We've seen our fair share of downgrades and downgrade warnings in the past couple of months, but something tells me another could be waiting just around the corner. I've got four good reasons why Italy could be next to get its rating cut.1. The European Union (NYSEARCA:EU) can't get its act together.
So far EU finance ministers have been settling for band-aid solutions, rather than implement permanent structural reforms to address the sovereign debt crisis. Heck, they haven't even figured out how they're gonna save Greece yet!
Some want the private sector involved in the debt restructuring while others believe that any form of restructuring would put the stability of the entire euro zone at risk. I say the longer it takes for these bigwigs to come to an agreement, the more they risk spreading debt contagion in the euro zone... and that puts Italy's credit rating at risk!2. Italy can't stick to its plans.
Of course, we can't just put the blame on the EU. Italy definitely had a hand in putting its own credit rating at risk. It hasn't exactly been sticking to the budget-cutting plans it laid out in April. If you recall, it was only a couple months ago that the government approved the Document on the Economy and Finance (NYSEARCA:DEF), which detailed a plan to balance Italy's budget by 2014. So far, it's already waaaaaaay behind schedule.
The Prime Minister says budget cuts in 2011 will probably hit 3 billion EUR, which is just a fifth of the figure originally planned. The government has also decided to push back the bulk of the budget cuts, with 5 billion EUR worth due in 2012, and the rest of the 22 billion EUR due in 2013 and 2014.
I don't know about you, but seeing Italy deviate from its plans so early into the program, I take this as a sign that it may not be able to pull off its budget-balancing goals in the long run.3. Its plans may not even be enough.
The economy, according to the most recent GDP report, looks as though it has stunted its growth. In the previous quarter, Italy posted a very small 0.1% growth, which is dangerously close to the negative territory. And this ain't no fluke either. Italy hasn't posted quarter-on-quarter growth above 0.5% since late 2009!
The country's current account balance also tells the same story. The country's export industry has actually been declining over the past ten years, which is quite a big deal since its neighboring nations like Germany, Spain, and Portugal have been posting improvements. Italy's current account balance currently stands at a 59.25 billion USD deficit, completely the opposite of the 8.21 billion USD surplus seen a decade ago.
And most importantly, inflation refuses to tame. One thing you should note is that the DEF and the government's budget cuts were based on the assumption that the inflation rate would decline. Unfortunately, this hasn't been the case.
The euro zone's overall inflation rate has actually been dancing above the target of the European Central Bank (ECB), which could lead to interest rate hikes. If interest rate hikes do occur, then Italy will have an even harder time repaying its debts.4. The government is divided on tax policies.
At the end of 2011, Prime Minister Berlusconi was able to maintain his position in Italy's lower house of parliament. However, his re-election was far from a landslide victory. A close look at the figures will reveal that he was only ahead by 3 votes.
This implies that there is a huge division in the government. In fact, right now, there is a huge division in the government with regard to its tax policy.
On one hand, Minister of Economy Tremonti believes that taxes should be raised to help the government fulfill its debt obligations. On the other hand, the Freedom party thinks that the government should focus on growth, and actually lower taxes to develop southern Italy more.
With the government divided on an issue that has a huge effect on government budget, it makes it even more difficult for Italy to bridge the gap between its income and expenses.Effect on the Euro
If Italy's credit rating does get downgraded, the effect on the euro will probably be much, much bigger than anything we've seen so far. Italy is the euro zone's third largest economy, and because of this, a credit downgrade could result in a significant decline in investor confidence and bring risk aversion and debt contagion concerns to new heights.
Should Italy's debt rating get cut, it might not be long before the markets bid the euro farewell and sell it off... again.