DBRS Confirms Italy at BBB (high), Stable Trend

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

Italy’s ratings are supported by its large and diversified economy as well as the government’s progress in fiscal consolidation demonstrated by successive governments, resulting in a relatively good budgetary position over the last few years. Italy also benefits from a demonstrated public debt-servicing flexibility, strong private-sector balance sheet and a well-financed pension system. However, political risk has increased since the rejection of the constitutional referendum in December 2016, and high public debt and low structural economic growth render the country vulnerable to adverse shocks. Moreover, 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. The Stable trend reflects DBRS’s view that the combination of the continued progress with fiscal consolidation and a moderate recovery balance the challenges arising from the high public debt and weak banking system.

The Italian economy is the third-largest in the euro zone and it is highly diversified. A slowdown in imports coupled with an improvement in export performance has led the country to generate current account surpluses since 2013. It peaked in 2016 at 2.6% of GDP, the highest level since 1997.

Italy’s credit profile is also supported by progress in fiscal consolidation. The budget deficit improved by 0.3% of GDP on average over the last two years, achieving 2.4% of GDP in 2016. The country also maintained high average primary surplus of 1.4% of GDP over the last six years. This compares favorably with most euro zone members. According to the government, the budget deficit is expected to continue to narrow in 2017 to 2.1% of GDP. In 2018, DBRS expects a further deficit reduction to 1.8% of GDP, slower than indicated in the Stability Programme (1.2% of GDP) in April 2017.

The economy has benefited from low funding conditions since the end of 2012, supported mainly by the European Central Bank’s (ECB) policies. Average sovereign yield at issuance bottomed out at 0.55% in 2016 and, despite an increase over the last few months, remained very low at 0.80% in June this year. Italy has also demonstrated debt-servicing flexibility during the crisis by maintaining a strong domestic investor base, currently holding 68.4% of government debt compared with 58.3% in March 2010. At the same time, the average maturity of government debt is 6.89 years, a comfortable level. In addition, the economy is supported by a strong private balance sheet with private debt at 118% of GDP in 2016, among the lowest in advanced countries.

Despite these strengths, Italy faces very important challenges. The rejection of the constitutional referendum and the subsequent resignation of Prime Minister, Matteo Renzi, opened a period of political uncertainty affecting government stability. However, following Mr. Renzi’s resignation, the current government (under the former Foreign Affairs minister, Paolo Gentiloni), despite its slim majority is expected to complete its full legislative term to Spring 2018. This is because the likelihood of holding early elections in the second half of this year has been reduced due to divergent views about the details of a new electoral law that could have lowered the chance for small parties entering the parliament.

If polls prove correct, the current proportional electoral system is likely to generate a hung parliament. Recent polls indicate that the centre-left Democratic Party (PD) and the anti-establishment Movimento Cinque Stelle (M5S) will be the two main contenders, both at around 28%. Despite poor results in the recent local elections, DBRS believes that M5S could be the largest party in the next political election; however, it could be short of a majority in both houses unless it is supported by other parties, which remains unlikely thus far. Instead, DBRS anticipates that a coalition among mainstream parties could have a better chance of forming a government, although this will bring challenges.

The European Commission’s greenlight on the precautionary recapitalisation of Banca Monte Dei Paschi di Siena, and the orderly wind-down of two smaller banks in the Veneto region significantly reduces contagion and systemic risk. DBRS believes that despite the total initial cost amounting to EUR 10.2 billion (0.6% of GDP), plus up to EUR 12 billion (0.7% of GDP) of guarantees provided for the two Veneto banks, these operations improve the confidence in the banking system which is critical for GDP growth and Italy’s creditworthiness. Moreover, the success of the two transactions is expected to translate into a significant reduction of the stock of gross non-performing loans which reached EUR 349 billion (21% of GDP) at the end of 2016. However, additional measures could be necessary in the future. A number of small and medium-sized banks could continue to be under pressure in generating profits, raising capital, and disposing of impaired assets in a challenging regulatory and market environment.

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

The elevated level of public debt-to-GDP continues to limit fiscal flexibility and hamper economic activity. Since 2008, government debt has increased each year, although at a very low rate in the last two years. Banking support and weak nominal GDP could lead public debt ratio to breach the 133.0% level of GDP in 2017. This will postpone the decline by one year to 2018, leaving the country exposed to adverse shocks and limiting the room for countercyclical policies.

RATING DRIVERS
A deterioration in fiscal position and a weakening in the government’s commitment to the reform agenda or a significant downward revision to growth prospects, leading to a materially higher public debt-to-GDP ratio, could put negative pressure on the ratings. Alternatively, fiscal progress that significantly reduces 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, would likely lead to a Positive trend.

Notes:

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: Ministero dell’Economia e delle Finanze, Banca d’Italia, ISTAT, European Commission, Eurostat, UNDP, ECB, IMF, Demos, Ixe’, Demopolis, Ipsos, SWG, Piepoli, Bidimedia, EMG, Lorien, IPR, 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 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.

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: Alan G. Reid, Group Managing Director, Financial Institutions and Sovereign Group
Initial Rating Date: 3 February 2011
Last Rating Date: 13 January 2017

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