DBRS Confirms Italy at BBB (high), Stable Trend

DBRS Ratings Limited (DBRS) has confirmed the Republic of Italy’s Long-Term Foreign and Local Currency – Issuer Ratings at BBB (high) and Short-Term Foreign and Local Currency – Issuer Ratings at R-1 (low). The trend on all ratings remains stable.

The Stable trend reflects DBRS’s view that the combination of continued progress with fiscal consolidation and higher economic recovery offset the challenges arising from the high public debt, still elevated level of Non-Performing Loans (NPLs) and political uncertainty. Over the last twelve months, economic growth has gathered momentum: Italy is estimated to have grown by 1.5% in 2017, the highest growth rate since 2010, and a similar pace of growth is expected for 2018. Moreover, systemic risk into the banking system receded last year, and further NPLs disposals are expected going forward. In terms of political risk, the new electoral law slightly improves but does not guarantee governability, with the risk of Italy having a hung parliament following the 4 March 2018 elections.

Italy’s BBB (high) ratings are underpinned by its large and diversified economy as well as the government’s progress in fiscal consolidation, as undertaken by successive cabinets. A strong private-sector balance sheet alongside an improvement in the external position and a well-financed pension system also support the ratings.

Despite these strengths, the high public debt ratio and low structural economic growth render the country vulnerable to adverse shocks. Moreover, the level of NPLs, despite the substantial decline in recent months, remains very high, affecting the banking sector’s ability to act as a financial intermediary to support the economy. Furthermore, following the rejection of the constitutional reform in the referendum in December 2016, political uncertainty has increased, although the new government formation, since former PM Renzi’s departure, has made some progress with reforms including the approval of the competition law and the new electoral system.

In DBRS’s view, the outcome of the next election is unlikely to provide a clear winner and a hung parliament could affect the next government stability and in turn the reform agenda as well as the pace of fiscal consolidation. If opinion polls prove correct, no coalition or party will be able to secure an outright majority in both chambers. While the centre-right coalition, comprising Forza Italia (15%), Lega (14%) and Fratelli d’Italia (5%) and others (2%), leads the polls with around 36% of the vote share, the centre-left coalition, including the Democratic Party (24%) and others (4%), trail at around 28%, the same vote share attributed to the Five Star Movement. This means that a grand coalition composed of traditional parties from different blocs, maybe with the indirect or direct support from small parties, could be the most likely outcome. However, such a grand coalition might still have a slim majority, and it is not clear how much scope it could have for structural reform and fiscal consolidation in the medium term.

In the event the parties maintain uncompromising positions and reluctance to convergence to form a government, DBRS does not rule out the possibility of another election, in which case the current PM Mr Gentiloni is expected to be reappointed temporarily, but it remains to be seen if his cabinet will be able to make further progress with reforms. Finally, despite the lower probability, a Five Star Movement–led government in coalition with other non-traditional parties could also occur. In this case, while the stances against the European Union and the euro have recently moderated, doubts on Italy’s fiscal position path remain. All in all, DBRS believes that as long as the economic recovery in combination with fiscal consolidation persist, political uncertainty should weigh less on the sovereign’s creditworthiness.

Italy’s credit profile is supported by progress in fiscal consolidation. The budget deficit has maintained a downward trend over the last few years and is estimated at 2.1% of GDP in 2017, an improvement of 0.9% of GDP since 2014. The country has also maintained a sound primary balance (1.6%, on average, since 2014), which compares favourably with most other euro area countries. Looking at 2018, while the government projects a further deficit decline to 1.6% of GDP, DBRS expects a slower reduction to 1.8%, as the revival of inflation could be lower than projected, constraining nominal GDP growth. At the same time, the approach of striking a balance between fiscal consolidation and supporting growth has resulted in repealing the safeguard clauses over the last years. While DBRS acknowledges the potential recessive effect of the VAT and excise duty increases, it is of the view that further deactivations in the absence of a material reduction in public expenditures, might delay the fiscal adjustment needed to place the public debt ratio on a firm downward path.

Despite Italy’s prudent fiscal stance in recent years, public debt (at 132.0% of GDP in 2016) remains very high and reduces fiscal space because of high interest costs exposing the country to adverse shocks. The European Commission estimates the public debt-to-GDP to have negligibly increased to 132.1% of GDP last year due to the banking support cost (0.9% of GDP) and lower proceeds from privatisations. Over the medium term, DBRS expects the public debt ratio to fall to 128.8% in 2019, at a slower rate than to 127.1% envisaged by the government. This is because more gradual budget deficit decline alongside lower nominal growth, due to weak inflation, could affect the pace of the decline. Nevertheless, the relatively long average-maturity of securities (6.86 years as at September 2017) and the large share of total debt indexed at a fixed rate help to limit the impact of potential shocks on yields. Moreover, the interest bill is expected to continue to decline to 3.6% of GDP in 2018 (compared with 3.8% in 2017), thanks to a still-accommodative monetary policy, which, however, is expected to be less expansionary going forward.

A high degree of diversification coupled with a strong manufacturing sector, which is the second-largest in Europe, is enabling Italy to enjoy a cyclical recovery. Growth has gathered momentum following the double-dip recession after the financial crisis, and now 2018 GDP looks set to expand at 1.5%, the same pace of growth estimated for 2017 which overshot the 1.1% forecast at the beginning of the year. The strengthening of global economic growth alongside the improvement in the labour market (around 345,000 jobs were created over the last twelve months), were the main engines of growth in 2017. This year, investment, supported by the extension of fiscal incentives, might be the key driver. Notwithstanding, the accelerated pace of growth, Italy remains among the worst performers in Europe chiefly because of a still-weak productivity dynamic, which hinders an upturn in future potential growth. This is a fundamental challenge that impacts Italy’s sovereign ratings and reflects low investment in education, research and development, as well as weak competitiveness and low employment rates.

Banking sector made progress throughout 2017, mainly thanks to an improvement in capital as well as a reduction of NPLs and restructuring operations. Moreover, systemic risk receded following the successful execution of UniCredit’s capital increase, government support in the precautionary recapitalisation of Banca Monte dei Paschi di Siena, and the orderly liquidation of Banca Popolare di Vicenza and Veneto Banca. Nonetheless, Italian banks continue to be challenged by the still high stock of NPLs (Gross NPLs ratio at around 14% at end-September 2017), modest profitability in the context of low interest rates as well as a tightening in the regulatory environment. These challenges constraint the ability of the banks to provide credit limiting the upside for economic prospects. In contrast, the private-sector balance sheet is sound, with total debt at 113.6% of GDP in 2016, one the lowest among advanced countries, which mitigates the risk of financial instability.

Italy’s external position has improved over the last few years, with the current account shifting into surplus since 2012 and estimated to reach 2.8% of GDP in 2017, the highest level since 1997. This contributed to the decline of the country’s negative net international investment position to -7.8% of GDP at end-September 2017 from -25% at end-March 2014. As global trade growth remains sustained, external demand should continue to support Italy’s goods trade surplus, although it is expected to slightly narrow as the euro appreciates and energy prices recover. By contrast, the primary income balance is expected to remain in surplus as foreign assets continue to show higher yields relative to domestic ones.

RATING DRIVERS

One or any combination of the following factors would likely lead to a Positive trend: (1) fiscal progress that significantly reduces the debt-to-GDP ratio, or (2) the occurrence of a further meaningful improvement in banking-sector credit quality and (3) receding political uncertainty. Alternatively, (1) a deterioration in fiscal position and (2) a weakening of the government’s commitment to the reform agenda or (3) significant downward revision to growth prospects, leading to a materially higher public debt-to-GDP ratio, could put negative pressure on the ratings.

RATING COMMITTEE SUMMARY

The DBRS Sovereign Scorecard generates a result in the A (high) – A (low) range. Additional considerations factoring into the Rating Committee decision included: (1) Italy's potential growth and low inflation hampering the decline in the public debt-to-GDP ratio (2) difficulty of the banking system in supporting the economy (3) political uncertainty in regard to the progress of structural reforms and fiscal consolidation.

The main points of the Rating Committee discussion included: (1) Potential scenarios after the elections, (2) Italy’s weak potential GDP growth rate (3) Italy’s debt progress in debt-to-GDP ratio decline in light of a less accommodative monetary policy (4) Banking sector progress.

KEY INDICATORS
Fiscal Balance (% GDP): -2.5% (2016); -2.1% (2017E); -1.8% (2018F)
Gross Debt (% GDP): 132.0% (2016); 132.1% (2017E); 130.8% (2018F)
Nominal GDP (EUR billions): 1,681 (2016); 1,715 (2017E); 1,759 (2018F)
GDP per capita (EUR thousands): 27,719 (2016); 28,308 (2017F); 29,040 (2018F)
Real GDP growth (%): 0.9% (2016); 1.5% (2017E); 1.5% (2018F)
Consumer Price Inflation (%, end of period): 0.5% (2016); 0.9% (2017E); 1.6% (2018F)
Domestic credit (% GDP): 113.6 (2016); 114.6 (Q2-2017)
Current Account (% GDP): 2.7% (2016); 2.8% (2017E); 2.3% (2018F)
International Investment Position (% GDP): -9.8% (2016); -7.8% (Sep-2017)
Gross External Debt (% GDP): 123.4 (2016); 123.4 (Q3-2017)
Governance Indicator (percentile rank): 71.6 (2016)
Human Development Index: 0.89 (2015)

Notes:

All figures are in euros (EUR) unless otherwise noted. Public finance statistics reported on a general government basis unless specified. Governance indicator represents an average percentile rank (0-100) from Rule of Law, Voice and Accountability and Government Effectiveness indicators (all World Bank). Human Development Index (UNDP) ranges from 0-1, with 1 representing a very high level of human development.

The principal applicable methodology is Rating Sovereign Governments, which can be found on the DBRS website www.dbrs.com at http://www.dbrs.com/about/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 at http://www.dbrs.com/ratingPolicies/list/name/rating+scales.

The sources of information used for this rating include Ministero dell’Economia e delle Finanze, Banca d’Italia, ISTAT, European Commission, Eurostat, International Monetary Fund, World Bank, United Nations Development Programme 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 and US regulations only.

Lead Analyst: Carlo Capuano, Assistant Vice President, Global Sovereign Rating
Rating Committee Chair: Roger Lister, Managing Director, Chief Credit Officer, Financial Institutions and Sovereign Group
Initial Rating Date: 3 February 2011
Last Rating Date: 14 July 2017

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