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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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