Italy’s Strategic Turn as a Model for Credible Fiscal Policy and Its Implications for Sovereign Debt Markets

Italy’s fiscal reforms over the past two years have positioned it as a pivotal case study in Southern Europe’s broader shift toward credible fiscal policy. Despite a public debt-to-GDP ratio of 136.9% in 2025—a figure that remains among the highest in the eurozone—the country has achieved a primary surplus and reduced its budget deficit to 2.9% of GDP, outperforming initial projections [1]. This fiscal consolidation, driven by higher-than-expected tax revenues and the phase-out of costly housing tax credits, has been instrumental in stabilizing market confidence. The National Recovery and Resilience Plan (NRRP), with its focus on digital and green transitions, has further underpinned growth in non-residential construction and productivity [2].

The Italian government’s balancing act—prioritizing national security spending under the “ReArm Europe Plan” while adhering to EU fiscal rules—has introduced new complexities. For instance, the allocation of €20 billion annually for defense and green investments has pushed the debt-to-GDP ratio higher, yet bond markets have absorbed the increased issuance without significant panic. As of August 2025, Italy’s 10-year bond yield stands at 3.58%, a modest increase from 3.50% in July but still lower than the 4.20% peak seen in early 2024 [3]. This resilience contrasts with the 2010–2012 eurozone crisis, when spreads between Italian and German bonds often exceeded 400 basis points.

Southern Europe as a whole has seen a re-rating of sovereign debt risk. Spain and Portugal, which implemented targeted tax reforms (e.g., reduced corporate rates for SMEs, windfall taxes on food distribution), now trade at 10-year yields of 3.33% and 3.17%, respectively [4]. These narrowing spreads reflect improved fiscal discipline, structural reforms, and the European Central Bank’s (ECB) Transmission Protection Instrument (TPI), which has acted as a backstop against fragmentation risks [5]. Investors are increasingly viewing the region as a haven for yield, with fixed-income fund managers overweight in Italian, Spanish, and even Greek bonds [5].

However, challenges persist. Italy’s debt trajectory remains precarious, with the ratio projected to rise to 138.2% by 2026 despite a shrinking deficit [1]. Structural issues—low productivity growth, an aging population, and bureaucratic inefficiencies—threaten long-term sustainability. The recent EU Court of Justice ruling against Italy’s “safe country of origin” designation for asylum seekers also underscores the political and legal risks that could indirectly impact economic stability [6].

For investors, the key takeaway is that Italy’s fiscal reforms have created a template for managing high debt while maintaining market access. The success of this model hinges on continued structural reforms, adherence to EU fiscal rules, and the ECB’s willingness to support liquidity. Southern Europe’s bond market renaissance is not a return to complacency but a recalibration of risk in a post-crisis era where policy credibility and institutional backstops matter more than ever.

Source:
[1] IMF Executive Board Concludes 2025 Article IV Consultation with Italy [https://www.imf.org/en/News/Articles/2025/07/21/pr-25258-italy-imf-executive-board-concludes-2025-article-iv-consultation]
[2] Economic forecast for Italy - Economy and Finance [https://economy-finance.ec.europa.eu/economic-surveillance-eu-economies/italy/economic-forecast-italy_en]
[3] Rates & Bonds [https://www.bloomberg.com/markets/rates-bonds]
[4] Southern Europe's Bond Market Renaissance: Narrowing ... [https://www.ainvest.com/news/southern-europe-bond-market-renaissance-narrowing-spreads-signal-opportunities-2506/]
[5] Why European Bond Fund Managers Now Back Italy ... [https://global.morningstar.com/en-gb/bonds/why-bond-fund-managers-now-back-italy-greece-spain]
[6] The Court of Justice of the EU puts the breaks on the externalisation in Albania of asylum procedures by imposing a judicial control on the 'safe' state of origin designation: the C-758/24 and C-759/24 judgment (1 August 2025) [https://unipd-centrodirittiumani.it/en/topics/the-court-of-justice-of-the-eu-puts-the-breaks-on-the-externalisation-in-albania-of-asylum-procedures-by-imposing-a-judicial-control-on-the-safe-state-of-origin-designation-the-c-75824-and-c-75924-judgment-1-august-2025]