DBRS Downgrades Republic of Italy to A (high) on Fiscal and Market Risks; Trend Remains Negative

DBRS Ratings Limited (DBRS) has today downgraded the ratings on the Republic of Italy’s long-term foreign and local currency debt to A (high) from AA (low). The trend on both ratings remains Negative. The downgrade reflects: (1) persistent stress in market funding conditions; (2) fiscal consolidation implementation risks due to economic and political uncertainties; and, (3) structural economic growth challenges.

The Negative trend reflects concerns of downside risks to the government’s debt reduction plan between 2011 and 2014, associated with a deteriorating political and economic environment that has the potential to impair the ruling coalition’s ability to implement fiscal austerity and structural reforms. Greater clarity on the structure and size of the European Financial Stability Facility (EFSF) and the treatment of private bondholders of Greek debt would help stabilise the ratings. However, should Italy continue to experience acute pressure in the funding markets, combined with an insufficient fiscal impulse to meet its deficit targets, this could lead to further downward pressure on the ratings.

The evolution of Italy’s ratings ultimately depends on the prospects for debt stabilisation. To change the trend to Stable, DBRS would need to see a more stable ruling coalition, a full and credible implementation of the fiscal austerity program with a faster reduction of the country’s debt burden, and the adoption of structural reforms to raise productivity and enhance Italy’s long-term growth potential.

The A (high) ratings take into account a number of credit strengths, which includes a budgetary position that remains relatively strong and compares favourably with the Euro zone average. Italy is expected to run a primary budgetary surplus of close to 1% of GDP in 2011 – the only country in the G7 to do so – and has maintained a relatively prudent fiscal stance over the past five years. Italy also benefits from a wealthy and diversified economy, limited external imbalances, relatively sound corporate and household balance sheets and a track record of pension reforms that supports the long-term sustainability of public finances.

In addition, Italy benefits from Euro zone membership. As the third largest economy in the Euro zone, and therefore important to its stability, DBRS believes that the European Financial Stability Facility (EFSF), the European Central Bank (ECB) and the International Monetary Fund (IMF) are likely to continue providing liquidity to the country in order to ease funding pressures. In the short-term, the ECB is likely to continue its selective purchase of Italian government bonds in the context of its Securities Market Programme (SMP) in order to prevent the seizing up of sovereign markets. Moreover, the measures announced on 26 October 2011 by European policymakers, with the enhancement of tools proposed for the EFSF and the more recent agreement to quarterly IMF/EU monitoring, may constitute important steps towards supporting greater financial stability and enhancing policy credibility in the medium-term.

Another important strength is Italy’s relatively stable financial sector. During the 2008-2009 financial crisis, the Italian banking sector performed better than those of many peers, thanks to its traditional business model and effective supervision. Government support for the banking sector has been very limited compared to that of other Euro zone countries.

Since July 2011, however, the financial sector has come under pressure as rising market volatility and higher government bond yields translated into higher costs of capital for Italian banks and corporates. Within this challenging environment, the resilience of Italian banks is being tested, affecting their below-average capital strength and subdued profitability. DBRS is concerned that Italian banks’ funding difficulties and their significant holdings of domestic government debt could jointly trigger a sharp tightening of lending standards with potentially significant negative knock on effects on current GDP activity, and through a potentially destabilising feedback loop between the real economy and tensions in the sovereign debt market.

The persistent increase in Italy’s funding costs has considerably weakened the country’s creditworthiness, given its high public debt, large borrowing needs and weak economic activity. With a level of debt expected to reach 120% of GDP in 2011, up from 104% in 2004, Italy has the second largest European Monetary Union (EMU) government bond market after Germany, and accounts for approximately one quarter of the Euro zone’s sovereign debt stock. The country’s heavy amortisation schedule (around EUR 250 billion a year) has heightened market risk, with yields on the 10-year bond trading above 6% since October 2011.

The downgrade also reflects growing implementation risks, and that the government may need more time to achieve its fiscal consolidation targets to reverse the adverse debt dynamics. On 14 September 2011, the Italian Parliament approved a sizeable fiscal package expected to produce savings of EUR 59.8 billion, or 3.5% of GDP, between 2012 and 2014, with most of the impact occurring in 2012 and 2013. The package aims to reduce the deficit to close to zero by 2013, down from 3.9% in 2011, and improve the primary balance to a surplus of 5.4% of GDP in 2013, from an expected 0.9% in 2011. This would be the largest primary surplus since 1997, the year before Italy’s EMU accession.

Despite this significant consolidation effort, however, DBRS believes that several uncertainties remain with regard to the government’s ability to achieve these targets. First, one third of the measures approved are undefined: out of total savings of EUR 54.2 billion by end-2013, EUR 20 billion stems from a reform to the tax system, which is to be approved by September 2012, ahead of a general election due in the spring of 2013.

Second, the fiscal package is highly skewed toward revenues rather than expenditures, and the targets are particularly vulnerable to weaker growth. Two thirds of the projected budgetary savings over the 2011-2014 period are expected to come from higher revenues. However, the Italian tax burden is already one of the highest in Europe and additional tax increases are likely to depress domestic demand further as consumers and firms devote more of their current income to paying value-added and other taxes. With lower GDP growth, the government may struggle to reach its targets or reduce debt-to-GDP below 120%.

In addition to low domestic demand growth, DBRS believes that Italy’s GDP performance may be adversely affected by a slowdown in external demand. As a result, economic growth may turn out below government estimates, which average 0.9% between 2011 and 2014. Given these constraints, combined with the synchronised fiscal consolidation efforts taking place across Europe, there is significant downside risk to Italy’s growth projections.

Indeed, over the last decade Italy’s economic performance has been uneven and persistently below the Euro zone average. Low economic growth is partly the result of weak productivity, low employment, low R&D expenditure and declining competitiveness. Italy’s GDP per capita in 2010 was below 2000 levels and real GDP growth has only averaged 0.2% per year since then. Longstanding obstacles remain for future improvements in economic performance due to physical and institutional infrastructure barriers in both product and labour markets, which have yet to be fully addressed.

In response to demands by Euro zone partners on 26 October 2011 for a new timetable on structural reforms, the Italian government committed itself to implementing a number of measures over the coming eight months. These include liberalisation of the labour market, forced redundancies for civil servants, an increase in the pension age by 2026 to 67 years, measures to attract private sector investment in infrastructure projects and a sale of state assets by November 2012 (estimated revenues from the sale are EUR 15 billion, or just below 1% of GDP).

If implemented, these measures would represent an important step forward in raising government credibility. However, DBRS believes that ongoing divisions within the government, which increase the likelihood of early elections before the scheduled date of spring 2013, lower the chances that the reforms will be approved or effectively implemented.

Notes:
All figures are in Euros (EUR) unless otherwise noted.

The applicable methodology is Rating Sovereign Governments, which can be found on the DBRS website under Methodologies.

The sources of information used for this rating include the Italian Treasury, Bank of Italy, ISTAT and Bloomberg. DBRS considers the information available to it for the purposes of providing this rating was of satisfactory quality.

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

Lead Analyst: Giacomo Barisone
Rating Committee Chair: Alan G. Reid
Initial Rating Date: 3 February 2011
Most Recent Rating Update: 3 February 2011

For additional information on this rating, please refer to the linking document under Related Research.