DBRS Places Italy A (low) Under Review with Negative Implications on Heightened Risks

DBRS Ratings Limited has today placed the Republic of Italy’s A (low) long-term foreign and local currency issuer ratings Under Review with Negative Implications, and confirmed the short-term foreign and local currency issuer ratings at R-1 (low) with a Stable trend. (See commentary press release: <a href="http://dbrs.com/research/297988/" target="_blank">‘DBRS Places Italy Under Review with Negative Implications on Heightened Risks’</a>.)

This action reflects DBRS’s assessment that the combination of political uncertainty surrounding a forthcoming constitutional referendum and pressure on Italian banks, amid a fragile recovery and a less stable external environment, pose downside risks to the ratings. Over the coming months, DBRS will assess these risks and to what extent they may adversely affect Italy’s efforts to stabilise its public debt.

This action reflects increased concerns in the Monetary Policy and Financial Stability, Political Environment, and Economic Growth and Performance sections of DBRS’ sovereign analysis. The review will focus on three areas:

• Outcome of the constitutional referendum, prospects for an amendment of the electoral law, and for a continuation of structural and institutional reforms.
• Progress in improving the strength of the Italian banking system.
• Developments in the real economy and the impact on the trajectory for government debt relative to GDP.

Rising political uncertainty is a challenge to the ratings. A constitutional referendum, to be held in the autumn, aims to streamline the legislative branch of government, resulting in the end of the so-called “perfect bicameralism”, in which laws must be voted on in both houses of Parliament. If approved, along with the current electoral law in the Lower House, it would provide more stability to the government and facilitate the passage of reforms.

However, uncertainty regarding the outcome has the potential to destabilize the government. Recent polls indicate that the number of voters who are uncertain about how they would vote is high. In case of rejection, Prime Minister Renzi has said he could resign. In this case, an interim government could be installed with the purpose of approving the budget law and amending the electoral law. However, this outcome is far from certain.

Since January 2015, the Italian government has implemented numerous measures to strengthen the banking system. However, the process of cleaning up of bank balance sheets remains slow and subject to uncertainty. Italian banks continue to show a high stock of non-performing loans (NPLs) and low profitability. The banking system has been subject to market volatility, especially following the 23rd June UK referendum. The government has since 2015 introduced several measures to help banks to repair their balance sheets. These range from new bankruptcy laws and the reform of mutual banks, to a securitization scheme for credit disposal and the sponsorship of “Atlante”, a private fund aimed at buying NPLs and supporting the recapitalisation of weaker institutions. Moreover, on 29th July, the European Banking Authority published stress tests, which showed that, excluding Banca Monte dei Paschi di Siena, Italian banks on average were relatively resilient to the adverse scenario. However, the stress tests failed to remove uncertainty over financial stability. In addition, the high stock of NPLs constrains the banks’ ability to improve profitability and expand the extension of credit.

Over the last decade, Italy’s economic growth has been flat and lower than the Euro area average. Italy's growth potential remains weak and the need to improve growth performance remains a fundamental driver of the ratings. Total factor productivity growth has been negative and corporate profits remain feeble. Fragile growth is largely the result of the low productivity of labour and capital, low employment rates, and low investment in education, and research and development, all of which have led to declining competitiveness.

The high level of public debt-to GDP continues to limit fiscal space and hamper economic activity. Although the government projects a rapid decline in debt to GDP, to 123.8% in 2019, uncertainty over contingent liabilities in the banking sector, weak growth and low inflation could offset fiscal consolidation, delaying the reduction in the debt ratio. If these risks materialize, the likelihood that public debt will be put on a firm downward path over the medium term would be reduced.

The current rating levels are supported by the government’s commitment to fiscal consolidation, as reflected in a relatively good budgetary position compared with its Euro area peers, as well as progress in delivering institutional and structural reforms. Italy also benefits from debt servicing flexibility, relatively low private sector debt, a well-financed pension system, and a large economy, which provides resilience.

Compared to its Euro area peers, Italy’s budgetary position is strong. After easing moderately in 2014, Italy’s fiscal consolidation effort accelerated in 2015, when the deficit declined to 2.6% of GDP from 3.0% of GDP in 2014. Moreover, Italy continues to register the highest average primary structural surplus since 2010 (2.8% of GDP) in the Euro area.

Nevertheless, in 2016, following a deviation of 0.75% of GDP granted by the European Commission from the Medium-Term Budgetary Objective (MTO), a more expansionary fiscal stance is expected to result in a higher structural deficit of 1.7% of GDP, compared to 1.0% of GDP last year. At the same time, for 2017, the government has pledged to implement corporate income tax cuts and deactivate the increase in the value-added tax (0.9% of GDP), which it intends to fund with spending cuts.

The government has also made progress in passing structural and institutional reforms aimed at boosting the potential growth of the Italian economy. The key reforms which have been approved or are at an advanced stage include: a reform of the labour market, aimed at increasing flexibility and reducing the segmentation of the work force, an educational reform to raise the quality of education, and a justice reform aimed at strengthening the courts, regulating settlement procedures and overhauling the civil justice system. There has also been progress in implementing the enabling laws of the reform of the Public Administration, aimed at improving public sector efficiency.

The ratings are also underpinned by the relatively high degree of diversification of a large economy. Moreover, net household financial wealth continues to represent a considerable buffer to absorb shocks. Italy continues to benefit from the significant improvement in funding conditions since the end of 2012. This is partly due to ECB bond purchases and other forms of liquidity support, resulting in low bond yields and greater debt servicing flexibility. The average maturity of government debt is 6.5 years, and this has helped to shelter the country from interest rate shocks.

RATING DRIVERS
Approval of the constitutional referendum that paves the way for a streamlining of the legislative branch of government would be credit positive. A timely resolution and reduction in non-performing bank loans and an improvement in banks’ asset quality could also contribute to a return to a Stable trend.

On the other hand, if the constitutional referendum fails to be approved, or the electoral reform is not amended, leading to a period of uncertainty and a stalling of the reform agenda, this outcome could lead to a downgrade. DBRS would view as negative an inability to improve bank balance sheets and create the conditions for the expansion of credit. If a downgrade were to occur, an adjustment of more than one notch is not likely.

If the government were to provide resources to facilitate the reduction in NPLs and the recapitalisation of Italian banks, DBRS would assess the benefits of stronger bank balance sheets against an expected increase in government debt to GDP. If bondholders were required to share in the burden of recapitalising banks, DBRS would assess the benefit of stronger bank balance sheets against a possible increase in political risk and a weaker economy. A worsening of growth prospects, due to either adverse external shocks or weak domestic demand, could also put downward pressure on the ratings.

Notes:
The rating committee discussed the consequences of a possible ‘no’ vote in the constitutional referendum this autumn, and the effect that this might have on the pace of approval of structural reforms. The committee also discussed the current situation of the Italian banking system in light of the fragile recovery.

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. 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, EBA, ISTAT, INPS, 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 to be of satisfactory quality.

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

This rating included participation by the rated entity or any related third party. DBRS had no access to relevant internal documents for the rated entity or a related third party.

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.

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

This rating is under review. Generally, the conditions that lead to the assignment of reviews are resolved within a 90 day period. DBRS reviews and ratings are under regular surveillance.

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Ratings assigned by DBRS Ratings Limited are subject to EU regulations only.

Lead Analyst: Carlo Capuano, Assistant Vice President
Rating Committee Chair: Roger Lister, Managing Director, Chief Credit Officer, Global FIG and
Sovereign Ratings
Initial Rating Date: 3 February 2011
Last Rating Date: 18 March 2016

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