DBRS Downgrades Italy to “A” on Deteriorating Growth Outlook and Rising Systemic Risks

DBRS Ratings Limited (DBRS) has today downgraded the ratings on the Republic of Italy’s long-term foreign and local currency debt to A from A (high), and assigned a Negative trend on both ratings. Today’s action concludes DBRS’s review of these ratings that commenced on 22 May 2012. As such, the ratings are no longer Under Review with Negative Implications.

The rating action reflects DBRS’s assessment that there has been a deterioration in Italy’s credit profile warranting the one-notch downgrade. Four factors are behind the downgrade: (1) the deteriorating growth outlook in Italy and its impact on the government’s ability to achieve its ambitious deficit reduction targets; (2) medium-term policy uncertainty with respect to fiscal consolidation implementation and the completion of structural reforms; (3) persistent stress in market funding conditions and rising systemic risks which are increasing downside risks to the growth outlook and prospects for public debt stabilisation; and (4) persistent doubts over the timing and extent of the policy response at the Euro area level.

The Negative trends reflect DBRS’s assessment that the ratings have yet to stabilise and that further deterioration in the growth outlook for Italy or material deviation from fiscal targets could exert further downward pressure on the ratings. Growth prospects are particularly important to achieving a sustainable path of debt reduction in Italy, given the size of the fiscal consolidation programme, the elevated funding costs and the high and rising public debt burden.

The Italian economy has entered a period of prolonged recession, with GDP set to contract by 2% in 2012 and -0.2% in 2013 and the unemployment rate rising to 10.8% in July 2012. DBRS believes that economic activity in Italy is facing several challenges that are affecting the country’s economic growth prospects. First, the significant fiscal tightening implemented since the second half of 2011 will have a further detrimental impact on growth in both 2012 and 2013. Second, ongoing funding tensions in financial markets are likely to continue to affect economic activity via the confidence channel, as firms and consumers put their investment and spending plans on hold. Finally, tensions in the sovereign debt market are having an adverse impact on the ability of Italian banks and corporates to raise funds and are likely to continue to affect growth prospects through both stricter financing conditions and the need for Italian banks to increase their capital ratios.

Despite the significant consolidation effort undertaken by the Monti government worth a cumulative EUR81.3bn (4.9% of annual GDP) between 2011 and 2014, DBRS believes that several uncertainties remain regarding the government’s ability to achieve its fiscal targets. First, should the economic outlook deteriorate further, Italy would most likely need to implement an additional fiscal adjustment in order to reach the deficit target for 2012. While the aim of achieving a structural budget position by 2013 has remained untouched, the government has already announced plans to reach a nominal balanced budget in 2015, two years later than previously expected. In the short term, even with structural reforms being gradually implemented, fiscal retrenchment is likely to hit economic activity. In addition, the fiscal consolidation packages approved in 2011 are skewed toward revenues rather than expenditures, making the targets vulnerable to weaker growth. In July 2012, the government began to shift its consolidation efforts by approving cuts in current spending of EUR 26 billion (1.7% of GDP) to end 2014 in order to postpone increasing the value added tax that was scheduled for October 2012.

The persistent high cost of funding has also weakened the country’s creditworthiness, given its high public debt and large borrowing needs. With a level of debt expected to peak at 123.4% of GDP in 2012, up from 104% in 2004, Italy has the largest European Monetary Union (EMU) government bond market, accounting for approximately one-quarter of the Euro zone’s sovereign debt stock. Moreover, the country’s heavy amortisation schedule (around EUR 405 billion through the end of 2013, equivalent to 26.8% of GDP) makes the country particularly vulnerable to the ongoing systemic stress. The sensitivity of Italian debt dynamics to the deepening recession and elevated borrowing costs are likely to put additional pressure on the government’s target of reducing debt-to-GDP to below 120% by 2014. Moreover, DBRS is concerned by signs of a steadily declining non-domestic investor base, which fell from 47% of government debt in June 2011 to an estimated 39.5% in the first quarter of 2012.

Improving Italy’s weak growth performance remains a fundamental challenge underpinning the ratings. DBRS believes that the Monti government’s broad range of structural reforms aimed at boosting productivity and potential growth, whilst a significant step in the right direction, will nonetheless take time to come into effect and that there is a high risk of a partial implementation. With elections scheduled in April 2013, and given the declining popularity of the main political forces which back the Monti government, the adoption of far-reaching reforms is likely to be more prolonged.

The “A” ratings balance these credit challenges with a number of credit strengths, which include the strong commitment by the Monti government to consolidate public finances, as reflected in a budgetary position that remains relatively strong and compares favourably with the Euro zone average. Italy is expected to have run a primary surplus of close to 1% of GDP in 2011 – the only country in the G7 to run a surplus – and has maintained a relatively prudent fiscal stance over the past five years. Italy also benefits from a wealthy and diversified economy, 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), European Stability Mechanism (ESM) and the European Central Bank (ECB) stand to provide financial assistance if requested by the Italian government if bond yields were to rise significantly from current levels. DBRS is also encouraged by the series of measures recently announced by Euro Area policymakers, including the creation of the ESM and a single supervisory mechanism for European banks.

Rising systemic risks and the prospects for debt stabilisation will continue to weigh on Italy’s ratings. To change the trend to Stable, DBRS would need to see a credible implementation of the fiscal austerity program, with greater commitment to a reduction of the debt burden to accompany the positive efforts made on the primary balance and the continuation and full adoption of structural reforms. An effective and wide ranging European policy response aimed at containing contagion risks, accompanied by a commitment to closer fiscal integration at the EU level, would also help to stabilise the ratings.

DBRS will host a teleconference on 9 August 2012, which will focus on the review of DBRS’s sovereign ratings of: Italy, Ireland, and Spain.

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

The principal 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 Ministry Economy and Finance, Department of Treasury, Bank of Italy, Eurostat, ISTAT, IMF and Haver Analytics. 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: 22 May 2012

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