DBRS Confirms the Republic of Italy at A (low), Negative trend

DBRS Ratings Limited (DBRS) has confirmed the Republic of Italy’s long-term foreign and local currency issuer ratings at A (low) and maintained the Negative trend on the ratings. DBRS has also confirmed the short-term foreign and local currency issuer ratings at R-1 (low) and maintained the Stable trend.

The rating confirmation reflects Italy’s strong commitment to fiscal consolidation, as reflected in a budgetary position that remains relatively strong and compares favourably with the Euro area average. Italy also benefits from demonstrated debt servicing flexibility, a wealthy and diversified economy, sound corporate and household balance sheets and the likely availability of financial support, if needed, from the Euro area support mechanisms. However, these supportive factors are balanced by significant challenges: the country’s low potential growth rate, high government debt, and political fragmentation.

The Negative trend reflects DBRS’s assessment that risks stemming from the country’s fragile economic prospects and large debt stock remain skewed to the downside. Weakened political commitment to reducing the public debt burden could lead to a downgrade, as would evidence of further deterioration in the country’s competitiveness and medium-term growth prospects. Failure to deliver credible measures aimed at boosting potential output could also put downward pressure on the ratings. On the other hand, the ratings could stabilise if the recovery were to strengthen and if the debt reduction plan were to continue as planned.

Italy has progressed substantially with fiscal consolidation. In 2013, the primary surplus was 2.2% of GDP, one of the highest among all single-A rated sovereigns, while the structural deficit of 0.8% of GDP was 0.6 percentage points lower than 2012, narrowing the gap with the medium-term objective of a balanced budget. By the end of 2013, the country had delivered a 2.9 percentage points worth in structural fiscal consolidation, and more recently public finances have benefitted from declining yields on sovereign bonds.

Italy has demonstrated debt servicing flexibility during the crisis by maintaining a strong domestic investor base, which in December 2013 held 66% of government debt, compared with 56% in 2010. Italy also maintained a high average maturity of government debt at 6.3 years, with average duration of 4.85 years. All these factors, together with disciplined primary expenditure, help to shelter the country against interest rate shocks. Other important factors supporting the rating include relatively low private sector debt (127% of GDP in 2013), and the likely availability of financial support, if needed, from the Euro area support mechanisms.

At the end of 2013, the Italian economy emerged from a two-year recession. After contracting 1.9% in 2013, Italy's economy is expected to stage a gradual recovery this year. The government expects GDP to expand by 0.8% in 2014 and by 1.3% in 2015, driven both by moderately stronger external demand and by improved domestic confidence. GDP growth in 2014 on will only partly benefit from the measures announced by Prime Minister Renzi, which will entail a structural reduction in the tax burden financed by expenditure cuts. According to government projections, the announced EUR10 billion annual tax rebate on low to medium paid employment incomes, the 10% cut in the regional production tax, and the payment of an additional EUR13 billion stock of public sector arrears, will only lead to an expansion in consumption and investment by 0.2 percentage points. However, by the end of the forecast period (2018) the announced government measures are expected to contribute to increase GDP by 0.6%. These measures will be budget neutral, as they will be financed via permanent expenditure cuts, a higher tax rate on capital income (from 20% to 26%) and lower interest payments on government debt. In 2014, the fiscal shortfall is marginal, at 0.1% of GDP.

While the announced measures will likely boost growth over the next years, Italy's growth potential remains weak, and improving its growth performance remains a fundamental driver of the ratings. Over the last decade, Italy’s economic growth has been flat and a full percentage point lower than the Euro area average. Total factor productivity growth has been negative and the annual potential growth rate has been just 0.3% on average. Weak growth is largely the result of low productivity of labour and capital, low employment rates and low investment in Research and Development and Education, all of which led to declining competitiveness. The implementation of structural reforms that boost the country’s potential growth rate would be credit positive, as they would support a smooth reduction of the debt burden.

At current growth estimates, Italy’s debt dynamics remain a concern. With high public debt equivalent to 132.6% of GDP in 2013, compared with 103% in 2007, Italy’s fiscal space remains heavily constrained. The general government debt-to-GDP ratio is set to peak in 2014 at nearly 135% and then decline slightly in 2015 driven by a structurally high primary surplus and stronger nominal GDP growth. The trajectory is subject to several risks, including less positive fiscal outturns, lower output growth, lower inflation and higher financing costs. If any of these risks were to materialise, the prospect that public debt will be put on a firmly downward path over the medium term would lower, putting pressure on the rating.

Another factor weighing on the rating is the high level of fragmentation of the Italian political landscape. Mr Renzi’s cabinet is Italy's fourth in less than two and half years, an element which underlines the instability of Italian politics. Mr Renzi brings a greater sense of urgency to Italy's economic and institutional reform agenda with his ambitious government programme for the first 100 days in office. This includes: an electoral and institutional reform, currently under discussion in Parliament; a reform of the labour market; an overhaul of public administration’s expenditures and procedures; a reform of the civil judiciary system; and a reform of the tax code. While most of these measures seem to address many of Italy’s long-dated weaknesses, DBRS believes that the new coalition faces similar challenges as previous coalitions. Mr Renzi’s government is supported by a fragile majority that lacks a decisive parliamentary backing and has no direct electoral mandate. This leaves Mr Renzi’s cabinet vulnerable to volatile parliamentary dynamics, especially if it were not to deliver on the reform programme or if the nascent recovery failed to materialize in the short term.

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 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 under Rating Scales. DBRS considers the information available to it for the purposes of providing this rating was of satisfactory quality.

These can be found on www.dbrs.com at:
http://www.dbrs.com/about/methodologies

The sources of information used for this rating include Ministero dell’Economia e delle Finanze, Banca d’Italia, ISTAT, European Commission, Eurostat, European Central Bank, IMF, OECD, Bloomberg and Haver Analytics. DBRS considers the information available to it for the purposes of providing this rating was of satisfactory quality.

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.

Information regarding DBRS ratings, including definitions, policies and methodologies are available on www.dbrs.com.

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

Generally, the conditions that lead to the assignment of a Negative or Positive Trend are resolved within a twelve month period, while reviews are generally resolved within 90 days. DBRS’s outlooks and ratings are under regular surveillance.

For further information on DBRS historic default rates published by the European Securities and Markets Administration (“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 regulations only.

Lead Analyst: Giacomo Barisone
Initial Rating Date: 3 February 2011
Rating Committee Chair: Alan G. Reid
Last Rating Date: 6 March 2013

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