Public investment is on the move again in Italy and Spain. This follows a steep decline in spending after the global financial and eurozone debt crises led to significant budgetary adjustments in both countries. EU RRF funds should boost public investment for both over the medium term. If spent effectively this should boost their economic growth prospects.

Public investment in both countries still lags the eurozone average.  Spain's public investment stabilized at just under 3.0% of GDP in 2022, slightly below the eurozone average of 3.4%. It had more than halved in 2009-2017 from 5.2% in 2009. Likewise, Italy's public investment fell to 2.1% of GDP in 2018 after averaging more than 3.2% annually before the global financial crisis. In 2022, Italy's public investment reached 2.7% of GDP, still below the eurozone average. We note that Italy's public investment is regularly more than one third below the eurozone average.

RRF grants differ from the traditional European Structural and Investment Funds (ESIF) that constitute the bulk of EU spending.  One striking contrast is that the RRF requires no cofinancing from national budgets. So governments facing pressure to improve their underlying fiscal position--Italy for instance--need not set aside financial resources to absorb the RRF grants. The funds are fiscally neutral.

Both countries have experienced significant delays in absorbing RRF funds and carrying out planned investments.  We estimate Spain and Italy have executed €7.7 billion out of €77.2 billion and €15.1 billion out of €69.0 billion, respectively, as of end-2022. Reduced administrative capacity following protracted budgetary adjustments has contributed to the delays, as have administrative complexities that include new processes to manage the funds. Anti-corruption oversight and EU state aid rules have further weighed on spending schedules. Recent high inflation has also been a contributing factor.

We expect absorption rates to increase as bottlenecks are gradually resolved.  That said, the lack of spending so far compared to the initial schedule signals that the 2026 deadline for full deployment is at risk. Unless Spain and Italy--as well as other major RRF beneficiaries--can hasten their RRF fund deployment over the next 12 months, their governments will likely call for a deadline extension.

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We do not take a negative view of Spain and Italy's under-execution.  RRF-funded projects tend to be long-term and challenging with ambitious digitalization, energy-independence, or social cohesion targets. Delays are also occurring in other member states such as Portugal and Greece, which are among the largest beneficiaries as a share of their GDP. Even if they have historically achieved higher ESIF absorption, their RRF execution is not higher than that of Italy or Spain (charts 1 and 2). We expect the EU will be flexible when it comes to a deadline extension as long as countries fall in line with its exacting approach to the qualitative aspects of the projects.

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Regional Governments And Public Spending

In Spain and Italy, a large portion of public investment is in the hands of regional governments. On average they are responsible for about 60% of total capital expenditure (capex). After recent crises, budgetary tightening and related austerity measures meant these governments were faced with dwindling revenues. In both countries, public investment typically bears the brunt of spending cuts. About 40% of Spanish regions' budgets are spent on health care and education. As public services, both are difficult to cut--and doing so has adverse political implications. Italian regional budgets, especially normal status, are even more rigid given that health care alone represents around 70%-80% of regional operating spending.

During 2008-2016, Spanish regions cut capex by 61%. This allowed them to significantly reduce the overall budget deficit from 5.2% of GDP in 2011 to 0.9% in 2016, with a corresponding reduction in the general government deficit. Similarly, during 2011-2018 Italy's central government applied increasing budgetary restraints, including deficit limits, to local and regional governments (LRGs). This in turn hurt public investment, which declined by 56% between 2009 and 2017.

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RRF Funds Should Help Governments Tackle Structural Weaknesses

The facility aims to help members' economic competitiveness via six main pillars, emphasizing climate objectives, the digital transition, and building economic resilience.  It offers a total of €338.0 billion in grants and up to €385.8 billion in loans to EU members. EU countries do not have to wait for RRF disbursements to start executing projects in line with their fiscal recovery plans. Indeed, most sovereigns have been prefinancing transfers that will be subsequently covered by future RRF grant disbursements.

Disbursements are performance-based in that they are linked to the completion of national structural reform milestones and targets.  We view this positively because it encourages governments to tackle key weaknesses that recent crises have exacerbated. Improved business environments, labor markets, and education, among others, will help members achieve the economic growth needed to reduce currently large budget deficits and government debt back to at least pre-pandemic levels. Governments might shy away from implementing unpopular economic measures but, in our view, if the reforms required under the RFF are fully implemented they could boost EU economic growth in the next few years.

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Spain and Italy are the largest RRF beneficiaries in absolute terms as they will together receive 43% of the grants and loans.  Spain stands to receive €77.2 billion and Italy €69.0 billion if they meet all related reform milestones and targets. These amounts include additional grants to both. This follows a reallocation based on their worse-than-expected economic contractions in 2020. They have also applied for loans. Italy's central government applied for €122.6 billion in 2021; the central government has contracted this loan directly, and will then transfer the funds in the form of grants to its LRGs. More recently Spain did the same, for €84.8 billion, on June 6, 2023. The Spanish government announced its intention to allocate €20 billion of the requested loan to its regions, to be managed by the European Investment Bank. Spain's Ministry of Finance is yet to announced further details.

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The funding does not stop with the RRF.  Both countries will also continue to receive ESIFs under the EU's 2021-2027 multiannual financial framework. Italy will get about €42.0 billion and Spain about €35.5 billion. Government cofinancing will bring Italy's total to €74 billion and Spain's to almost €53 billion. And after recent energy market disruptions the EU has also set up a €20 billion plan (RePower EU) to improve energy efficiency, accelerate the clean energy transition, and diversify energy supplies. Spain and Italy have been granted €2.6 billion and €2.7 billion, respectively, which we expect the central governments will manage.

The RRF allows some flexibility as to how reform plans are implemented.  Funds can be centralized or channelled to other levels of government or via other financial vehicles. In Spain about 54% of RRF grants will be managed by the regions, while the rest will be managed by the central government through strategic projects (PERTE). These can include collaborations between the public administrations and private enterprises.

Italy will channel approximately one third of RRF grants and loans (about €70 billion) through its LRGs.  While the central government assigns funds directly to the regions, it manages their allocation through public tenders. Central government ministries launch tenders for various missions that the LRGs then apply for. For example, funds for the construction of nurseries have been managed in this way. Funds have also been assigned directly to some large public sector companies. Rete Ferroviaria Italiana has received €24 billion to build, among others, high-speed lines in northern Italy connecting with the rest of Europe and to upgrade railways for passengers and freight in southern Italy.

Grants Should Return LRGs' Spending Almost To Historical Highs

By the end of 2024 Spain should have received about 80% of its planned grants. We estimate it will receive about €17 billion in 2023 and €24 billion in 2024, including from RePower EU. Funds will be subject to Spain meeting all targets and milestones set by the European Commission.

We estimate the Spanish regions will have received all €41.6 billion in transfers from the state by end-2026. Catalonia, Andalusia, and Madrid will end up receiving the most given their larger populations. According to national statistics, at end-2022 the regions had received €20.6 billion, half the estimated total.

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We estimate Italian LRGs will receive around €70 billion in grants and loans, approximately one third of the total funds available. Up to February 2023, the central government had assigned €61.4 billion to the regional territories. The southern regions, from Molise to Campania, get the highest share as a percentage of GDP per capita. This is because 40% of RRF funds are earmarked for southern Italy to address the EU's objective of reducing territorial disparities (chart 7).

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RRF transfers have elevated Spanish and Italian LRGs' incoming funds earmarked for capex to all-time highs.  Spanish regional capital revenues were 189% higher in 2022 than in 2019. LRGs are therefore being challenged to absorb in some cases triple their average yearly volume of capital revenues. We estimate Spanish LRGs' regional capex will peak in 2023, after troughing in 2021-2022, and remain elevated through 2024-2026. Italian LRGs' capital revenues will likely peak in 2024, while public investment should accelerate in 2024-2025 with limited mismatches between revenues and expenditures.

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Several factors explain the significant lags in RRF grant execution.  Delays in implementation reflect reduced administrative capacities and complex administrative burdens such as a new process to manage public funds. Anti-corruption oversight, state aid rules, and recent high inflation have also slowed things down. In Spain, for example, RFF-funded spending stood at 0.6% of GDP (€5.3 billion; European Commission data) in 2021-2022 versus the government's initial plan of 3.7% of GDP over the two years.

We estimate that Spanish LRGs have executed on average only about 18% of grants received up to the end of 2022. For Italy we estimate LRGs have executed around 30%, but they accrued fewer funds in 2022 compared to their Spanish counterparts.

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The variety of EU funds--with their different operating mechanisms and accounting and program requirements--has added to execution lags.  The beginning of the RRF coincided with the end of the EU's 2014-2020 multiannual ESIF framework, which allows regions to certify expenses up to the end of 2023, after which the disbursements are made. In 2021, LRGs also received transfers from React-EU (under NextGenerationEU), which was set up to cover operating expenditures emanating from the pandemic. LRGs can still certify expenditures from as far back as 2020.

Spanish and Italian LRGs have had to adapt to important differences in the way RRF funds work, which has weighed on administrative capacity.  Notably, RRF grants--unlike ESIF and React-EU funds--are received before project execution and before related expenses are undertaken. Some LRGs have brought in new personnel to build expertise and capacity, while others have passed laws to facilitate internal bureaucracy. Supply-chain bottlenecks in the industrial sector and, more recently, high inflation, have also dragged on the planned execution of investments. In several cases by the time public tenders were announced, high inflation and uncertainty as to how long it would last, as well as tighter financial conditions, had eroded the interest of potential bidders.

Given the required build up in administrative capacity, we expect project execution will pick up in 2023 and remain high through to 2026. We also understand that if an LRG does not have sufficient capacity to absorb the funds, the central government might decide to reallocate them elsewhere. This, however, could be difficult to implement in practice. LRGs are likely to resist funds being taken away once granted.

The low execution of large RRF transfers has temporarily improved Spanish regions' liquidity and capital accounts balances, but the effect has been muted in Italy.  Italy's central government grants RRF funds to LRGs via advance payments linked to intermediate targets. Cash accumulation at the LRG level related to RRF funds is therefore limited and has little effect on LRGs' liquidity profiles. There is some mismatch between revenues accrued by LRGs and the execution of investments, but its much smaller than in Spain. We estimate that by end-2022 Italian LRGs accrued, as expenses, less than 7% of the RRF funds they will receive--or less than €5 billion out of €70 billion (grants and loans combined). This is lower than the corresponding capital transfers accrued. Payment rates are even lower. We estimate LRGs received around €2 billion of advance payments from the central government as of February 2023. This reflects very slow execution as advances only follow the completion of project targets. We foresee RRF-linked investments peaking in 2024 and 2025 in Italy, with total EU-funded investments representing 136% of investments executed in 2017, which will be challenging for LRGs to absorb.

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The regional tier's cash position has almost doubled compared to 2019. According to recent data from the Spanish central bank, total regional deposits stood at €28 billion at the end of March 2023, up from about €15 billion in 2019. We expect this large cash buffer to decline in the coming years once the Spanish regions accelerate the execution of investments.

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We have also seen a significant improvement in Spanish regions' net capital accounts (the difference between capital revenues and capital expenditures) in 2021 and 2022, and, as a result, in their balances after capital accounts. By end-2023 the regions will have received almost all their allocated EU funds, while the execution of the funds will accelerate. This will reverse their capital accounts and balances after capital accounts performance, albeit temporarily. Under official accounting methods (used by central governments and the European Commission) the effects from RRF grants are adjusted on a yearly basis and are not computed for fiscal target purposes.

In Italy, the net capital account improves slightly in 2022 and 2023 because of the low execution of RRF funds accrued. However, the difference in 2024-2026 is less pronounced because revenues are distributed across the period. In our analysis, we assess the budgetary performance of LRGs over a five-year period, which dilutes this mismatch effect. As a result, RRF-related inflows and spending will, in our view, not affect the creditworthiness of Spanish and Italian LRGs.

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Additional funds from the RFF will not affect Italian LRGs' debt evolution, but Spanish regions could be impacted.  This is because the central government transfers RRF loans to LRGs as grants. For Spanish regions, additional RRF funds could come in the form of loans given that the central government has assigned (but not transferred) €20 billion of the portion of loans to the regions. However, it remains unclear as to whether these additional funds will end up in the hands of the regions as ultimate obligors or if this liability will be on-lent. Whatever the case, we expect additional funds would increase LRGs' capital investments while the debt impact would be limited to €20 billion--if they were to use the full amount and bear the risk on their accounts.