respect to the underlying economy.

Brexit has had a mixed impact on the Irish economy. The consequences of greater friction in UK-Ireland trade after Great Britain’s exit from the single market contrasts with Brexit’s boon for foreign direct investment in Ireland, the latter which supports real growth.

An improving profile of the outstanding government debt

A constructive element is an improving profile of Ireland’s general government debt. The official sector holds an increased share of government debt. Official sector loans represented 19% of the Irish debt stock at end-2020, including bailout loans from 2011-13. An additional near 30% of the debt stock will likely be held on the Eurosystem balance sheet, after ECB asset purchases, by the end of this year, further reducing the outstanding proportion of rateable Irish debt owned by the private sector. Debt-service costs have moderated, with 10-year financing rates of 0.2%.

Ireland’s National Treasury Management Agency has taken advantage of benign borrowing conditions to extend the maturity of debt instruments to a weighted average of 11.2 years at end-March, comparing favourably with an advanced-economy average of 7.1 years. Year-to-date issuance in 2021 has averaged a lengthier 14.6-year maturity. Ireland has raised EUR 6.1bn in sovereign green bonds since 2018.

Economy retains significant inherent vulnerabilities

Irish fiscal dynamics will improve over time after the crisis, but we need to bear in mind that the economy retains significant inherent vulnerabilities to external and/or domestic shocks, given the prominence of multinational corporations in the private sector, a very open economic structure, high public and private debt stocks, and a considerable size of the financial system as compared with the size of the real economy. Forthcoming shifts in international corporation tax policy represent a relevant risk to Ireland’s economic comparative advantages.

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: Political Interference At Central Bank, Weak Lira Risk Policy Mistakes Ahead Of Elections

Structural depreciation of lira – averaging 17% annual losses against the dollar since 2015 – and increased state intervention to slow currency devaluation have reduced the domestic sector’s confidence in the lira.

The proliferation of cryptocurrencies as investors seek protection is a sign of a growing currency crisis. Unless the authorities reverse policy missteps, growing domestic loss of trust in the currency risks structurally higher inflation and balance of payment problems longer term.

Continued heavy political interference into monetary policy

However, President Recep Tayyip Erdoğan’s removal last month of a third senior member of the central bank’s powerful Monetary Policy Committee (MPC) in two months underscores ever greater political interference in monetary policy making. Erdoğan commented publicly of his expectations of a return to single-digit inflation and interest rates this year, and cited on Tuesday July or August as a possible timetable for rates to begin declining.

By stacking the MPC with figures who favour reduced rates, the president has raised the stakes for forthcoming central bank meetings – starting with the session due 17 June. While new central-bank governor Şahap Kavcıoğlu and his deputies will be given some time from the president, the president’s patience is waning.

Pressure for easing rates at odds with elevated levels of inflation

Pressure for more accommodative monetary policy remains at odds with Turkey’s high inflation rate, running at an annual 16.6% in May. Any easing of Turkey’s currently significant positive real benchmark interest rate of 2.1% could make the economy more vulnerable to capital outflows, lira depreciation and higher inflation.

The central bank is in a bind: it may have a tacit mandate to hold rates unchanged for a short period, but likely does not have one to hike rates should this be later required.

Policy missteps partially reflect Erdoğan’s party’s poor ratings in polling

Policy missteps are partially a function of Erdoğan’s attention on the latest opinion polling. They suggest all-time lows in support for the president’s AK Party and rising popularity of the President’s possible rivals in the next presidential elections – such as Istanbul Mayor Ekrem İmamoğlu and Ankara Mayor Mansur Yavaş.

In view of the criticism of the management of the economy, the president feels pressure to reverse the course of the economy during this Covid-19 crisis. Unfortunately, in the past, Erdoğan has given priority under such conditions to supporting higher short-run economic growth, rather than seeking to correct underlying economic imbalances and achieve sustainable longer-term growth.

GDP expanded 7% YoY in the first quarter, supported by lira lending growth of 25% YoY in April.

Increase in pre-election economic and institutional risk

Importantly, Erdoğan is unlikely to simply step aside in next elections. If he cannot engineer higher economic growth and higher employment to reverse declining popularity, he could resort to more significant oppression of his political opponents, intensifying economic and institutional risks ahead of the vote by 2023.

Degradation of economic policies leads decline in official reserves

The degradation of economic policy making has led to some decline in central bank foreign-currency reserves – after more than USD 100bn of reserves were spent in defence of lira in 2020 alone. Gross reserves stood at USD 92.4bn on 23 May – roughly unchanged from levels as of end-2020 – but swap-adjusted net reserves remained near all-time lows at negative USD 54.3bn in April.

In part, loss of official reserves has reflected impact of the pandemic on tourism revenues, contributing to deterioration in the current-account balance to -5% of GDP in the year to March 2021 from a 1.7% of GDP surplus in the year to August 2019.

It is difficult to see how structural deterioration in fundamentals could be easily reversed with Erdoğan increasingly in the driver’s seat over economic policy.

Our next scheduled review of Turkey’s B/Negative foreign-currency credit ratings is on 10 September.

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.

Italy: Fiscal Prudence Requires Attention Even as Draghi Investment Plan Critical to Reviving Growth

The Italian government presented earlier this month the fiscal plan and economic strategies for 2021 and beyond under the Economic and Financial Document (DEF). This week, the government of Prime Minister Mario Draghi outlines historic plans to put to prudent usage EUR 191.5bn of EU loans and grants – including spending on critical areas such as the green transition, digitalisation and infrastructure, targeting Italy’s less-developed southern regions – alongside around EUR 70bn of other national and EU resources and associated structural reform.

The government puts growth this year at 4.5%, rising to 4.8% in 2022, before falling back to 2.6% in 2023, 1.8% in 2024, and averaging 1.1% a year at the end of the decade under a scenario that incorporates the full effects of Next Generation EU (NGEU) funding from which Italy is the most significant EU beneficiary.

Sustained growth of above 1% per year seems optimistic

The sustained growth of well above 1% per year after Covid-19 does seem very optimistic – even with the positive economic support from the NGEU and associated government investment. Looking back over the last decade, economic growth averaged only 0.3% in the decade before the coronavirus crisis.

Our estimate of Italy’s potential growth of 0.7% is similar to a government estimate of 0.8-0.9% medium-run growth under government scenarios of incomplete implementation of NGEU. Italy’s realised economic growth has fallen short of comparatively modest potential growth estimates in the years pre-pandemic – constraining a higher estimate at this stage for future growth potential. Next, the scale of the growth impetus of this historic post-Covid-19 investment programme is unclear at this stage and will rest on how effectively implementation proceeds.

Italy is unlikely to reverse debt ratios by such a scale as to reach pre-crisis levels

The government expects economic impetus as well via an additional EUR 40bn (2.4% of 2020 GDP) fiscal package after the earlier EUR 32bn “DL Sostegni” support sleeve.

Italy’s budget deficit will widen at minimum short term: the government’s estimate in 2021 is 11.8% of GDP – above an earlier 7% government estimate as well as above Scope’s December forecast of 9% for this year – before shrinking to 5.9% of GDP next year and to the 3% Maastricht limit by 2025. Under government projections, public debt rises to around 160% of GDP in 2021 from 156% in 2020 before declining, under a scenario of “full NGEU effects”, to 135.5% of GDP by 2032, close to the 134.8% level before the crisis.

In our view, Italy is unlikely to reverse debt ratios by such a scale as to reach pre-crisis levels. The risk to budget deficits is, furthermore, skewed to the upside – as many households and businesses may require extended support and growth expectations might prove optimistic. While we are similarly of the view concerning the appropriateness of governments spending counter-cyclically during crisis, the issue, during a present early recovery, will be in deciding when and for which sectors government support will be pulled back to allow markets to again function and re-allocate resources more effectively, as well as when to allow select insolvencies.

Fewer restraints preventing higher sovereign borrowing

In view of ongoing transitions in fiscal orthodoxy in favour of pro-growth policies, the checks and balances pre-crisis that restrained the scale of spending have been eased exiting this crisis. Market disciplining powers against high spending and government excess are also likely to remain suppressed for a prolonged phase as ECB intervention has put in place an implicit put option, likely holding more durable signalling effects even after central bank purchasing begins to be wound back – restricting market willingness to sell off past boundaries.

Within such conditions of curtailed guardrails restricting sovereign balance sheet expansion, we have touched on in the past that projections of the government, the IMF and other forecasting organisations for a swift, sustainable decline in Italian public debt ratios starting from 2021 might be optimistic. Instead, we expect the Italian debt ratio to remain on an upward trajectory longer term – looking through the cycle. In this respect, general government debt might reach meaningfully higher levels beyond 160% of GDP.

Italy may not need to reverse public debt to pre-crisis levels

But, at the same time, Italy may not need to reverse public debt to pre-crisis levels.

Italy can sustain somewhat higher debt ratios at prevailing BBB+ credit rating levels than it could pre-crisis. This is partly because of the extraordinary European monetary and fiscal support but as well because of improvements in the profile of Italy’s government debt.

The weighted average cost of outstanding debt has fallen from 4% as of 2012 to an estimated 2% this year. With a 10-year BTP yield of only 0.8%, this weighted average cost of outstanding debt will continue declining. The Italian Treasury has lengthened the average life of debt to 7 years from 6.7 as of August last year.

Even if Italy’s current 160% debt ratio does not automatically signal crisis as this would have 10 years ago, there are nevertheless limits to how much debt Italy can ultimately hold within a monetary union in which the Italian sovereign does not have an independent monetary policy.

In the end, monetary space creates fiscal space

In the end, monetary space creates fiscal space – and how much fiscal space Italy has, as an example, to spend counter-cyclically in a future crisis even with higher levels of debt – depends on market confidence in the efficacy of Italian government policies, which might presently be high, but also on how much support the ECB is willing to give Italy and other euro area member states and the associated constraints the ECB itself faces in being able to provide continued scale in such support.

At this stage, we believe that even with high public debt, Italy has the fiscal space in a next crisis partly in view of the capacity for the ECB to ensure accommodative market conditions. But this, in and of itself, does not mean governments can ignore longer-run fiscal sustainability challenges.

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. Giulia Branz, Associate Analyst at Scope Ratings, contributed to writing this commentary.

Turkey: Persistent Challenges in Monetary Governance Increase Risk to Macroeconomic Stability

Saturday’s announcement of the sudden change in central-bank leadership, shortly after a market-friendly, above-expectation 200bp tightening of rates on Thursday, underlines President Recep Tayyip Erdoğan’s wish for looser monetary policy in support of unsustainably high growth.

Under new Governor Şahap Kavcıoğlu, the central bank is less likely to be proactive near term in addressing challenges of a weaker lira, rising inflation and elevated credit growth. Instead, Turkey’s significant macroeconomic imbalances may return to being exacerbated rather than counteracted by central bank policy.

Undermining credibility of Turkey’s central bank

The sudden dismissal of Ağbal – after he had pre-emptively raised rates 875bps since November last year, achieving a high real rate in the process – undermines once more the credibility of Turkey’s central banking.

Ağbal’s untimely exit is likely to result in a fresh deterioration of Turkish reserves after the short-run stabilisation during his tenure. Gross Turkish reserves rose by around USD 9bn since November to a still-inadequate USD 92bn as of 14 March. Net capital flows ex-foreign direct investment had returned to net inflows rather than net outflows.

With more question marks around central-bank independence as well as around monetary-policy efficacy, we are likely to see the central bank turn again to drawing upon diminished foreign-exchange reserves to prop up an ailing currency. The latest lira sell-off is especially untimely as the currency was already under pressure under a context of outflows from emerging markets triggered by US reflation concerns.

Low official reserves may dwindle further

Official reserves could see downside risk as well due to renewed capital outflows and a wider current-account deficit. Reserves had not recovered from damage done over recent years with net foreign assets ex-short-term swaps of negative USD 53bn as of January (an all-time low), so a fresh drop in reserve stocks increases the risk of a balance-of-payments crisis.

Comparatively robust growth of 1.8% in 2020 and 6.2% expected by Scope this year, enhanced by elevated lending growth, resulted in widening economic imbalance. Turkey’s current-account deficit expanded to 5.6% of GDP in the year to January 2021, near 2018 lira crisis lows.

Erdoğan’s consolidation of power main factor in deteriorating creditworthiness

We have been sceptical in the past about growing investor optimism over market-friendly changes in Turkish central-bank policy since November considering the country’s unchanged institutional framework in which President Erdoğan ultimately oversees monetary governance and retains his unorthodox belief that high rates cause inflation.

Erdoğan’s consolidation of power through the executive presidency remains a prime factor underscoring the structural deterioration of the sovereign’s creditworthiness.

In the end, Kavcıoğlu could see abrupt dismissal should a crisis escalate.

While Turkish authorities have refreshed pledges to deliver a permanent fall in inflation and ensure exchange-rate flexibility, the Turkish president’s interventions in monetary governance have contributed to the country becoming increasingly prone to economic crisis over recent years with significant structural damage to realised growth, the health of public finances and external sector resilience.

A misunderstanding with respect to limited space for monetary easing

At its core, there remains a misunderstanding within Turkish leadership with respect to the limited monetary policy space the government has to prematurely ease rates with rising inflation. Turkey simply cannot seek to emulate the ultra-low-interest policies of advanced economies with reserve currencies such as the US and the euro area, when the value of lira itself faces a crisis of confidence and Turkish inflation is nearly 16% – more than three times the official target. Any easing of monetary policy will result in greater currency volatility and possibly a return to other illiberal steps such as back-door rate increases in time or implementation of types of capital control to avoid overly rapid draining of reserves.

Persistent weaknesses in Turkey’s governance framework are captured in Scope’s B/Negative foreign-currency ratings.

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.

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.