Why a Downgrade of Italian Sovereign Debt Is Increasingly Likely

There are at least four reasons why a downgrade of rating/outlook of the Italian sovereign debt by the main rating agencies is becoming increasingly likely, some home-made, some imported.

1.      The municipal elections have weakened the government and, most importantly, the “pro-fiscal-discipline” faction within it: I discuss this point here .

2.      In late April, the government approved the Document on the Economy and Finance (DEF), the fundamental program which laid out the time frame for achieving a balanced budget within 2014.  Many observers have criticized the plan for being back-loaded and therefore not entirely credible:  about 2/3 of the consolidation efforts were scheduled in 2013, the general election year, and 2014. Today, fresh from the electoral débacle, the Prime Minister stated that the consolidation measures envisaged for 2011 would be a meager 3 billion, compared with the 15 originally planned, followed by 5 billion in 2012 and the remaining 22 (to get to 40) in 2013 – 4.  In other words, the budget cuts are being postponed even more, and their credibility is suffering even more.

3.       The economy is almost flat, growing at 1% year-to-year according to Istat today’s release, while inflation is edging up up.  The DEF projections assumed a declining inflation rate, from 2.3 in 2011 to 1, 8% in 2014, whereas inflation is moving up and is already at 2.6%. This, together with the likely tightening of the ECB, will inevitably raise real interest rates on the debt. Worse-than-expected fundamentals, lower growth rates and higher real interest rates, will deteriorate the solvency of the country.

4.      The Sovereign debt crisis in Europe is getting worse. The conflict between the (reasonable) German stance in favor of private sector involvement and the ECB stark opposition to any form of soft restructuring is postponing the day-of-reckoning, making it harsher when it comes, and increasing  the risk of contagion to other peripheral countries.

Thus a downgrade of Italian debt, if national and international conditions do not improve substantially in the next weeks, is becoming increasingly likely.