DBRS Downgrades Italy to BBB (high), Stable Trend

DBRS Ratings Limited (DBRS) has today downgraded the Republic of Italy’s (Italy) Long-Term Foreign Currency - Issuer Rating and Long-Term Local Currency - Issuer Rating to BBB (high) with a Stable trend from A (low). At the same time, DBRS has confirmed the country’s Short-Term Foreign Currency - Issuer Rating and Short-Term Local Currency - Issuer Rating at R-1 (low) with a Stable Trend. This concludes the Under Review with Negative Implications for all ratings.

The rating action reflects a combination of factors including uncertainty over the political ability to sustain the structural reform effort and the continuing weakness in the banking system, amid a period of fragile growth. DBRS considers that, following the referendum rejecting constitutional changes that could have provided more government stability and the subsequent resignation of Prime Minister Renzi, the new interim government may have less room to pass additional measures, limiting the upside for economic prospects. Moreover, despite recent plans for banking support, the level of non-performing loans (NPLs) remains very high, affecting the banking sector’s ability to act as a financial intermediary to support the economy. In this context, low growth has resulted in lingering delays in the reduction of the very high public debt ratio, leaving the country more exposed to adverse shocks.

A deterioration in the “Monetary Policy and Financial Stability” and the “Political Environment” sections were the key factors in the downgrade. The Stable trend reflects DBRS’s view that Italy’s challenges are commensurate with the BBB (high) ratings and are balanced by the country’s strong commitment to fiscal consolidation and evidence of some, albeit very modest, economic recovery.

The new interim government, although supported to some extent by the same majority as the Renzi government, may have less room to make progress with growth-enhancing measures, as it was formed with the main aim of facilitating parliamentary discussion on the electoral law before political elections scheduled to be held in 2018. Furthermore, the risk of an early election remains, especially after a decision is made by the Constitutional Court on the electoral law, expected in late January 2017. This decision could affect the duration of Prime Minister Gentiloni’s cabinet. Political parties could immediately put more pressure for snap elections in the first half of 2017, using the electoral law produced by the decision of the Court. This pressure would be expected to capitalise on the result obtained in the referendum in December 2016.

However, there is also a lack of clarity over the timing of elections. DBRS considers that the next election is unlikely to be held before Autumn 2017, as the parliamentary discussions on the electoral law are likely to take time. DBRS also considers that the next electoral law is likely to have a higher proportional characteristic, increasing the chances of having a coalition government of mainstream parties and lowering the electoral chances of Euro-sceptic parties. Nevertheless, support for the opposition parties could increase if economic conditions were to not improve, especially for the young and the long-term unemployed.

Despite a slight decline in the stock of impaired assets since December 2015, uncertainty regarding the asset quality of the banking system continues to affect both investor appetite for bank capital and the ability of banks to act as a financial intermediary to support the economy via the credit channel. Although the Italian government has implemented several measures to facilitate the disposal of NPLs, these have so far had limited effectiveness and the weakness in the banking sector remains a factor in the rating. Moreover, while the decision to set up a Fund of EUR 20 billion (1.2% of GDP) to support ailing banks is a good start, it does not completely remove uncertainty about the vulnerability of the Italian banking system, nor does it clearly pave the way for a significant reduction in the high level of NPLs.

Over the last decade, Italy’s economic growth has been generally flat and lower than the euro area average. Growth potential remains weak. The need to improve growth performance is a fundamental challenge that affects the country’s ratings. Total factor productivity growth has been fragile and corporate profits have been weak. Feeble growth and weak competitiveness are likely the result of the low productivity of labour and capital, low employment rates and low investment in education and research & development.

The elevated level of public-debt-to-GDP continues to limit fiscal flexibility and hamper economic activity. Since 2008, government debt has continued to rise each year. In accordance with the Draft Budgetary Plan, the government projects a reduction of public debt in 2017, but following its decision to support banks, public debt could breach 133.0% of GDP instead of declining to 132.6%. This will likely further postpone the decline by one year to 2018. This high debt level makes the country more exposed to shocks.

Italy’s BBB (high) ratings are underpinned by the government’s commitment to fiscal consolidation, as reflected in a relatively good budgetary position compared with its euro area peers. Italy also benefits from demonstrated debt-servicing flexibility, relatively low private sector debt, a well-financed pension system and a large and diversified economy.

Italy’s credit profile is also supported by progress in fiscal consolidation achieved since 2009. According to the government, the budget deficit is expected to continue declining in 2017 to 2.3% of GDP, the lowest level in ten years.

Moreover, Italy continues to benefit from a significant improvement in funding conditions since the end of 2012, supported by measures taken by the ECB. Yields on ten-year Italian sovereign bonds, despite a slight increase in past weeks, continue to remain below 2%. Italy has also demonstrated debt-servicing flexibility during the crisis by maintaining a strong domestic investor base, which held 66.6% of government debt in September 2016 compared with 56.7% in 2010. At the same time, the average maturity of government debt has remained moderately high at 6.76 years.

Also underpinning the rating is Italy’s large and diversified economy. Importantly, this economy has generated a current account surplus since 2013, which amounted to 2.7% of GDP in October 2016. An important feature of the economy is that private debt (117% of GDP in 2015) is among the lowest in advanced countries and compares favourably with the European peer average (148% of GDP).

RATING DRIVERS
If weaker political commitment to fiscal consolidation and the reform agenda or a significant downward revision to growth prospects were to materialize, further delaying a steady decline in the public debt-to-GDP ratio, this weakening could lead to a Negative trend. On the other hand, progress on the fiscal side that was leading to a significant reduction in the debt-to-GDP ratio combined with the emergence of a strong structural reform effort and/or the occurrence of a meaningful improvement in banking sector credit quality, this would likely lead to a Positive trend.

Notes:
The key points discussed in the Rating Committee included political uncertainty, vulnerability in the banking system and debt dynamics amid a weak economic recovery.

All figures are in euros 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 Ministry of Economy and Finance (MEF), Banca d’Italia, ISTAT, European Commission, Eurostat, ECB, IMF 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 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 12-month period. DBRS’s outlooks and ratings are under regular surveillance.

For further information on DBRS historical default rates published by the European Securities and Markets Authority (“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: 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: 5 August 2016

DBRS Ratings Limited
20 Fenchurch Street
31st Floor
London
EC3M 3BY
United Kingdom
Registered in England and Wales: No. 7139960

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