DBRS Morningstar Confirms Republic of Italy at BBB (high), Stable Trend

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

KEY RATING CONSIDERATIONS

The confirmation of the Stable trend reflects DBRS Morningstar’s view that Italian banks’ progress with improving credit quality and the Italian government’s more moderate fiscal strategy mitigate risks for debt sustainability, despite the country’s still high level of political uncertainty and stagnating economic growth. Recent decisions from the European Central Bank (ECB) indicating a more accommodative policy stance and the expectation of a less confrontational relationship between the new Italian government and European Commission (EC) have shored up investor confidence. Perceived risks regarding Italy’s departure from the euro zone have reduced markedly and this is reflected in a sharp decline in sovereign spreads and public debt funding costs. This improves debt sustainability and increases Italy’s fiscal space, albeit at the margin.

Lega’s decision to withdraw from the government in August paved the way for an unexpected majority, which avoided early elections, with the aim of cancelling the already legislated VAT hike in 2020 and preventing a right-wing government. However, so far there is little evidence of a material discontinuity with the previous government regarding the implementation of structural reforms, and challenges remain given that the fiscal outlook remains complex. It is unlikely that the current government will serve the full term until 2023, but presidential elections in 2022 along with Lega’s strong lead in the polls might represent two important disincentives preventing the ruling parties from bringing down the government.

The country’s BBB (high) ratings are underpinned by its large and diversified economy, low private sector debt and sound external position. Italy is the second-largest manufacturing economy in Europe and benefits from a current account surplus of 2.9% of GDP and a net international investment position (NIIP) that is close to balance. Private sector debt is one of the lowest among advanced economies and reduces risks to financial stability. Moreover, Italian banks are expected to continue to register progress in the reduction of non-performing loans (NPLs), making the banking system more resilient to shocks.

RATING DRIVERS

Upward pressure on the ratings could emerge if (1) successful reform efforts lend support to medium-term growth prospects or (2) fiscal consolidation significantly improves the trajectory of the government debt-to-GDP ratio. One or any combination of the following factors would likely lead to downward pressure on the ratings: (1) a significant downward revision to growth prospects, leading to a materially higher trend for the public debt-to-GDP ratio; (2) further fiscal relaxation combined with substantial higher interest costs that put significant upward pressure on the public debt-to-GDP ratio; or (3) evidence that the authorities are further rolling back implementation of past structural reforms.

RATING RATIONALE

New Government Formation Reassures but a More Fragmented and Slimmer Majority is a Source of Uncertainty

Despite a new government, political uncertainty remains a concern and weighs on the ratings. In DBRS Morningstar’s view, this reflects both a structural feature of the Italian political system characterised by the frequent change in governments and the recent political rhetoric which appears incompatible with a coherent and affective reform effort. Moreover, there is little cross party consensus on how to address structural problems. All these factors contribute to affecting the capacity of the government to address economic challenges and led to a negative adjustment in the “Political Environment” building block.

The latest constitutional amendment, which points to a reduction in the number of MPs will generate limited savings and is subject to a potential confirmative referendum. In DBRS Morningstar’s view, it does not improve the functioning and the governance of parliament, which continues to be burdened by a complex legislative process. That said, the new government, the fourth in about four years and composed of the Five Star Movement (M5S), the Democratic Party (PD), ex-Prime Minister Matteo Renzi’s “Italia Viva” party and other smaller parties/groups, is expected to show a more conciliatory and constructive tone with EU authorities, removing doubts regarding Italy’s continued membership of the eurozone. This bodes well for Italy’s credibility and strengthens investor confidence. However, although the new agenda appears to have shifted towards more moderate policies than under the previous government, appetite for structural reforms appears weak, as the current majority requires more compromise and the risk of early elections remains present. Current polls point to Lega having a strong lead, at about 34%, while the PD and M5S trail at around 19% and 18%, respectively. The government is supported by a slim and fragmented majority and further internal divisions, frictions among parties and the outcome of the regional elections might influence the longevity of the government.

The New Government’s Fiscal Strategy Appears More Moderate, but Uncertainty Remains

Italy’s credit profile is supported by persistent government budget primary surpluses. Excluding 2009, the primary fiscal balance has been in surplus since 1992, and currently stands at around 1.5% of GDP on average since 2014. Going forward, however, the fiscal outlook remains uncertain despite the new government’s more moderate fiscal strategy.

DBRS Morningstar positively sees recent decisions from the Italian authorities not to derail the fiscal trajectory from the commitment, although very gradual, to progress further with fiscal consolidation. This follows both the decision during the summer to adopt a fiscal correction of EUR 7.6 billion (0.4 % of GDP) as well as the new government’s fiscal strategy, which by abandoning the introduction of a “flat tax” results in a more reliable fiscal trajectory. In addition, the new government intends to have a more stable relationship with the European Commission with regard to respecting the EU’s fiscal framework and projects a budget deficit of 2.2% of GDP this year, the same level registered in 2018, and an improvement in the structural deficit of 0.3 percentage points of GDP.

According to the 2020 Budget Law, the government plans the budget deficit to remain at 2.2% of GDP next year, and to cancel the already legislated VAT increase for 2020, equivalent to 1.3% of GDP, mainly with a higher deficit compared with the no-policy change scenario, and additional revenues. These will largely stem from a series of small taxes and increased revenues from tax evasion. DBRS Morningstar assesses positively the reduction of the labour tax wedge in the coming years, despite being very modest at EUR 3 billion and EUR 5 billion from mid-2020 and from 2021 onwards, respectively, but this could be the first step towards a more comprehensive tax reform. On the other hand, the spending review points to only a reduction of 0.1% of GDP, which appears not to be very ambitious even though the government plans also to freeze EUR 1.0 billion in 2020 as safeguard clause to limit expenditure growth.

Going forward, the government projects the headline deficit at 1.8% of GDP and 1.4% in 2021 and 2022, respectively. These targets are mainly underpinned by higher revenues, as well as low funding costs that are expected to more than compensate rising current expenditures. However, further reliance on VAT increases (1.0% of GDP in 2021 and 1.3% in 2022) and higher inflation, represent the main element of uncertainty. While higher inflation is unlikely to materialize when economic performance is weak, the government has frequently deactivated VAT increases leading to higher fiscal deficits in the past and this could occur again. This places pressure on Italian authorities to find additional measures to avoid a potential recessive impact on consumption and continue with fiscal consolidation mindful of the economic cycle.

Public Debt-to-GDP Ratio Expected to Rise Modestly in Coming Years but Implicit Interest Costs Will Fall Further

The public debt-to-GDP ratio is very high and makes Italy vulnerable to shocks. Following the statistical revision last September, the government estimates public debt to increase to 135.7% of GDP this year from the 134.8% (previously thought to be 132.2%) registered in 2018, mainly as a result of the cancellation of planned privatisations (1.0% of GDP) and lower nominal economic growth. The revision, due to the redefinition of the scope of the general government and to accounting changes for postal saving bonds, does not impact the deficit as the accrued interest of these bonds were already accounted.

Looking forward, the Italian authorities project a gradual decline of the debt ratio to 131.4% of GDP in 2022 on the assumption of a higher primary balance, a continuation in the decline in funding costs as well as stronger nominal growth. This is highly dependent on both market conditions and cyclical recovery as well as on the ability of the government to compensate for the likely repeal of further VAT increases in coming years. DBRS Morningstar anticipates the debt ratio to rise modestly in 2020 and in 2021 and then to broadly stabilize at around 136% of GDP as the commitment for making progress on fiscal consolidation appears weak when economic growth remains fragile. Should Italy’s economic performance deteriorate more than expected and be accompanied by a more material fiscal relaxation to support the economy, DBRS Morningstar does not rule out further substantial increases in the public debt-to-GDP ratio that could further weigh on the ratings.

On the other hand, DBRS Morningstar views the improvement in the interest rate profile as positive for Italy’s public debt sustainability. The 10-year sovereign spread versus the German Bund has declined to around 160 bps from the 240 bps registered at the beginning of August. The fall in interest costs reinforces Italy’s ability to service its public debt reducing the impact of the snow-ball effect on the debt in absence of shocks. The government estimates that the decline in interest rates will bring total interest costs to 3.4% of GDP this year and 2.9% in 2022 from the 3.7% registered in 2018. Similarly, the implicit interest cost of around 2.58% as of October 2019 will likely further decline. At the same time, the relatively long average maturity of securities (6.87 years as at October 2019) and the large share of fixed-rate total debt should help limit a potential impact of shocks on yields, should investor confidence again deteriorate, or monetary policy become tighter. These factors reflect enough financing flexibility such that to lead to a positive adjustment in the “Debt and Liquidity” building block.

The Economy is Stagnating, but Progress in Strengthening the Banking System Continues

A high degree of economic diversification, coupled with a strong manufacturing sector, support the ratings. However, after a 2018, when growth stalled, Italy’s economy is struggling to recover, with latest estimates pointing to a marginal increase of real GDP of 0.3% year-on-year in Q3 2019. The government views that the high resilience of the external sector would compensate for weaker domestic demand and the sharp drag of inventories this year. These have reflected the slowdown in the manufacturing sector as well as both domestic and external uncertainty. Although DBRS Morningstar expects more resilient private consumption because of the full impact of the social transfers implemented this year, economic growth is projected to remain subdued in both 2020 and 2021 as weaknesses in the labour market are intensifying. The EC estimates that Italy’s output will expand on average by 0.6% in the same period, and risks are tilted to the downside. In DBRS Morningstar’s assessment, these are mainly external in nature and they include both higher tariffs on the auto sector and the U.K.’s still possible disorderly departure from the EU. Long-term growth prospects remain fragile because of the weak structural growth of the Italian economy mainly due to sluggish productivity dynamics and a poor demographic trend. This affects debt sustainability significantly and led to a downward adjustment in the qualitative assessment of the “Economic Structure and Performance” building block.

By contrast, the banking system continues to make progress in reducing the stock of its NPLs, and this bodes well for the ratings. According to the Bank of Italy, in Q2 2019 the total gross NPL ratio was 8.1%, down from around 18.2% in Q3 2015 and net bad loans declined by around 20% in the last twelve months. DBRS Morningstar expects further improvement in the asset quality, although at a more gradual pace in the future after the significant reduction in past years. The flow of new NPLs has remained moderate so far despite the enduring weakness of the economy in recent quarters, but the high stock of NPLs, however, continues to remain a vulnerability and led to the negative adjustment in the qualitative assessment of the “Monetary Policy and Financial Stability” building block.

Italian banks have benefited from the reduction in the sovereign risk premia with a sharp reduction of the cost of funding. However, the sector´s profitability remains modest, reflecting the low interest environment and high market competition. Despite interest rates remaining at very low levels, credit growth to non-financial corporations remains weak, because of a combination of weak demand and tightened credit supply policies related to higher risk due to the stagnating GDP. In this context, however, risks to financial stability are contained. Total household and non-financial private-sector debt of 110.1% of GDP in Q2 2019 is one of the lowest among advanced economies.

A Sound External Position Supports the Ratings, but Uncertainty over Trade Growth Remains

The improvement in Italy’s external position in recent years supports the ratings. Since 2013, the current account has shifted into surplus and in the 12 months ending August 2019, amounted to 2.9% of GDP - one of the highest levels since 1997. Stronger export performance, reflected in a reversal in the decline in Italy’s market share since 2013, along with the surplus in the income balance, have supported the improvement in the current account position. This, in turn, has contributed to the decline of the country’s negative NIIP, which is close to being balanced (-2.2% of GDP at end-June 2019), following the peak of -25.1% of GDP registered at end-June 2014. Should this trend continue, the NIIP might shift into surplus in 2020.

This year, Italy’s exports, despite the heightened risk stemming from geopolitical tensions and protectionist policy, have performed well. The government projects total export to increase by 2.8% year-on year in 2019 compared with 1.8% registered in 2018. According to Confindustria, the Italian association of firms, Italy’s exporters have been able to adapt to changing international scenarios and have also taken advantage of the opportunities created by the US’s measures to replace Chinese goods. Looking forward, main risk stem from higher US tariffs especially on the car sector, as well as the U.K.’s potential disorderly departure from the EU, and a further slowdown of the European economy, including Germany. However, the improvement in Italy’s external position achieved so far makes the country more resilient to a potential external negative shock compared with past years.

For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments:
https://www.dbrs.com/research/352841.

EURO AREA RISK CATEGORY: LOW

Notes:

All figures are in euros unless otherwise noted. Public finance statistics reported on a general government basis unless specified.

The principal applicable methodology is the Global Methodology for Rating Sovereign Governments, which can be found on the DBRS Morningstar 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, Confindustria, Ufficio Parlamentare di Bilancio, BIS, European Central Bank, IMF, World Bank, UNDP, Haver Analytics. DBRS Morningstar 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 Morningstar had no access to relevant internal documents for the rated entity or a related third party.

DBRS Morningstar 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 Morningstar’s outlooks and ratings are under regular surveillance.

For further information on DBRS Morningstar 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, Vice President, Global Sovereign Ratings
Rating Committee Chair: Chair: Roger Lister, Managing Director, Chief Credit Officer, Global FIG and Sovereign Ratings
Initial Rating Date: February 3, 2011
Last Rating Date: July 12, 2019

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