DBRS Confirms Italy at BBB (high), Stable Trend

DBRS Ratings Limited (DBRS) 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.

KEY RATING CONSIDERATIONS

The confirmation of the BBB (high) ratings and Stable trend reflects DBRS’s view that Italy’s economic and financial fundamentals are gradually improving, including the health of the banking system, offsetting elevated political risks. Expected deviations from current fiscal targets due to the new political agenda are unlikely to weaken significantly public debt sustainability. Major fiscal measures, intended to revamp growth, are expected to be implemented gradually and prudently. Though there is a lack of clarity about offsetting fiscal measures, market discipline reinforced by institutional constraints, including the constitution and European Union (EU) fiscal framework are likely to mitigate the risk of material deterioration in Italy’s fiscal position.

Italy is the second-largest manufacturing country in Europe, and since 2011 its current account position has improved significantly with a surplus of 2.8% of GDP in 2017. Economic growth is projected to slow modestly to 1.3% this year, mainly due to lower external demand, but would remain higher than the 1.1% average growth rate registered over the last three years. Political uncertainty has increased following the election in March 2018, and a new political platform brings a risk of reversing some structural reforms, with potentially adverse implications for growth. Nonetheless, Italian banks’ credit quality continues to improve, with further non-performing loans (NPLs) disposals expected going forward.

RATING DRIVERS

One or any combination of the following factors would likely lead to upward pressure on the ratings: (1) fiscal consolidation that significantly reduces the government debt-to-GDP ratio; (2) continued improvement in banking sector credit quality; or (3) continued implementation of reforms to support medium-term growth prospects. Downward pressure on the ratings could emerge if (1) government policy decisions result in significantly larger structural fiscal deficits or (2) significant downward revision to growth prospects occurs, leading to a materially higher public debt-to-GDP ratio.

RATING RATIONALE

Fiscal Deficit Likely to Increase, but no Likely Material Deterioration in the Public Debt-to-GDP Ratio Trajectory

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 in 2017 amounted to 2.3% of GDP, or 1.9% excluding supportive measures to the banking sector. Except for 2009, the primary fiscal balance has been in surplus since 1992, and at 1.5% of GDP on average since 2014, compares favourably with most other euro area countries. This year, assuming no-policy changes and despite a slowdown in the economic growth rate, the fiscal deficit is projected to fall to 1.7% of GDP. This level is, however, slightly higher than the 1.6% of GDP indicated in the stability programme as defined by the previous government.

The new government’s fiscal agenda is likely to be less expansionary than indicated in the governing contract. Proposed measures include mainly a dual tax rate for corporates and personal income, a citizenship and pension income, a revision to the pension reform and the deactivation of the safeguard clauses. In DBRS’s view, the latter, which accounts for 0.7% of GDP, is likely to be implemented as the government may want to avoid the potential recessive effect on consumption in 2019 due to the pre-legislated VAT increase. The remaining measures are not expected to be implemented immediately and in full without offsetting deficit measures, and the government now appears more willing to pursue these policies as objectives during the five-year legislature rather than as imminent priorities. If the measures were implemented more rapidly and in full, this might result in a significantly higher fiscal deficit with a potential severe implication for debt sustainability. Recent discussions suggest that the government might focus more on revamping public investment, with the expectation of a high fiscal multiplier, to boost both short-term and potential economic growth.

The fiscal trajectory will be reassessed with the update to the stability programme and with the presentation of the budget law in Autumn this year. DBRS does not expect the fiscal deficit to exceed the 2.5-3.0% of GDP range in 2019-2020. This does not differ significantly from the 2.3% of GDP recorded in 2017, though it could entail a slightly larger change in the structural fiscal position. Market discipline and institutional constraints are likely to mitigate the risk of a material deterioration in Italy’s fiscal position. Higher sovereign funding costs could reduce the advantages associated with expansionary policies if no offsetting fiscal measures are taken. In addition, the government will face pressure to adhere to constitutional and EU fiscal rules supporting a balanced government budget through the economic cycle.

Since 2014 Italy’s public debt ratio has stabilised, but at 131.8% of GDP in 2017 it remains very high. This reduces fiscal space because of high interest costs, which expose the country to adverse shocks. DBRS does not anticipate a material deterioration in the public debt-to-GDP path, despite the likelihood of a less conservative fiscal policy. However, the declining trajectory of the public debt ratio might be less steep than previously indicated, and it is yet to be seen whether Italy will benefit from fiscal expansionary measures. Nevertheless, the relatively long average maturity of securities (6.87 years as at June 2018) and the large share of total debt indexed at a fixed rate, help to limit the impact of potential shocks on yields. Moreover, despite the recent increase in the sovereign yield curve, the interest cost is expected to continue to decline this year, although slightly, following the 3.8% of GDP registered in 2017. This slow decline is mainly because the total average interest costs paid on maturing debt remain higher than the total average cost expected to be paid on new issuances. This advantage, however, is expected to gradually narrow especially as monetary policy becomes less accommodative or a further increase in funding cost occurs.

Economic Growth Likely to Slow, but Further Improvement in the Banking System to Continue

A high degree of economic diversification coupled with a strong manufacturing sector, which is the second-largest in Europe, is enabling Italy to enjoy a cyclical recovery. Growth gathered momentum following the double-dip recession after the financial crisis. Real GDP expanded by around 1.1% on average over the last three years, sustained by private consumption and higher exports compared with the 1.5% average rate of contraction recorded in the 2012-2014 period. Favourable financing conditions, the labour market reform and recent supporting governing measures aimed to incentivise investment have contributed to the recovery of total employment, now above the pre-crisis level, and the still gradual capital accumulation. Real GDP, however, remains at 5.5% below the peak registered in 2007 and recent leading indicators point to a slowdown in economic growth. GDP of 1.3% is expected this year as lower external demand, higher energy prices and political uncertainty weigh on net exports and domestic demand. In addition, potential economic growth is constrained by weak productivity. This is a fundamental challenge that impacts Italy’s sovereign ratings. It reflects low investment in education, research and development, weak competitiveness in the service market, high taxes, and the small size of firms.

The banking sector made progress throughout 2017, mainly due to an improvement in capital, the reduction in the stock of NPLs and various restructuring measures. This progress led to a significant reduction in systemic risk demonstrated by 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. According to the Bank of Italy, total NPL disposals and write-downs reached EUR 35 billion last year (up significantly from only EUR 8 billion in 2016), which is around 10 percent of the total stock at the end of 2016. Further transactions are projected to be completed going forward benefiting from the government guarantee scheme, which is expected to be extended by another six months.

In this context, DBRS anticipates the improving trend in Italian banks to continue, although there is potential for a reversal of some measures, including the reform of the cooperative banks. The strengthening of the banking system is expected to remain a priority. DBRS projects the Italian NPL ratio to continue to decline in the medium to long term from the level of 14.5% at end-2017 towards the EU average, which amounted to 4% in the same period. The elevated stock of NPLs, alongside modest profitability and tighter regulation, constrain the ability of the banks to provide credit, although some signs of an acceleration in credit lending have been recorded since early 2018. Against this background, non-financial private-sector debt at 113.9% of GDP in 2017, is one of the lowest among advanced countries, and mitigates the risk of financial instability.

A Sound External Position Supports the Ratings

Italy’s external position has improved over the last few years, but risks are tilted to the downside. The current account has been in surplus since 2012 and reached 2.8% of GDP in 2017 — the highest level since 1997. This improvement contributed to the decline of the country’s negative net international investment position (NIIP) to -8.5% of GDP at end-March 2018 from -24.7% at end-March 2014. Looking forward, potential escalation in protectionist policies and the subsequent slowdown in global trade along with higher energy prices might likely weigh on Italy’s current account. The U.S. is Italy’s third-largest trading partner, so an escalation in tariffs between the U.S. and the EU would impact Italian exports and in turn Italy’s external position.

Increased Political Uncertainty Related to the Current Government’s Longevity and its Policy Implementation

Political uncertainty has further increased following the inconclusive election in March 2018 and the subsequent agreement to form a government between the two main anti-establishment parties: Lega and the Five Star Movement. This is because the new agenda seems not to suggest a continuation in growth-enhancing reforms that would be supportive for Italy’s potential GDP dynamic. By contrast, it entails a risk of a reversal of some structural policies, including the 2011 pension reform. However, DBRS does not expect a complete or substantial reverse of the progress achieved so far and remains of the view that, despite some Eurosceptic elements in the government platform, the risk of Italy leaving the euro area is still very low. Potential renewed Euroscepticism will likely be limited by concerns regarding adverse market reactions. Moreover, according to article 75 of the constitution, referenda on international treaties, including EU treaties, are not allowed.

The likely policy moderation compared with the ambitious policies announced during the electoral campaign, along with the relatively small majority in the Senate, cast doubt on the longevity of the government. Moreover, a firm foreign policy on immigration is leading Lega to no longer be perceived as the junior coalition partner, with opinion surveys indicating that both parties could receive around 29% of votes. In this context, should the two parties pursue their own priorities aimed at keeping high their own electoral support, potential frictions within the government might arise.

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 low potential growth, which hampers its ability to reduce the public debt-to-GDP ratio; and (2) Political uncertainty constraining the progress of structural reforms and fiscal consolidation.

The main points discussed during the Rating Committee include (1) fiscal implications of the new government’s agenda (2) growth prospects and progress on structural reforms, and (3) Italy’s stance towards EU authorities.

KEY INDICATORS

Fiscal Balance (% GDP): -2.3 (2017); -1.7 (2018F); -1.7 (2019F)
Gross Debt (% GDP): 131.8 (2017); 130.7 (2018F); 129.7 (2019F)
Nominal GDP (EUR billions): 1,717 (2017); 1,767 (2018F); 1,811 (2019F)
GDP per capita (EUR thousands): 28,359 (2017); 29,189 (2018F); 29,921 (2019F)
Real GDP growth (%):1.5 (2017); 1.3 (2018F); 1.1 (2019F)
Consumer Price Inflation (%, eop): 1.3 (2017); 1.4 (2018F); 1.6 (2019F)
Domestic credit (% GDP): 115.3 (2016); 113.9 (Dec-2017)
Current Account (% GDP): 2.8 (2017); 2.6 (2018F); 2.4 (2019F)
International Investment Position (% GDP): -6.7 (Dec-2017); -8.5 (Mar-2018)
Gross External Debt (% GDP): 123.2 (2016); 124.2 (Dec-2017)
Governance Indicator (percentile rank): 71.6 (2016)
Human Development Index: 0.925 (2015)

Notes:
All figures are in euros (EUR) unless otherwise noted. Public finance statistics reported on a general government basis unless specified. General Government balance and General Government debt are presented according to Maastricht definition. 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, EBA, Eurostat, IMF, World Bank, UNDP, 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: 12 January 2018

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