The S&P Downgrade of Italy and the Real Elephant in the Piazza

By Doug Short

Standard & Poor's downgrade yesterday of Italy's long- and short-term sovereign credit ratings came as no surprise to anyone who follows the Italian stock market.

Italy's benchmark equity index, the FTSE MIB (Milano Italia Borsa) dropped 3.17% yesterday. Today recovered some of that loss with a gain of 1.91% in the wake of the downgrade. However, a longer-term look at the MIB illustrates its exceptionally poor performance since its peak in May 2007. At its March 2009 low, the index had declined 71.6% from its peak. At today's close the index is still down 67.6% from its all-time high and 41.2% off its interim high set less than eight months after the 2009 low.

As for the S&P downgrade, the company uses five main factors in determining its sovereign ratings:

1. Political: The ability of government and policy makers to deliver sustainable public finances, economic growth, and responding to shocks.
   
2. Economic: A combination of income levels, growth prospects, and economic diversity and volatility.
   
3. External: The ability to generate receipts from abroad to meet its obligations to nonresidents.
   
4. Fiscal: The sustainability of a sovereign's deficits and debt burden.
   
5. Monetary: The ability to support sustainable economic growth, deal with shocks, and thus support sovereign creditworthiness.

In its published explanation, dated the day of the downgrade, S&P identified the political and fiscal (specifically fiscal debt) factors as the primary drivers for their decision. The scores relating to economic, external, and monetary factors did not contribute to the downgrade.

Standard & Poor's ratings method focuses on dynamics that can be altered by significant changes in business and political cycles. In the case of Italy, however, there is a demographic elephant in the room that will probably become the major determinant in the long-term ability of the country to improve its sovereign stature.

The chart below is based on international data from the U.S. Census Bureau. It differs from the standard pyramids on the Bureau's website in that I've constructed it to show the percent of population by age group and gender.

Italy has an astonishing demographic bulge in the 35-49 age brackets. This is an age group that is commonly associated with the early peak earning years in developed economies. If Italy's sovereign responsibilities can be hitched to this demographic elephant and the political and economic leadership can drive it in the correct direction, Italy can eventually get its economic act together.

If, on the other hand, the Italian government and other policy makers are unable to harness this population bulge in its prime, it will eventually become an economic drag of, well, elephantine proportions — one that will burden the country for generations to come.

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