DBRS Assigns AA (low) Rating to Italy on Low Private Debt and Economic Resilience

DBRS Inc. (DBRS) has today assigned initial ratings on the Republic of Italy’s long-term foreign and local currency debt at AA (low). The trend on both ratings is Negative. The Negative trend reflects heightened risks associated with a deteriorating political environment that has the potential to impair the ruling coalition’s ability to implement fiscal austerity and structural reforms.

The ratings take into account Italy’s strengths, which include the size of the economy, which has provided resilience during the crisis, low private sector debt, high private saving, strong corporate and household balance sheets, a stable financial sector, a fairly healthy net foreign asset position and the benefits of euro zone membership. Euro zone membership includes the assumption that the European Financial Stability Facility (EFSF), the European Central Bank (ECB) and other EU institutions would provide liquidity to each member state if needed.

These strengths are offset by Italy’s considerable challenges: high public sector debt, a heavy public amortization schedule, weak public finances, low growth prospects and deep structural imbalances. In the near term, greater fiscal consolidation and structural reforms may be needed to bolster investor confidence and stabilise debt ratios.

To change the trend to Stable, DBRS would need to see a more stable ruling coalition and full implementation of the fiscal austerity program. Greater clarity of policy intentions at the EU level with regard to the structure of the EFSF and the treatment of private bondholders, would help to stabilise the rating. Should Italy encounter acute pressure in the funding markets, combined with an insufficient fiscal impulse to meet its deficit targets, this could lead to downward pressure on the ratings.

Since the onset of the international financial crisis, fiscal measures have been sufficient to reduce the deficit from 5.3% of GDP in 2009 to 5% of GDP in 2010. The Ministry of Economy and Finance is targeting a deficit of 3.9% of GDP in 2011, a deficit of less than 3% of GDP in 2012, and a balanced budget over the medium-term. The Bank of Italy expects that the primary balance will move from a deficit of 0.3% of GDP in 2010 to a surplus of 0.8% of GDP in 2011. If achieved, this should help to stabilize Italy’s gross public debt at close to 120% of GDP.

DBRS is very concerned at the size of the debt burden, as well as Italy’s high interest bill of 9% of revenues, which constrains budget flexibility. A heavy amortisation schedule heightens market risk during periods of asset price volatility. Nevertheless, Italy’s debt dynamics have a long average maturity and a relatively low sensitivity to market interest rates, and this provides some comfort.

Another area of concern is Italy’s uneven economic performance. Italy excels in small, niche markets, particularly in the north of the country. However, many other parts of Italy suffer from low productivity and a distinct lack of competition, especially among small, mainly family-owned firms in the non-tradable sector. The fiscal program assumes that growth will reach 1.3% in 2011 and 2% in 2012, contrasting with the Bank of Italy’s more modest forecasts of 0.9% in 2011 and 1.1% in 2012. Given slack domestic demand, and in the absence of deeper structural reforms aimed at increasing competition and productivity growth, employment growth is likely to be moderate at best over the medium-term. In the coming years, if growth surprises to the downside, this could influence the government’s ability to stabilise public debt ratios, placing downward pressure on the ratings.

Over the medium term, reforms aimed at addressing labor market rigidities, increasing the efficiency of public administration, consolidating small and medium-sized enterprises, improving legal accountability and tax compliance, raising educational standards and liberalising information technology, to name a few, would help to stabilise the credit. In the near term, while the fragility of the economic recovery may justify a delay in a deeper fiscal adjustment, should investor sentiment deteriorate, an even larger adjustment may be called for. How Italy addresses these dynamics is central to the rating.

Notes:
All figures are in Euros unless otherwise noted.

The principal methodology applicable is Rating Sovereign Governments, which can be found on www.dbrs.com.

The sources of information used for this rating include the Italian Ministry of Economy and Finance, the Bank of Italy, IStat, Eurostat, JEDH, UN, Doing Business, OECD, BIS, World Bank, IMF. DBRS considers the information available to it for the purposes of providing this rating was of satisfactory quality.

This rating was disclosed to the Department of Treasury, Public Debt Management, at the Ministry of Economy and Finance, and amended following that disclosure before being assigned.

This is the first DBRS rating on the Republic of Italy.

Lead Analyst: Fergus McCormick
Rating Committee Chair: Alan G. Reid

Initial Rating Date: 7 February 2011
Most Recent Rating Update: 7 February 2011

For additional information on this rating, please refer to the linking document below.