Reducing the public debt-to-GDP ratio is a key economic policy goal of the Italian government. The past two years have seen a near stabilisation in the public debt ratio and a decline is expected in 2017 net of likely disbursements for banks’ recapitalisation. While the outlook is not immune from risks, the government expects that the fall in the debt ratio will gain momentum in the next three years thanks to improving macroeconomic conditions and continuing fiscal consolidation.

KEY POINTS

• Italy’s gross public debt ratio has nearly stabilized in the past two years despite continuing deflationary pressures. The government expects the debt ratio to decline from 132.4 percent of GDP in 2015, and an only slightly higher level in 2016, to around 132 percent this year (net of banking system support) and 123.5 percent by 2020.
• Since 2012, Italy’s budget balance has fulfilled the deficit rule thanks to persistent primary surpluses and declining interest payments. It fell from 3.0 percent in 2014 to 2.6 percent in 2015 and 2.4 percent or less in 2016. Including the effects of forthcoming budget adjustments, the deficit is projected to drop to 2.1 percent of GDP this year.
• The forthcoming 2017 Stability Program will chart a path towards budget balance for the next three years according to which by 2018 the debt-reduction rule would be satisfied on a forward-looking basis. The projected decline in the debt ratio is predicated on higher nominal GDP growth, larger primary surpluses, significant privatisation revenues and lower interest payments.
• This report discusses the relevant factors that in the opinion of the government should be considered when assessing Italy’s compliance with the Stability and Growth Pact. The first is the persistence of deflationary pressures. Italy’s inflation rate averaged -0.1 percent in 2016, and only turned slightly positive in the final months of the year. Core inflation fell to a historical low of 0.5 percent. Consistent with virtual price stability, nominal GDP growth has been weak, hindering a significant reduction in the public debt ratio. The decline in bond yields supported debt stabilisation, but Italy’s implicit interest cost declined only gradually due to a high financial duration of public debt.
• Looking forward, worldwide excess capacity and strong competitive pressures are still bearing down on prices. Oil and commodity prices have recovered some ground, but euro area growth remains low by historical standards, the impact of euro exchange rate depreciation is tapering off, and protectionist risks for European exports are looming. On balance, nominal growth seems likely to remain low in the short to medium term. Given this outlook, the government judged it appropriate to aim for gradual deficit reduction in 2017 while targeting faster consolidation in 2018-2020.
• The second key factor is that Italy’s output gap is grossly underestimated. Despite a sharp output loss compared to 2008, an unemployment rate of 11.6 percent and virtual stability in wages and prices, the Commission estimates that Italy’s output gap will shrink to a mere 0.8 percentage points of GDP in 2017 and zero in 2018.
• This report presents alternative output gap estimates based on the ‘commonly agreed methodology, which suggest the gap remains close to 3 percent in 2017 and, crucially, will close more gradually than suggested by the Commission over the coming years.
• Thirdly, Italy’s reform effort continues. The effect of recent reforms is estimated at 2.2 percentage points of GDP by 2020, 3.4 points by 2025 and 8.2 in the long run.
• Other highly relevant factors include Italy’s track record of fiscal discipline and the budgetary impact of the ongoing immigration wave and of the recent earthquakes.