DBRS Confirms Republic of Italy at A (low), Changes Trend to Stable from Negative

DBRS Ratings Limited has confirmed the Republic of Italy’s long-term foreign and local currency issuer ratings at A (low) and changed the trend to Stable from Negative. 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, with 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, moderate levels of private sector debt and a sustainable pension system. However, these supportive factors are balanced by significant challenges: the country’s exposure to external shocks, high government debt and low potential growth.

The change in trend to Stable from Negative reflects three key drivers: (1) the country's robust debt-affordability profile, which is underpinned by low funding costs by historical standards and supported by the European Central Bank's expansionary measures; (2) the government's progress in delivering a comprehensive agenda of structural reforms, and (3) the recent capital strengthening of the banking sector.

DBRS sees risks to the ratings as being broadly balanced. If sustained improvement in the primary fiscal balance were to lead to a material reduction in the debt to GDP ratio, the ratings could experience upward pressure. On the other hand, weakened political commitment to fiscal consolidation and the reform agenda, or a material downward revision to growth prospects, either due to adverse external shocks or weak domestic demand, could lead to a return to a Negative trend.

Italy has progressed with fiscal consolidation. The government reduced its structural budget deficit by 2.3 percentage points between 2011 and 2014 and generated a healthy primary surplus of 1.7% of GDP on average over the same period. That compares favourably to the Euro area average deficit of 0.2%. After easing moderately in 2014 and 2015, Italy’s fiscal consolidation effort is expected to resume from 2016, with primary surpluses averaging approximately 3% in 2016-18.

Italy has benefited from the significant improvement in funding conditions since the end of 2012, supported by measures taken by the ECB, with yields on 10-year sovereign bonds declining to a historically low of 1.3% in March 2015. Italy has also demonstrated debt-servicing flexibility during the crisis by maintaining a strong domestic investor base, which held 66.4% of government debt in December 2014, compared with 56.7% in 2010. At the same time, the average maturity of government debt has remained high at 6.4 years in February 2015, with average duration of 5.64 years. Together with disciplined primary expenditure, this has helped 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 a track record of pension reforms that supports the long-term sustainability of public finances.

In the year since it took office, the current government has made progress with structural reforms to address deeply rooted structural weaknesses and increase growth potential. The government has adopted a comprehensive reform of the labour market focused on increasing flexibility and reducing the segmentation of the work force. Other reforms underway include education and justice reforms, a simplification of the tax system and measures to improve small and medium-sized enterprises’ access to capital markets.

However, structural reforms are expected to improve growth potential only over the medium term, and the short-term economic outlook is fragile. After contracting 0.3% in 2014, Italy's economy is only expected to gradually recover in 2015 with real GDP set to rise by 0.6%, supported by strengthening external demand and improving domestic confidence. The recovery will be underpinned by the ECB's expansionary measures, the depreciation of the euro, and the less restrictive fiscal policy stance. Altogether, real GDP growth is forecast at 1.4% in 2016. Improvements in the trade balance are also expected to continue. This, combined with lower oil prices, entails a further increase in the current account surplus to 2.6% of GDP in 2015-16.

Risks stemming from the banking sector are gradually receding. The country's largest banks either have stronger capital adequacy, or are in the process of strengthening capital in the coming months. Following the results of the ECB’s comprehensive assessment the residual capital shortfall of Italian banks was EUR3billion (0.2% of GDP), taking into account the EUR10.5 billion equity Italian banks raised during 2014. However, asset quality remains a key challenge. Non-performing loans increased to EUR 313billion in 2014Q3 (17% of total gross loans) and are likely to move upwards throughout 2015, until the effects of the gradual economic recovery take hold.

Despite these strengths, the Italian economy faces a number of challenges. The increased uncertainty over the negotiations between Greece and its Euro area partners, could add to downside risks to the growth outlook. Moreover, as one of the largest contributor to the official rescue packages, Italy is financially exposed to a re-intensification of the Eurozone crisis. Finally, an escalation of geopolitical tensions over Ukraine and Russia could also negatively impact Italy’s economy via the supply of energy and financial linkages.

While the government’s ongoing structural reforms will likely boost growth over the next years, Italy's growth potential remains weak, and improving 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 has 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 public 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 2015 at close to 133% of GDP, and to decline gradually in 2016 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 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, adding pressure on the ratings.

Notes:
The main points discussed during the rating committee were: (1) Italy’s economic outlook, (2) the issuer’s fiscal consolidation plan, and (3) developments in the financial sector. The committee discussed the impact of the ECB’s expanded asset purchase programme on the issuer’s growth and funding costs and the progress on structural reforms. Other factors discussed included risks stemming from the external environment, the political outlook, and the commitment of the current government to implement the reform agenda.

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: 10 October 2014

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