Italy's social security reform efforts indicate significant progress toward alleviating risks to the long-term sustainability of public finances due to population aging. Yet, we expect that the country's budgetary outlook will remain challenged, given the modest near-term economic growth outlook and the absence of a resolute reduction in the budget deficit and government debt.
S&P Global Ratings' analysis of Italy is part of a global study conducted to analyze the cost of aging. We presented our findings in "Global Aging 2016: 58 Shades Of Gray," published April 28, 2016, on RatingsDirect. The study explores various scenarios--including a no-policy-change scenario--and the implications that we currently believe these different scenarios could have on sovereign ratings over the next several decades. We included an additional eight sovereigns in this year's report, which expanded the scope of the study's coverage to a total of 58 sovereigns, representing 70% of the world's population. For the 50 sovereigns that we included in the previous edition of our Global Aging series, our findings this year provide an update of our analyses--including information on long-term demographic, macroeconomic, and budgetary trends, all in the context of the countries' current fiscal positions.
A Demographic Shift Is In Progress…
According to Eurostat population projections, the old-age dependency ratio in Italy will rise to 52.9% in 2050 from 32.8% in 2015 (see table below; the old-age dependency ratio is the number of people 65 and older divided by the number of those 15 to 64). Even now, Italy has one of the highest old-age dependency ratios in our sample, second only to Japan (43.3% in 2015) and just ahead of Germany (31.8%) and Greece (31.2%). Overall, we project that the total population will grow over the coming decades, but that growth will slow down in the early 2040s, reaching 67 million in 2050. We forecast that the share of working age population in total population will fall to 56.5% by 2050 from the current 64.8%.
…But With A Smaller Budgetary Impact Than In The Rest Of Europe
In our view, an aging population is likely to place substantial pressure on Italy's economic growth and public finances.
Demand for publicly provided health care and long-term care services and public pensions will likely increase. Without further government reforms (not our base-case scenario), the EU Aging Working Group projects that total age-related public expenditures in Italy will increase from the current level of 24.4% of GDP to 25.2% in 2040, before declining to 24.7% of GDP in 2050. This overall increase of 0.3% of GDP over the period is less than the projected 3.7-percentage-point increase for the median of our 58-sovereign sample. As already indicated in our previous aging report, advanced sovereigns have already taken action on pension reforms and health care systems aimed at improving financial sustainability. We think that, as is currently the case, the bulk of Italy's age-related spending will go toward pension outlays, followed by health care, representing 14.8% and 6.8% of GDP, respectively, by 2050. However, contrary to the dynamics in pension spending, which we see declining toward the end of the projection period, we expect health-care expenditures to increase at a gradual but moderate pace throughout the period.
These dynamics suggest a gradual deterioration in Italy's budgetary position in the long term. If unmanaged, the weight of general government spending--including social security--could rise as age-related spending increases, coupled with a rising interest bill as deficits and debt mount. Our analysis suggests that, without further fiscal or structural policy reforms, Italy's net debt could rise to 138% of GDP by 2050, slightly higher than the sample median, which stands at 134% of GDP. Nevertheless, the respective projected increases in Italy and the 58-country median, indicate that future budgetary challenges emanating from population aging in Italy appear comparatively much less pronounced than for the average sovereign included in our analysis.
Such macroeconomic and fiscal dynamics would, over the long term, imply a possible change to the current 'BBB-' long-term foreign currency sovereign rating on Italy. Based on the fiscal projections of our study, we derived hypothetical sovereign credit ratings for Italy (see table). In practice, S&P Global Ratings takes a large number of factors into consideration when determining sovereign credit ratings (see "Sovereign Rating Methodology" published Dec. 23, 2014). In the very long term, however, prolonged fiscal imbalances and wealth (as measured by GDP per capita) tend to become the dominant factors. Using this approach, our 'BBB-' rating on Republic of Italy could show a tentative improvement around 2020, but the budgetary impact of the demographic shift would burden the ratings trajectory. As a result, by 2025, according to our simulation, Italy's fiscal indicators would be in line with the hypothetical 'bbb' category.
Budgetary Consolidation And Structural Reforms Should Yield Further Benefits
The base-case scenario is not a prediction. Rather, it is a simulation that highlights the importance of age-related spending trends as a factor in the evolution of sovereign creditworthiness. In our view, it is unlikely that governments would, as a general matter, allow debt and deficit burdens to grow unrestrainedly or that creditors would be willing to subscribe to such high levels of debt. In fact, as we have observed about many sovereigns in our 2016 Global Aging report, governments are able to confront the prospects of unsustainably rising debt burdens by implementing budgetary consolidation or reforms of their social security systems.
As such, we believe that Italy will continue introducing policies to further contain the future budgetary impact of population aging. In addition to our no-policy-change scenario, we have considered several other long-term scenarios. Two of these scenarios involve Italy undertaking radical structural reforms in its social security system and freezing all age-related spending at the current level (as a percentage of GDP) or balancing the budget by 2019. Under each scenario, fiscal indicators in Italy appear to hold up better if the government were to undertake structural reforms to prevent age-related spending from rising or move to consolidate its budget for a sustained period.
Encouraging Progress, But Important Tasks Lie Ahead
Italy's consecutive pension reforms since 2004 have been significantly improving prospects for the long-term sustainability of its pension system and we view the government's policy response as oriented toward the right direction. This area is particularly important as Italy's total public pension spending as a share of GDP is among the highest in the world.
The most recent pension reform, in 2011, extended the notional defined contribution system to all workers as of 2012.
The reforms also introduced the sustainability factor into calculation of pension benefits. As a consequence, since 2013, all pension eligibility conditions are indexed to changes in life expectancy with reference to the three previous years on a regular three-year review until 2019. After 2019, the adjustment of the retirement requirements to changes in life expectancy will occur every two years. As a result of the overall reform process inaugurated in 2004, the effective average age at retirement is set to rise from 60-61 during the 2006-2010 period to approximately 64 years in 2020, 67 in 2040 and 68 in 2050 (according to the Stability Programme Update, 2016) Overall, the abovementioned reform effort includes reductions in income replacement rates and tightened eligibility rules, which should lead to substantial savings over time. However, concerns have now shifted to pension adequacy, since reduced pension benefits (introduced to control public spending) could result in poverty among elderly populations. The government has addressed this concern in the 2017 budget, which includes increases in pension benefits for low-income retirees.
As a part of the strategy to rapidly contain government spending since 2010, the government has implemented a number of measures in the health-care sector. These include containment of the trend of the various components of healthcare expenditure, such as spending on pharmaceuticals, outlays for services regarding tenders and supplies of goods and services, and the modification of spending limits for the purchase of medical devices. Moreover, the central government and regions negotiated an agreement on health-care spending that includes a modification in their respective contributions as well as introduction of restructuring and deficit-reduction plans for those hospitals that have significant financial imbalances--including university hospitals, public institutions for hospitalization and health, and other entities that provide hospital and health services.
However, while we expect the ongoing changes in the social security system will improve the long-term sustainability prospects for public finances, the near-term budgetary outlook is clouded by a number of impediments to economic growth, among other things. Although currently in a recovery mode and with the job market on the mend, Italy has suffered a significant decline in employment in the recent past, which has strained social safety nets faster than policymakers expected some years ago. The situation is at times further aggravated by increasing emigration of young
citizens in search of work or better jobs. Such dynamics can amplify demographic shifts, raise a country's old-age dependency ratio, and increase the burden on the remaining taxpayers who fund social security systems. And that's without considering what the outflow of human capital means for future GDP growth.
In this context, further improvements in Italy's labor market, together with rising labor participation (which is currently among the lowest in the EU), will be key not only to support the economic recovery in the near term, but also to mitigate the negative budgetary consequences of population aging.