Italy Back In Spotlight After S&P Says One In Three Chance It Will Cut Ratings In Next 24 Months

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From S&P, which explains why Italian banks have dominated Sigma X trading in the last few days:

Despite Announced Austerity Measures, Italy Still Faces Substantial Risks To Debt Reduction

  •     The Italian government has introduced additional fiscal measures for 2011-2014.
  •     Italy's weak growth outlook remains the key downside risk to the government's debt reduction plan.

LONDON (Standard & Poor's) July 1, 2011--Yesterday, the Italian government introduced additional fiscal austerity measures that aim to reduce the general government deficit by €47 billion (3% of 2011 GDP) by 2014. Despite these measures, however, we believe substantial downside risks to the government's debt-reduction plan remain, primarily due to Italy's weak growth prospects.

Several of the announced measures, in our view, could indirectly benefit Italian competitiveness: in particular, cuts to higher-bracket public sector wages and the planned rationalization of Italy's complex system of tax deductions. If implemented, adjusting the retirement age in 2014 rather than in 2015 as originally planned would reinforce our opinion that Italy's age-related contingent liabilities are among the lowest in Europe. We also view the agreement between the employers' confederation and Italy's three main labor unions to decentralize wage-setting as an important first step toward promoting wage flexibility.

Nevertheless, in light of Italy's weak growth (per capita GDP growth averaged minus 0.9% between 2005 and 2011) it is our opinion that far more substantial microeconomic and macroeconomic reforms will be required to incentivize private investment and match wage levels with productivity. Without such measures, we believe Italy's economic potential will not be realized. This will imply insufficient wealth creation to deliver meaningful declines in the general government's debt-to-GDP ratio, which was a high 119% at end-2010. As a consequence, we continue to hold the view that there is an approximately one-in-three likelihood that the ratings on Italy could be lowered within the next 24 months, as reflected in our negative outlook.

On the fiscal package itself, we view the latest austerity plans as generally credible, particularly the measures that aim to contain the public sector wage bill and pension spending. We believe, however, that the government could be overly optimistic about how effective its fight against tax evasion will be. We anticipate the government will likely retain its tight fiscal stance and will respond to potential future fiscal slippage with additional measures. The government has also introduced a tax reform package, which includes the simplification of personal income, service, and transaction taxes, while raising VAT by one percentage point.

The negative outlook on Italy reflects Standard & Poor's view of certain downside risks to the government's debt-reduction plan over 2011-2014, and represents our belief that there is approximately a one-in-three likelihood that the ratings could be lowered within the next 24 months. In our view, these downside risks will primarily stem from weaker growth than our current assumption of average GDP growth of 1.3% during 2011-2014. In addition, we believe that extended political gridlock could contribute to fiscal slippage.

If one or a combination of these risks materializes, Italy's general government debt burden could stagnate at the current high level. In this case, we may lower the long- and short-term ratings on Italy. On the other hand, if the government manages to gather political support for the implementation of competitiveness-enhancing structural reforms, paving the way for higher economic growth and faster reduction of its debt burden, the ratings could remain at the current level.