DBRS Confirms Italy at A (low), Stable Trend

DBRS Ratings Limited (DBRS) has confirmed the Republic of Italy’s Long-Term Foreign and Local Currency Issuer Ratings at A (low) and the Short-Term Foreign and Local Currency Issuer Ratings at R-1 (low). All ratings have a Stable trend.

The rating confirmation reflects Italy’s relatively strong budgetary position that compares favourably with the Euro-area average as well as the government's progress in delivering institutional and structural reforms. 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 such as the country’s exposure to external shocks, low potential growth and high government debt.

The confirmation of the Stable trend reflects DBRS’s view that the risks for the ratings remain 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’s sovereign ratings reflect strong commitment to fiscal consolidation, as reflected in a budgetary position that remains relatively strong, with the second highest primary surplus in the Euro area. After easing moderately in 2014 and 2015, Italy’s fiscal consolidation effort is set to remain gradual over the medium term. The government has committed to additional tax cuts amounting to EUR28 billion (1.6% of GDP) over the next three years to 2018 which it intends to fund with spending cuts, an improved economic outlook, and by seeking increased budget flexibility from the European Commission. DBRS expects the proposed measures to have a positive impact on household confidence and business sentiment. However, the impact on the economy will depend on a clear identification of the funding for structural tax cuts through detailed spending cuts. The improving growth outlook and current low bond yield environment should provide some support for the implementation of the consolidation plan, with the budget deficit expected to decline modestly to 2.6% and 2.2% in 2015 in 2016 respectively. Nevertheless, DBRS believes that the plan’s implementation will depend on the government’s ability to meet the challenges of its structural reform agenda.

After a prolonged three-year recession, Italy's economy has started to gradually recover with real GDP estimated to rise by 0.8% in 2015, supported by strengthening external demand and improving domestic confidence. The recovery is underpinned by the European Central Bank’s (ECB) expansionary measures, the depreciation of the euro, the fall in oil prices and the less restrictive fiscal policy stance. Altogether, real GDP growth is forecast to grow 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 forecast to reach 2.3% of GDP in 2015-16. Despite the improving outlook, the modest recovery is lagging other European peers and remains fragile with real GDP still below pre-crisis levels.

The government has made concrete progress in passing institutional and structural reforms. A new electoral law to come into effect in 2016 is expected to promote government stability over the medium term. The labour market reform has started to produce some positive effects with labour market duality declining following the introduction of a single open-ended labour contract. Some advances have been made to improve the education system as well as the resilience of the banking sector. The government has approved a decree reforming bankruptcy laws to facilitate the rescue and turnaround of distressed companies and non-performing loans (NPL) disposals which should support growth from 2016. Although progress is encouraging, DBRS remains cautious regarding the full impact of structural reforms and believes that the success of reforms goes beyond the Parliamentary approval, as they need to be followed through at the public administration level before having an effect on the broader economy.

Italy continues to benefit from the significant improvement in funding conditions since the end of 2012, supported by measures taken by the ECB. Yields on 10-year Italian sovereign bonds have declined to 1.76% in September 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 2014, compared with 56.7% in 2010. At the same time, the average maturity of government debt has remained high at 6.46 years in June 2015, helping to shelter the country against interest rate shocks.

Despite these strengths, the Italian economy is exposed to some risks. The country is vulnerable to external shocks, especially to slowdowns in global trade. While Italian exports to China only amount to 0.6% of GDP, a more severe economic deceleration in China could negatively affect Italy’s main trading partners and dampen its export sector’s performance. Also fallout from disruptive events in Greece or escalating tensions with Russia could dampen the growth in Europe and adversely affect the recovery in Italy.

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 have led to declining competitiveness.

At current growth estimates, Italy’s debt dynamics remain a concern. With high public debt at 132.1% 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:
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.

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Lead Analyst: Giacomo Barisone, Senior Vice President.
Initial Rating Date: 3 February 2011
Rating Committee Chair: Roger Lister
Last Rating Date: 27 March 2015

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