DBRS Confirms Republic of 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). At the same time, DBRS confirmed the Republic of Italy’s Short-Term Foreign and Local Currency – Issuer Ratings at R-1 (low). The trend remains Stable on all ratings.

KEY RATING CONSIDERATIONS

The confirmation of the Stable trend reflects DBRS’s view that Italian banks’ progress with improving credit quality and the Italian government’s pledge to a more prudent fiscal strategy, mitigate risks for debt sustainability, despite the country’s high political uncertainty and lower-than-expected economic growth. A stagnating economy and a complex and unstable political equilibrium between two ruling parties, the Five Star Movement (M5S) and the Lega, competing to pursue ambitious spending plans have not prevented Italian authorities from committing to a more conservative fiscal target for 2019. DBRS positively views the combination of pledged lower expenditures and higher revenues which should result in a headline deficit of 2.0% of GDP compared with the previously expected 2.4%, this year. This has averted the opening of an excessive deficit procedure (EDP) by the European Union (EU) and, to some extent, restored investor confidence, contributing to a decline in sovereign yields.

The fiscal outlook from 2020 onwards remains challenging. However, in DBRS’s view, Italy’s track record gives some comfort that the government will avoid a significant deterioration in the fiscal deficit, reducing the likelihood of a material and prolonged deviation from the EU fiscal framework rules. The public debt-to-GDP ratio is expected to modestly rise in 2019 and 2020, largely because of fragile economic growth. A gradual increase in the nominal growth rate, moderate interest costs, because of a still-accommodative monetary policy, and Italy’s adherence to fiscal prudence, should shift worsening public debt dynamics toward stabilisation in the medium-term. In the current environment, although the risk of rolling back further structural reforms seems diminished a lack of political focus on the implementation of a growth-enhancing strategy could have long-term implications for Italy’s GDP potential growth. The government is unlikely to serve its full legislative term and snap elections could result in a new government with a more uniform and potentially pro-business agenda that could be more favourable for growth.

The country’s BBB (high) ratings are underpinned by the large and diversified economy, low private sector debt and sound external position. Italy is the second-largest manufacturing economy in Europe and benefits from a current account surplus of 2.7% of GDP and a net international investment position (NIIP) that is close to balance. Private sector debt is one of the lowest among advanced countries and reduces risks to financial stability. Moreover, Italian banks are expected to continue to register progress in the reduction of non-performing loans (NPLs), making the banking system more resilient to shocks.

RATING DRIVERS

Upward pressure on the ratings could emerge if (1) successful reform efforts lend support to medium-term growth prospects 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; or (3) evidence that the authorities are further rolling back implementation of past structural reforms.

RATING RATIONALE

The Government Maintained a Conservative Deficit Target in 2019, But its Fiscal Outlook is Challenging

Italy’s credit profile is supported by persistent government budget primary surpluses. Excluding 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.

DBRS positively views the government’s revision of its headline fiscal target in 2019 from 2.4% of GDP to 2.0% despite weaker-than-expected nominal growth. However, high uncertainty remains with regard to the fiscal trajectory from 2020 onwards. This was broadly in line with DBRS’s expectation as detailed in the commentary, “Italy - Striking a Difficult Balance to Stay in Power”. A combination of lower costs from citizenship income and the temporary early retirement scheme option, as well as additional revenues, led the Italian government to avoid the opening of an of EDP for the time being. According to the European Commission (EC), the revision of 0.4% of GDP in the nominal deficit should result in a structural deficit improvement of 0.2 percentage points, compared with a deterioration of 0.2 percentage points projected in the EC 2019 Spring forecast.

Significant uncertainty remains regarding future fiscal targets. Mr. Salvini, the leader of the Lega, announced the possibility of a personal income tax cut, estimated to be worth around EUR 15 billion and it is not clear if enough compensating measures will be implemented. In addition, indirect tax increases already legislated amounting to around EUR 23.0 billion (1.3% of GDP) and EUR 28.7 billion (1.5%) in 2020 and in 2021, respectively, might be in part deactivated leading to lower primary surpluses. With part of higher revenues appearing to be temporary this year, the fiscal deficit target of 2.1% of GDP in 2020 presented in the Stability Programme may not be achieved, but DBRS does not expect the deficit to exceed the 2.7%-3.0% of GDP range. A moderate deterioration in Italy’s government deficit once again would result in a potential request of correction by the EC when the government will present the 2020 draft budgetary law in Autumn this year. On the other hand, a potentially more conservative approach from the Italian government, introducing a gradual combination of tax cuts and lower expenditures, could reduce uncertainty over fiscal targets. This, however, appears difficult considering there is still a high risk of snap elections leading to politically motivated fiscal rhetoric and decision-making.

Public Debt-to-GDP Ratio Expected to Rise but Implicit Interest Costs are Still Historically Low

The public debt-to-GDP ratio is very high and makes the country vulnerable to shocks. It is expected to rise modestly in 2019 and 2020, constraining fiscal room for countercyclical policies. Following a period of broad stabilisation between 2014 and 2017, Italy’s public debt-to-GDP ratio increased by 0.8 percentage points to 132.2% last year. This was largely driven by a significant stock flow adjustment component amounting to 0.9 percentage points and lower-than-expected nominal growth, which in turn weighed on the primary balance.

While the government’s latest projection points to the ratio rising to 132.6% of GDP, the ambitious privatisation plan accounting for 1.0% of GDP is unlikely to be achieved, and public debt will likely exceed 133% of GDP in 2019. In addition, the activation of the already legislated indirect tax increase amounting to 1.3% of GDP in 2020, which could positively impact the primary balance, is subject to high uncertainty. The government has frequently deactivated VAT increases leading to higher fiscal deficits in the past and, in DBRS’s view, this could occur again, especially if the risk of snap elections remains elevated. These elements do not bode well for debt trajectory in light of still-weak nominal growth. Should Italy’s economic performance remain fragile also because of the modest European growth and, at the same time, fiscal policy be less conservative than expected, the public debt-to-GDP ratio increases in the 2019-2020 period are unlikely to be temporary. This could further weigh on the ratings.

Despite the track record of a primary surplus of 1.5% of GDP on average since 2001, according to the latest International Monetary Fund (IMF) World Economic Outlook projections, a significant deterioration in the primary balance surplus from 1.6% in 2018 to 0.4% of GDP on average in 2019-2023 period, contributes to an increase in Italy’s debt-to-GDP ratio to 137.5% in 2023. Considering this baseline, an adverse shock on real GDP to average -0.4% year-on-year in 2019-2023, compared with the +0.6% projected by the IMF, could further contribute to an increase in the debt ratio to 142.3% of GDP in 2023. On the other hand, debt dynamics appears to be less sensitive to interest rate shocks. This is because the relatively long average maturity of securities (6.79 years as at June 2019) and the large share of total debt that is at a fixed rate, help to limit the impact of shocks on yields. Moreover, the recent decline in the sovereign yield curve bodes well for a reduction in the debt service burden. The implicit interest cost at around 2.76% as of June 2019, was the lowest in three decades.

The Economy is Stagnating, but Progress in Strengthening the Banking System Continues

A high degree of economic diversification, coupled with a strong manufacturing sector, support the ratings. Total employment has returned to pre-crisis levels and looking ahead, measures implemented by the government are expected to reduce the poverty rate, which has increased significantly over the past years. Strong export growth and the recovery in both investment and private consumption have led the cyclical GDP growth recovery over the last few years. However, following the 1.7% GDP growth rate registered in 2017, economic growth slowed down to 0.9% in 2018. 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 since it was appointed, which weighed on business investment.

This year, although real GDP growth came in better than expected in the first quarter at 0.1% quarter-on-quarter, high frequency indicators point to a stagnant growth for the full year 2019. This is because of a still-weak manufacturing sector performance affected by uncertainty regarding the external environment and the potential less positive impact on consumption of the two government flagship measures that are registering take-up rates lower than expected. Looking forward, GDP is expected to pick up modestly in 2020 to 0.8%, driven by a recovery in domestic demand that could likely contribute to an improvement in the unemployment rate, which is for the first time since early 2012 below 10%, as of May 2019.

The introduction of the early retirement option scheme will weigh on the implicit public debt but the lower than expected take-up rate should mitigate this impact. It is not clear if the government will implement a revision of the tax system aimed at boosting the disposable income of households or reducing the tax wedge, but the risk of a reversal of structural reforms seems diminished. However, a lack of material commitment to resolve structural problems remains an key issue in DBRS’s view. The country’s structural problems include low productivity growth, a lengthy justice system, weak competitiveness in the service sector, low investment in research & development, an inefficient public administration and low female labour participation, which all together hamper Italy’s potential growth.

By contrast, the banking system continues to make progress in reducing the stock of its NPLs, and this bodes well for the ratings. According to the Bank of Italy, in Q1 2019, the total gross NPL ratio was 8.5%, down from around 18.2% in Q3 2015. 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. Although sovereign premia levels have moderated following the more accommodative communication from the European Central Bank (ECB), the high concentration of public asset in the banking system portfolio makes Italian banks exposed to potential new tensions in the sovereign market. Despite interest rates remaining at very low levels, some tightening in credit conditions has resulted in a slowdown in credit growth. In DBRS’s view, bank profitability and asset quality, particularly in the case of small and medium-sized banks, remain quite vulnerable to prolonged periods of high spreads. However, risks of financial stability remain contained. Household non-financial private-sector debt of 110.5% of GDP in Q4 2018, 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 2013, the current account has shifted into surplus and in the 12 months ending April 2019 amounted to 2.7% of GDP - one of the highest levels since 1997. Stronger export performance, reflected in a reversal in the decline in Italy’s market share since 2013, along with the surplus in the income balance, have supported the improvement in the current account position. This, in turn, has contributed to the decline of the country’s negative NIIP, which is close to being balanced (-2.6% of GDP at end-March 2019), following the peak of -24.6% of GDP registered at end-March2014. According to the Bank of Italy, NIIP might shift into surplus in 2020. 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 U.K. 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 and weighs on the ratings. Despite a moderation in the economic agenda and a more conservative fiscal policy compared with the electoral promises and the governing contract, the ruling parties continue to focus more on political rhetoric to keep high electoral support rather on structural reforms. The divergent views on the agenda occasionally generate internal frictions that undermine policy predictability, weighing on business confidence.

In addition, the shift in the balance of power between the two parties following the European parliamentary elections does not bode well for government stability. M5S electoral support dropped significantly and current polls point to around 17% share of votes from 33% obtained in the national elections last year. This places the M5S in a weaker position and it may be required to accommodate Lega’s agenda priorities in order to avoid snap election. Conversely, Lega’s success in the European elections, where it obtained around 34.3% of total votes, compared with M5S’s 17.1% has made it more likely that it could pull the plug on the government and try to build on these good results through a snap election. However, DBRS expects a political muddle-through scenario with the current government remaining in power, but not serving the full five-year legislative term. In DBRS’s view, a centre-right government with Lega and Brothers of Italy and/or Forza Italia or a centre-left government, formed by a coalition between the Democratic Party and the M5S, potentially might have a more uniform agenda with less risk of increasing expenditures to support different segments of voters.

Italy’s risk of exiting from the euro area remains remote but Eurosceptic political rhetoric does not bode well with respect to restoring investor confidence following the spike in yields, because of a governing contract in May 2018 containing some eurosceptic elements. DBRS continues to believe that leaving the euro area does not meet with popular support and institutional strengths along with significant economic and in turn political costs reduce substantially this risk. However, frequent clashes with the European Commission and extreme proposals from some MPs, including a parliamentary motion to introduce small size government debt (mini-bots) to pay commercial debt arrears or a revision in the Italian Central Bank’s independence, generated concerns among investors. DBRS monitors the evolution of such political rhetoric and it is of the view that it undermines Italy’s credibility and weakens the Italian authorities‘ ability to negotiate with the EU.

RATING COMMITTEE SUMMARY

The DBRS Sovereign Scorecard generates a result in the A (high) – A (low) range. Additional considerations factoring into the Rating Committee decision included: weak potential GDP growth rate, lack of reform effort and vulnerabilities in the banking system. The main points discussed during the Rating Committee include Italy’s fiscal outlook, Excessive Deficit Procedure, public debt sustainability and economic performance.

KEY INDICATORS

Fiscal Balance (% of GDP): -2.1 (2018); -2.0 (2019F); -2.7 (2020F)
Gross Debt (% of GDP): 132.2 (2018); 133.4 (2019F); 134.1 (2020F)
Nominal GDP (EUR Billions): 1757.0 (2018); 1770.2 (2019F); 1801.4 (2020F)
GDP per Capita (EUR): 29071.0 (2018); 29299.2 (2019F); 29826.2 (2020F)
Real GDP Growth (%): 0.9 (2018); 0.1 (2019F); 0.8 (2020F)
Consumer Price Inflation (%): 1.2 (2018); 0.9 (2019F); 1.1 (2020F)
Domestic Credit (% GDP): 112.2 (2017); 110.5 (2018)
Current Account (% GDP): 2.6 (2018); 2.9 (2019F); 2.6 (2020F)
International Investment Position (% GDP): -3.9 (2018); -2.6 (Mar-2019)
Gross External Debt (% GDP): 120.3 (2018); 121.2 (Mar-2019)
Governance Indicator (percentile rank): 69.7 (2017)
Human Development Index: 0.88 (2017)

EURO AREA RISK CATEGORY: LOW

Notes:

All figures are in Euros 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.
Fiscal balance (Istat, MEF, DBRS), Gross debt (Istat, IMF), Nominal GDP (Istat, European Commission), GDP per Capita (Istat, European Commission), Real GDP Growth (Istat, IMF, MEF), Inflation (Istat, European Commission), Domestic Credit (ECB, Istat), Current Account (Istat, Bank of Italy, IMF), International Investment Position (Istat, Bank of Italy), Gross External Debt (Istat). 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, European Central Bank, 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: Chair: Roger Lister, Managing Director, Chief Credit Officer, Global FIG and Sovereign Ratings
Initial Rating Date: February 3, 2011
Last Rating Date: January 11, 2019

DBRS Ratings Limited
20 Fenchurch Street, 31st Floor,
London EC3M 3BY United Kingdom
Registered and incorporated under the laws of England and Wales: Company No. 7139960

For more information on this credit or on this industry, visit www.dbrs.com.