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

DBRS Ratings Limited 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 progress on fiscal consolidation, as reflected in a budgetary position that remains relatively strong and compares favorably with the Euro area average. Italy also benefits from demonstrated debt servicing flexibility, a wealthy and diversified economy, moderate levels of private sector debt 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, 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. The ratings could be subject to downward pressure if the public debt were to rise beyond our present expectations and failed to stabilize within the forecast horizon, or if the current outlook for a recovery in economic activity over the coming 12 months fails to materialise. Sustained delays to deliver credible measures aimed at boosting potential output could also lead to a downgrade. On the other hand, the trend could be changed to Stable if the economy were to strengthen, the debt-to-GDP ratio were to stabilise, and if economic and labour market reforms were to be successfully implemented.

Italy has progressed substantially with fiscal consolidation. In 2013, the primary surplus was 2% of GDP, while the structural deficit of 0.7% of GDP was 0.8 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 in structural fiscal consolidation, and more recently public finances have benefitted from declining yields on sovereign bonds. However, in 2014 and 2015 the fiscal stance is set to be moderately expansionary, with the headline deficit set to rise to 3% of GDP in 2014 from 2.8% in 2013, before decreasing marginally to 2.9% in 2015. DBRS expects the Italian government to focus on growth-enhancing measures using the limited fiscal flexibility provided by savings from the recently completed spending review to support the economy through tax reductions in the near term. The achievement of the medium-term objective of a balanced budgetary position in structural terms is expected to be postponed by one year to 2017.

Italy has demonstrated debt-servicing flexibility during the crisis by maintaining a strong domestic investor base, which in June 2014 held 66.4% of government debt, compared with 56% in 2010. Italy also maintained a high average maturity of government debt at 6.3 years in June 2014, with average duration of 5.03 years. All of this, together with disciplined primary expenditure, helps 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.

Italy’s persistently weak economic performance continues to weigh on the rating. After contracting 1.9% in 2013, Italy's economy is expected to remain in recession in 2014 with GDP set to contract by 0.3%. The renewed weakness of domestic demand is due to persistently tight financing conditions and ongoing uncertainty holding back consumption and investment. Against the background of significant economic slack, unemployment increased to 12.3% and annual inflation declined to 0.4% in August 2014, further reflecting the fragility of the economy. GDP is expected to grow by 0.5% in 2015 on the back of moderately stronger external demand and improved domestic confidence. Domestic demand should also draw strength from the tax rebates introduced in May to support lower incomes, and the repayments of government debt arrears. This should help lift household disposable income and corporate liquidity.

While the government’s ongoing structural reforms will likely boost growth over the next years, Italy's growth potential remains weak. Improving its growth performance remains a fundamental driver of the rating. 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 potential growth 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 estimated at 131.6% of GDP in 2014, compared with 115.3% in 2010, Italy’s fiscal space remains heavily constrained. DBRS expects government debt to peak in 2016 at close to 134% of GDP, and to decline slightly in 2017 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 be lower, putting pressure on the rating.

Another factor weighing on the rating is the high level of fragmentation of the Italian political landscape. Prime Minister Matteo Renzi, whose political mandate was strengthened by a strong performance in May's European Parliament elections, has accelerated the pace of his ambitious reform agenda. This includes: an electoral and institutional reform, currently under discussion in Parliament; a wide reaching reform of the labour market focused on increasing flexibility and improving active labour market policies; reforms in the judicial system and the public administration which have also been initiated, and competition-enhancing reforms to be legislated by the end of the year. Although the government’s policies intentions are encouraging, DBRS believes that the execution risks associated with implementing these initiatives are significant given the strength of vested political interests inside and outside the coalition that might oppose them, and the country’s uneven track record in implementing such reforms.

Notes:
All figures are in Euro 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.

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, Senior Vice President.
Initial Rating Date: 3 February 2011
Rating Committee Chair: Alan Reid
Last Rating Date: 11 April 2014

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