DBRS Confirms Italy at BBB (high), Stable Trend

DBRS Ratings Limited (DBRS) confirmed the Republic of Italy’s Long-Term Foreign and Local Currency – Issuer Ratings at BBB (high) and Short-Term Foreign and Local Currency – Issuer Ratings at R-1 (low). The trend remains Stable on all ratings.

KEY RATING CONSIDERATIONS

The country’s BBB (high) ratings are underpinned by its large and diversified economy, even as political uncertainty remains elevated. Italy is the second-largest manufacturing economy in Europe. Since 2011, its current account position has improved significantly with a current surplus of 2.7% of GDP and its net international investment position (NIIP) is close to being balanced. Private sector debt is one of the lowest among advanced countries, which mitigates risks to financial stability. Moreover, despite a very high public debt-to-GDP ratio, which is estimated at 131.7% in 2018, the implicit interest cost of public debt at 2.8% remains close to its lowest level in around three decades.

The confirmation of the Stable trend reflects the combination of two factors. Firstly, the Italian government, by revising its fiscal targets to a more conservative level, has avoided the launch of a procedure by the European Commission (EC) for non-compliance with the debt criterion. This outcome has shored up investor confidence and lowered, albeit moderately, its sovereign interest cost. Secondly, although domestic banks continue to deal with the consequences of elevated sovereign yields and still weak credit growth, they are making progress in reducing their non-performing-loans (NPLs), which is further improving the banking system’s balance sheet credit quality. Against this background, DBRS’s main concern lies in the lack of government focus on structural issues amid slowing economic growth and a fiscal outlook that will become more challenging in 2020. In DBRS’ view, the next months will be critical in assessing whether the government agenda will shift from the radical electoral promises to a more conservative programme, including fiscal spending review and measures to boost job creation and investment. That said, the possibility of a government reshuffle or early snap election remains elevated. While this increases near term uncertainty, it may pave the way for a new government with a more moderate agenda.

RATING DRIVERS

Upward pressure on the ratings could emerge, if (1) successful reform efforts that support medium-term growth prospects occur or (2) fiscal consolidation significantly improves the trajectory of the government debt-to-GDP ratio. One or any combination of the following factors would likely lead to downward pressure on the ratings: (1) a significant downward revision to growth prospects leading to a materially higher trend for the public debt-to-GDP ratio; (2) further fiscal relaxation combined with substantial higher interest costs that put significant upward pressure on the public debt-to-GDP ratio (3) no evidence over time of a renewal of meaningful growth-enhancing reforms to support growth.

RATING RATIONALE

Government Budget Maintained Conservative Deficit Targets, But its Fiscal Outlook is Challenging

Italy’s credit profile is supported by a persistent government budget primary surplus and a still historically low sovereign interest cost. Except for 2009, the primary fiscal balance has been in surplus since 1992, and at 1.5% of GDP on average since 2014, compares favourably with most other euro area countries. Despite a recent increase in sovereign yields, the implicit interest cost remains at 2.8% - one of the lowest levels over the last 30 years.

However, the Italian government intends to deviate from the previous path of fiscal consolidation by implementing an increase in current expenditures with the goal of boosting GDP growth. Reflecting electoral campaign promises, the new strategy is mainly based on redistributing resources, by strengthening the poverty mechanism (citizenship income) linking it partially to active labour market policies and easing the early retirement requirements for three years.

These measures would have implied a significant rise in the fiscal deficit. However, as expected, lengthy and complex negotiations between the Italian government and the EC, resulted in a more conservative fiscal trajectory because of higher taxes; a delay in the measures’ implementation; and a lower revaluation of medium-high income pensions. The parliament passed a revised 2019 Budget Law after an adjustment of around EUR 10.3 billion compared with the draft Budgetary Plan presented in November 2018. Italian authorities now project a budget deficit of around 2.0% of GDP in 2019, slightly higher than the estimated 1.9% of GDP of last year, that will also include a frozen expenditure amount of EUR 2 billion as guarantee in case of a deterioration in the fiscal outturns. In addition, the 2019 structural deficit target has been revised to 1.3% of GDP, which points to a moderate deterioration of 0.2 percentage points compared with the 2018 estimated level.

Looking forward, Italy’s fiscal outlook remains very challenging. This is because of a total cumulative EUR 52 billion of indirect tax increases for 2020-21, already legislated to compensate for increased fiscal spending. The government intends to deactivate VAT increases to avoid the recessive impact. As a result, significant compensatory measures are needed to achieve fiscal targets set at 1.8% of GDP in 2020 and 1.5% in 2021. In this context, should economic growth slow more than expected, the government would have less fiscal room to implement countercyclical policies.

Public Debt-to-GDP Ratio Remains Elevated but Implicit Interest Costs are Still Historically Low

Since 2014, Italy’s public debt ratio has broadly stabilised, but at 131.7% of GDP estimated for 2018, it remains very high and exposes the country to adverse shocks. According to the government, despite the downward revision in economic growth projections, the public-debt-to-GDP ratio will decline, albeit slowly to 128.2% in 2021. This improvement would be helped by an ambitious asset sale plan for 2019, along with the VAT increases in 2020 and 2021. However, according to the Italian fiscal watchdog, even if the government were to fully deactivate the legislated indirect tax increases through higher deficits, public debt will increase only slightly, provided that yields do not rise substantially, and nominal GDP growth does not worsen materially. The relatively long average maturity of securities (6.78 years as at December 2018) and the large share of total debt that is at fixed rate, help to limit the impact of shocks on yields. Moreover, despite the rise in the sovereign yield curve, the interest cost at 3.7% of GDP is expected to increase gradually over time.

Economic Growth Likely to Continue to Slow, but Further Improvement in the Banking System to Continue

A high degree of economic diversification coupled with a strong manufacturing sector, which is the second-largest in Europe, support the ratings. Strong export growth and the recovery in both investment and private consumption led the cyclical GDP growth recovery over the last few years. However, following the 1.6% GDP growth rate registered in 2017, economic growth has slowed down to 0.9% in 2018, according to the latest estimate from the Bank of Italy. This reflected the combination of a less supportive external environment in the first half of 2018 and lower business confidence likely related to the uncertainty over government policy in recent months, which weighed on business investment.

Looking forward, the benefits of the government agenda for economic growth could remain limited. Implementing redistributive policies when Italy’s performance is still weak might only partially boost economic growth. Structural problems including low productivity growth, a lengthy justice system, weak competitiveness in the service sector, low spending in R&D and an inefficient public administration continue to hamper Italy’s potential growth. On the other hand, DBRS views positively the government’s intention to streamline administrative procedures, as well as to revise the procurement code to speed up the implementation of public investments. Total resources allocated to investment are significant over the medium-term, but lengthy and bureaucratic processes continue to put a brake on spending. Against this background, downside risks to the economic outlook for 2019-20 have intensified and economic performance might be materially lower than the government projection of 1% of real GDP growth on average. Nevertheless, a more favourable external environment could be supportive to economic growth.

The banking system continues to make progress in reducing the stock of its NPLs. In Q2 2018, the total gross NPL ratio was 10%, down from around 16% in Q2 2017. Further reduction is expected going forward. However, the sector´s profitability remains modest, reflecting the low interest environment, high market competition, and the banks’ vulnerability to market volatility and rising sovereign spreads. Sovereign premia levels have moderated following the agreement between the Italian government and the EC, but remain still elevated at around 270bps. In DBRS’ view, a prolonged period of high spreads and market uncertainty could pose further challenges for the banks’ profitability and asset quality, particularly in the case of small and medium sized banks.

Latest developments at Banca Carige following the temporary administration imposed by the European Central Bank (ECB) are not expected to have a material impact on financial stability (<a href="https://www.dbrs.com/research/338102/impact-of-carige-developments-on-italian-banking-system-likely-to-be-contained" target="blank">Impact of Carige Developments on Italian Banking System Likely to be Contained</a>). The government has recently approved a decree to support the bank by offering a series of options including liquidity guarantees and the precautionary recapitalization, which is expected to have a very limited impact on the debt if activated (<a href="https://www.dbrs.com/research/338135/italian-government-actions-positive-for-carige-final-plans-still-to-be-finalised" target="blank">Italian Government Actions Positive for Carige; Final Plans still to be Finalised</a>). In addition, risks of financial instability remain contained also because of a non-financial private-sector debt of 112.1% of GDP as of Q2 2018, which is one of the lowest among advanced countries.

A Sound External Position Supports the Ratings, but Uncertainty over Trade Growth Remains

The improvement in Italy’s external position in recent years has been a positive factor for its rating. Since 2012, the current account has shifted into surplus and now hovers at around 2.7% of GDP - one of the highest levels since 1997. This improvement has contributed to the decline of the country’s NIIP, which is close to being balanced (-3.4% of GDP as of Q2 2018), following the peak of -24.6% of GDP registered in Q1 2014. Looking forward, although DBRS projects a gradually declining current account surplus, uncertainties over global trade growth as a result of protectionist policies, an economic slowdown in China, and a potential disorderly UK departure from the EU may weigh on Italy’s external trade performance. However, the improvement in its external position achieved so far makes the country less exposed to a potential external negative shock compared with past years.

Still Elevated Political Uncertainty Related to the Current Government’s Longevity and Policies

Political uncertainty remains a concern that has been exacerbated by recent events. After the inconclusive election in March 2018, the two leading populist parties Lega and the Five Star Movement agreed to form a government based on an initial radical agenda which reflected a strong popular mandate to implement a significant expansionary policy. But, the agenda has been subject to substantial moderation in recent months. However, a weak and unclear communication strategy, in particular during the first months of the legislature, generated investor concerns. A rise in sovereign interest costs followed, causing a worsening of banks’ capital positions and funding costs until a more moderate approach was adopted with the European authorities.

Also contributing to uncertainty are the frictions between the two coalition parties. One factor is the divergence in the polls. Lega’s sharp rise in the polls has been accompanied by a fall in the approval ratings of Five Star Movement. While the former now stands at around 32% compared with 17% obtained at the elections, the latter has fallen by about 5% in the polls to 27%. The current divergence of views on several policy matters does not bode well for government stability. DBRS does not rule out a government reshuffle or snap election. This could occur after the European elections. If Lega obtains large popular support, it might decide to lead a centre-right government. While adding to uncertainty in the near term, both options could pave the way for a government with a more moderate fiscal and pro-reform agenda.

RATING COMMITTEE SUMMARY

The DBRS Sovereign Scorecard generates a result in the A (high) – A (low) range. Additional considerations factoring in the Rating Committee decision included: (1) Italy's low potential growth, which hampers its ability to reduce the public debt-to-GDP ratio, and (2) remaining vulnerabilities in the banking system.

The main points discussed during the Rating Committee include Italy’s economic performance, fiscal position, vulnerabilities in the banking sector and the reform agenda.

KEY INDICATORS

Fiscal Balance (% GDP): -2.4 (2017); -1.9 (2018E); -2.0 (2019F)
Gross Debt (% GDP): 131.2 (2017); 131.7 (2018E); 130.7 (2019F)
Nominal GDP (EUR billions): 1,725 (2017); 1,761 (2018E); 1,801 (2019F)
GDP per capita (EUR thousands): 28,494 (2017); 29,192 (2018E); 29,925 (2019F)
Real GDP growth (%): 1.6 (2017); 0.9 (2018E); 1.0 (2019F)
Consumer Price Inflation (%, eop): 1.3 (2017); 1.3 (2018E); 1.4 (2019F)
Domestic credit (% GDP): 112.5 (2017); 112.1 (June-2018)
Current Account (% GDP): 2.8 (2017); 2.7 (2018E); 2.5 (2019F)
International Investment Position (% GDP): -5.3 (2017); -3.4 (June-2018)
Gross External Debt (% GDP): 122.3 (2017); 122.4 (June-2018)
Governance Indicator (percentile rank): 69.7 (2017)
Human Development Index: 0.88 (2017)

EURO AREA RISK CATEGORY: LOW

Notes:
All figures are in euros (EUR) unless otherwise noted. Public finance statistics reported on a general government basis unless specified. General Government balance and General Government debt are presented according to Maastricht definition. Governance indicator represents an average percentile rank (0-100) from Rule of Law, Voice and Accountability and Government Effectiveness indicators (all World Bank). Human Development Index (UNDP) ranges from 0-1, with 1 representing a very high level of human development.

The principal applicable methodology is Rating Sovereign Governments, which can be found on the DBRS website www.dbrs.com at http://www.dbrs.com/about/methodologies. The principal applicable rating policies are Commercial Paper and Short-Term Debt, and Short-Term and Long-Term Rating Relationships, which can be found on our website at http://www.dbrs.com/ratingPolicies/list/name/rating+scales.

The sources of information used for this rating include Ministero dell’Economia e delle Finanze, Banca d’Italia, ISTAT, European Commission, UPB, Eurostat, Poll of Polls, IMF, World Bank, UNDP, Haver Analytics. DBRS considers the information available to it for the purposes of providing this rating to be of satisfactory quality.

This is an unsolicited rating. This credit rating was not initiated at the request of the issuer.

This rating included participation by the rated entity or any related third party. DBRS had no access to relevant internal documents for the rated entity or a related third party.

DBRS does not audit the information it receives in connection with the rating process, and it does not and cannot independently verify that information in every instance.

Generally, the conditions that lead to the assignment of a Negative or Positive Trend are resolved within a twelve month period. DBRS’s outlooks and ratings are under regular surveillance.

For further information on DBRS historical default rates published by the European Securities and Markets Authority (“ESMA”) in a central repository, see:
http://cerep.esma.europa.eu/cerep-web/statistics/defaults.xhtml.

Ratings assigned by DBRS Ratings Limited are subject to EU and US regulations only.

Lead Analyst: Carlo Capuano, Vice President, Global Sovereign Ratings
Rating Committee Chair: Roger Lister, Managing Director, Chief Credit Officer, Financial Institutions and Sovereign Group
Initial Rating Date: 3 February 2011
Last Rating Date: 13 July 2018

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