Stability Programme: Italy’s hinges on growth

Italy’s updated Stability Programme should be published this week. The government is likely to argue that the fiscal expansion embodied within it will stimulate real GDP growth, reduce poverty and public debt.By contrast, we are sceptical that the proposed fiscal expansion will increase real GDP growth and lead to a decline in the public debt-to-GDP ratio.

Based on our analysis of fiscal multipliers , we find that  tax cuts have a more stimulative effect than spending increases; but  both tax cuts and spending increases have a much smaller positive effect on growth in high debt countries such as Italy.

Market scepticism on Italy and Italian assets is well-justified and likely to persist. In our view, the prices of Italian assets are likely to remain lower and more volatile (even compared with current levels). As our market strategy team have pointed out, Italian spreads to Bunds have entered a new regime, a macro no man’s land. As such, they expect BTP-bund spreads to remain in the upper half of the post-May range.

In our view, the size and composition of the Italian fiscal expansion increases the risk of a series of credit rating downgrades and could lead to difficult discussions with the European Commission. At this stage, we do not expect that developments in Italy will have systemic implications for the global economy and global markets. That said, the probability of potential financial spillovers to other markets has risen, in our view. Given the systemic relevance of Italy to the Euro area and the size of the Italian bond market, we think one cannot ignore the potential contagion that could, for example, materialise in the event that rating agencies downgraded the Italian sovereign by more than one notch and investors once again re-focus on the institutional vulnerabilities in the Euro area.