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

DBRS Ratings GmbH (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 Negative on all ratings.

KEY RATING CONSIDERATIONS

The Coronavirus Disease (COVID-19) pandemic continues to weigh on Italy’s public finances and prospects for growth. At this stage, there is still little evidence of significant economic scarring that would undermine Italy’s already fragile growth and in turn its debt sustainability in coming years. However, faced with considerable uncertainty over the economic recovery, the trend remains Negative. The next few months are expected to be important in setting the stage for (1) a stronger recovery provided that the vaccine rollout accelerates and/or the country is able to cope with any more vaccine-resistant variants, (2) initiating the reforms outlined in the National Recovery and Resilience Plan (NRRP). Italy’s debt to-GDP ratio came in better than anticipated last year at 155.8% but the government plans to continue to provide support which will likely bring debt close to 160% of GDP in 2021, before gradually declining. DBRS Morningstar is aware that removing support now could be more damaging than prolonging it but further delay in repairing public accounts is not without risks. The public debt is more affordable due to declining interest costs. As the Next Generation EU (NGEU) programme commences, Italy could address some of its structural weaknesses by supporting reform implementation and further increasing public investment. Execution risk is the main challenge but the NRRP if successfully implemented could raise productivity and in turn potential GDP growth, improving debt sustainability.

The confirmation of the BBB (high) rating reflects several factors. Italy benefits from the European Central Bank’s (ECB) current extraordinary financial backstop and is effectively managing the sharp increase in funding requirements with a historical low interest cost. A large part of Italy’s public funding needs is accommodated in the secondary market by the ECB, and in addition a higher flow of interest will likely be returned to the Italian government from the Bank of Italy’s net income related to the ECB’s bond buying programmes. Moreover, Italy has a wealthy and diversified economy, and the manufacturing and construction sector in aggregate have provided signs of resilience so far. With a solid current account surplus and a net international investment position (NIIP) that is positive for the first time in 30 years, the country’s external position is good. At the same time, both households and corporations are facing this shock with one of the lowest levels of private sector debt among advanced countries and the household savings ratio has risen substantially, both of which bode well for releasing pent-up demand once the healthcare situation improves. Italy’s banking system is in a stronger position than in the past in terms of capitalisation and has made progress in reducing markedly net impaired assets, even though the economic fallout of the coronavirus pandemic will affect asset quality.

RATING DRIVERS

An upgrade is unlikely in the near term. However, the ratings could be upgraded if the economic outlook improves dramatically, supporting a very rapid fiscal consolidation and reduction in corporate and financial sector stresses. The ratings trend could return to Stable: (1) if further evidence arises of a successful policy response, for example by revamping public investment and the reform effort and/or (2) downside risks to the near-term economic outlook materially diminish.

Ratings could be downgraded if one or a combination of the following factors should occur (1) prospects for a sustained economic recovery weaken (2) the government shows significant lower commitment to reduce the debt-to-GDP ratio in the medium term (3) a crystallisation of a sizable amount of contingent liabilities and/or a substantially lower than expected EU resources’ disbursements within the NGEU, leading to a material deterioration in public accounts.

RATING RATIONALE

The Rise in Infections Interrupted the Recovery but Resilient Manufacturing and Construction Sectors and NGEU Opportunity Provide Comfort

A high degree of economic diversification, coupled with a strong manufacturing sector and a wealthy economy, support the ratings. Italy also benefits from a GDP per capita of around USD 31,300 in 2020 that compares well with rating peers. Prior to the outbreak, the country’s real GDP had not yet recovered to its 2007 level, and the impact of the pandemic has been severe but the outlook now is brighter albeit with considerable uncertainty. Compared with the previous crisis, Italy appears better equipped to recover rapidly thanks to a resilient manufacturing and construction sector, a supportive fiscal stance along with sizeable EU resources.

After the sharp GDP fall in the first half of last year, the rapid rebound of 15.8% quarter-on-quarter in Q3 2020 was interrupted by a new set of restrictions in the Autumn, causing economic activity to contract by 1.8% in Q4 2020. This translated into an overall GDP drop of 8.9% for the whole of 2020. While consumption remains weak largely because of the economic restrictions, business investment is holding up and this is positive for recovery and growth potential in the medium term. It is likely that the manufacturing and the construction sector in aggregate will recover more strongly than the service sector, which remains heavily affected by restrictions but is less capital intensive, with low entry barriers and could recover, albeit gradually, once the pandemic is under control. This limits significant risks to economic scarring.

The Italian Statistical office (ISTAT) estimates a contraction in economic activity by 0.4% quarter-on quarter in Q1 2021 but GDP is expected to start recovering significantly in Q3 this year. The government projects GDP to grow by 4.5% and 4.8% in 2021 and in 2022, respectively, thanks to a gradual lifting of restrictions from the end of April, with the expectation of vaccinating around 80% of the population by Autumn this year, and with the support of fiscal policy. However, DBRS Morningstar sees risks tilted to the downside as the country is now gradually reopening the economy with intensive care units still at relatively high occupancy levels and a large share of people between 60 and 79 years of age not yet vaccinated. At the same time, the spread of new and more vaccine-resistant variants could lead to new lockdown measures. DBRS Morningstar will monitor the evolution of the pandemic and how Italy copes with a possible new wave of infections later in the year. This would undermine the recovery, require additional fiscal support, and amplify risks of a prolonged loss in production capacity.

Government support to the labour market remains in place and the fall in employment, although severe, has been contained compared with the drop in GDP. This is costly for public accounts but it has so far provided a significant safety net. According to the Bank of Italy, 400,000 permanent jobs were protected in 2020 by government measures. By prolonging short-time working schemes, the government in parallel has extended the full freeze on dismissals until June and selectively until the end of the year. This should prevent a large share of low-skilled workers in sectors highly affected by the restrictive measures from fueling long-term unemployment or inactive workers in coming months that could weigh on the recovery and on potential growth. But at the same time, this is constraining the restructuring process of firms, making the labour market more rigid. DBRS Morningstar will monitor labour market developments and how these affect Italy’s recovery.

That said, Italy’s growth prospects are more favourable compared with previous shocks and increasing investment and implementing reforms with the support of the EU’s large resources represent a significant opportunity for the country. Moreover, this shock does not reflect particular imbalances and previous crises have been quite selective for firms, leaving the corporate sector stronger in aggregate. Italy’s GDP growth should benefit from EUR 153.9 billion of additional new resources (8.6% of 2019 GDP) to allocate for projects included in the NRRP. The Italian government has the opportunity to revive economic growth by increasing public investment, reducing red tape, effectively improving market competition, the management of the public administration and justice system, along with the announced tax reform. This could enable Italy to tackle some of the structural weaknesses that have undermined its GDP growth potential in the past and weigh on the qualitative assessment on the “Economic Structure and Performance” building block. DBRS Morningstar will continue to monitor Italy’s perspectives and further progress with public investment as well as with reforms.

The Improvement in the Fiscal Trajectory is Highly Dependent on the Pandemic and on Government Support Measures

Despite a prolonged weak economic performance, Italy’s past fiscal profile has on average seen primary surpluses higher than the majority of euro area countries since 1992. Nevertheless, in pre-pandemic years progress in reducing the fiscal deficit was very gradual and the impact of the pandemic caused the public accounts to markedly deteriorate. Since October 2020, the economic restrictions to contain the spread of the virus are constraining Italy’s growth and the government plans additional fiscal support, which will delay the improvement in the fiscal trajectory. At this stage, DBRS Morningstar acknowledges that still appears less risky to maintain a supportive fiscal stance rather than removing government support too early to contain economic scarring.

Prior to the coronavirus outbreak, the headline fiscal deficit came in better than expected at 1.6% of GDP in 2019, but the fall in nominal GDP and the large support package led the budget deficit to rise substantially in 2020. Nonetheless, a higher flow of revenues along with lower expenditures resulted in a deficit of 9.5% of GDP in 2020, better than anticipated by the government in September 2020 (10.8%). By planning to both continue to provide support to the economy and to expand significantly public investment, the government envisages another increase in the deficit to 11.8% of GDP this year before a reduction to 5.9% in 2022 because of the largely temporary nature of the fiscal expansion. DBRS Morningstar assesses positively the focus on public investment which is expected to increase considerably this year and to narrow the gap with the 2009 level going forward. Nevertheless, DBRS Morningstar considers that the substantial improvement in the deficit in coming years would remain conditional on a rapid economic growth. At the same time, government guarantees, mainly to provide liquidity, increased markedly to around EUR 215 billion in 2020 (13% of GDP) from about EUR 86 billion in 2019 (4.8% of GDP). This caused provisions for claims to rise to EUR 12 billion in the 2020 deficit largely because of guarantees for Small Medium Enterprises (SMEs). Should the economic recovery result be much weaker than expected, a large number of guarantees could be called, weighing on the fiscal trajectory. Moreover, fiscal targets incorporate EU grants, estimated at EUR 68.9 billion from the Resilience and Recovery Facility (RRF) facility, whose disbursement is dependent on achieving milestones agreed in the NRRP. Should Italy not achieve milestones, it risks losing the EU grant payments with an adverse impact on the fiscal position.

The Change in Government Bodes Well for Structural Reforms but Uncertainty Remains in the Medium Term.

Political uncertainty traditionally remains a concern in Italy 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 weak appetite for reforms. Moreover, there is usually little cross-party consensus on how to address structural problems in the context of generally low electoral support for reforms. All these factors contribute to a weak capacity of the government to address economic challenges, implement forward looking policies, and provide support for a negative qualitative assessment of the “Political Environment” building block.

Italy’s government led by Prime Minister Conte collapsed in January 2021. A large but heterogeneous majority is now supporting a new cabinet under the former President of the ECB, Mario Draghi. DBRS Morningstar is of the view (see the commentary DBRS Morningstar: Italy – Draghi Reassures for Now https://www.dbrsmorningstar.com/research/373906/dbrs-morningstar-italy-draghi-reassures-for-now) that this development interrupts a period of high uncertainty and slow policy implementation. The new government provides welcome stability to manage the health crisis, accelerate the rollout of the vaccine, place Italy on a recovery path, and initiate important reforms. The term of Mr Draghi’s government, however, could be limited, but it might have a time window to initiate those measures that could strengthen Italy’s recovery, including important reforms aimed at boosting the country’s potential GDP. Nevertheless, the reform effort will need to continue well beyond this government. The new cabinet is expected to rule at least until the election of the President of the Republic, to be held in early 2022, and Mr Draghi’s election as President is one possibility. In this case, parliamentary elections are likely to be held before the end of the legislative term in March 2023. Despite the more moderate and pro-EU stance from the Five Star Movement and Lega, as the probability of elections increase, frictions within the majority could rise and weaken Mr Draghi’s policies. This would undermine the enacting legislative process of the reforms required for the NRRP.

The Public Debt-to-GDP Ratio Continues to Rise but Debt Service is Expected to Remain Affordable

The public debt-to-GDP ratio, after broadly stabilising since 2016 at around 135% of GDP, because of the impact of the pandemic and the sizeable fiscal package, rose to a record level of 155.8% in 2020. Although the debt increase was lower than the 158.0% anticipated by the government, the country’s vulnerability to further shocks has risen considerably. The large government support package provided this year will likely bring the debt close to 160% of GDP, but its affordability is projected to improve. Moreover, the impact stemming from the NRRP, if effective, is projected to bring the debt on a more sustainable footing. However, debt-to-GDP stabilisation and future reduction in coming years hinge mainly on the assumption the interest costs continue to decline as well as on a more sustained GDP growth trajectory compared with the historical evidence. A clear strategy to reduce fiscal vulnerabilities remains key in light of the reimposition of the EU fiscal framework likely from 2023 onwards as well as future monetary tightening from the ECB.

Nevertheless, Italy’s weighted-average interest service cost is expected to continue to benefit from the ECB’s current extraordinary support. Last year, the new debt issuance average cost reached the very low level of 0.59% with total debt cost declining to 2.4% from 2.5% in 2019. Since January 2021 Italy’s debt average yield at issuance has been 0.11% making the debt more affordable despite the rise in the stock. This reflects also the expectation that the ECB will continue to accommodate a sizable share of Italy’s debt issuances this year despite the further increase in funding needs. Total share of Italy’s public debt held by the euro system will therefore likely increase after reaching 21.7% of Italy’s total public debt as end of January 2021. The ECB’s policy is therefore an important safety net in the near term. The government projects interest costs to continue to decline to 3.3% of GDP this year, before decreasing to 3.0% in 2022. The debt profile remains sound reflecting the relatively long average maturity of securities at 6.96 years in March 2021, and the large share of fixed-rate total debt. These features should help limit the potential impact of shocks on yields, should investor confidence again deteriorate, or monetary policy become tighter.

The Banking System is in a Better Position Than In The Past but a Rise in NPLs is Expected, Although Gradual

Italian banks are stronger than in the past as both credit quality and capitalisation have improved but as the economic consequences of the pandemic unfold asset quality will deteriorate. The rise in NPLs, however, is expected to be manageable and lower than the peak reached after the previous crisis should the economic growth recover rapidly. Past important banking reforms have also led to the development of a secondary market that is expected to facilitate the disposal in NPLs in coming years.

Last year, the combination of high credit growth, further disposal of NPLs, as well as government support measures enabled the gross NPL ratio to remain on a declining trend with the flow of new NPLs still at a pre-financial crisis level. However, despite the significant reduction in the gross NPL ratio to 4.4% as of Q4 2020, down from 18.2% in Q3 2015, the stock remains high and it is expected to increase, particularly when government support measures are withdrawn. Furthermore, some small and medium-size banks, which are implementing restructuring and cost efficiency programmes, are less diversified and still show high levels of impaired assets. These factors are likely to weigh on banking support to Italy’s economy post-pandemic and led to a negative qualitative assessment in the “Monetary Policy and Financial Stability” building block.

In aggregate, government measures have been contributing to support business viability and a further extension is likely. So far, firms funding needs were met with large liquidity thanks to a marked increase in credit growth provided by the banking system on the back of the ECB expansionary monetary policy, debt moratoria and government guarantees. These two last measures have been providing considerable relief offered in sizeable amounts. Total outstanding loans subject to debt moratoria and covered by government guarantees stood at about EUR 158 billion and EUR 167 billion, respectively as of the first week of April 2021. The government plans to further extend, although selectively, the two measures to contain a fast deterioration in credit quality as well as a credit tightening.

As a result of the high credit growth, private debt is rising but remains one of the lowest among advanced countries. nonfinancial corporate debt increased to 77% of GDP in Q4 2020 from 70% in Q1 2020; however, it still remains below the Euro Area average of around 116% of GDP and benefits from favourable financing conditions. In parallel, nonfinancial enterprises have seen a large albeit not uniform increase in deposits by around EUR 76 billion since March 2020 compared with approximately EUR 15 billion in the period between March 2019 and February 2020. Similarly, household debt is one of the lowest in the EU and the savings ratio (the ratio of gross savings to gross disposable income) increased significantly, achieving a record level of 17.5% on average in 2020 compared with around 10% in 2019. This mitigates risks to financial stability.

The Ratings Benefit from Italy’s Sound Goods Export performance, but the Tourism Sector Continues to Struggle

The improvement in Italy’s external position supports the ratings. On the back of a sustained export performance and a sound primary income surplus, the current account surplus has been averaging around 2.9% of GDP over the last five years. This, in turn, has contributed to a persistent decline in the country’s negative NIIP. In September last year, for the first time in thirty years, Italy has returned to being a net external creditor and ended 2020 with a positive NIIP of 1.8% of GDP. This represents a significant improvement since the trough of -25.1% of GDP registered in Q1 2014.

The pandemic appears not to have significantly weakened the resilience of Italian merchandise exports so far, while the contraction in tourist flows has been marked. According to the Bank of Italy, in the twelve months ending in February 2021, the current account surplus amounted to 3.6% of GDP (EUR 59.2 billion) and was supported by a large surplus in the trade balance (EUR 67.3 billion).

A strong impetus in goods exports since May 2020 was accompanied by a slower recovery in imports due to weak demand and lower import prices. This reflected Italian exporters’ ability to maintain market shares by relying on dynamic markets as well as adapting to price and quality competition. The fall in goods exports stood at 1.8% year-on-year in Q4 2020 after the contraction of 28.5% recorded in Q2 2020. Conversely, the deficit in services slightly widened to -0.4% of GDP last year from a balance position in 2019. This is mainly because the travel balance surplus declined to 0.5% in 2020 from 1.0% of GDP in 2019 despite being sustained by domestic tourism in particular during the summer months. DBRS Morningstar believes that Italy’s merchandise exports will continue to recover despite the rise in the price of raw materials and the uncertainty related to the UK’s non-tariff barriers. Services instead are expected to recover in full only in the coming years. As internal demand strengthens with the economic recovery, the current account surplus is projected to narrow but Italy’s external position should remain a key strength for the country’s ratings in the medium term.

ESG CONSIDERATIONS

Human Capital and Human Rights (S) and Institutional Strength, Governance & Transparency (G) are among the key drivers behind this rating action. According to the IMF WEO, Italy’s GDP per capita of USD 31,300 in 2020 was comparatively low with its euro area peers. At the same time, Italy ranks in the 62nd and 69th percentile for Rule of Law and Government effectiveness, respectively in 2019 according to the World Bank indicators. These factors have been taken into account in the “Economic Structure and Performance”, “Fiscal Management and Policy” and” Political Environment” building block.

A description of how DBRS Morningstar considers ESG factors within the DBRS Morningstar analytical framework can be found in the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings at https://www.dbrsmorningstar.com/research/373262.

For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments: https://www.dbrsmorningstar.com/research/377814.

EURO AREA RISK CATEGORY: LOW

Notes:
For more information regarding rating methodologies and Coronavirus Disease (COVID-19), please see the following DBRS Morningstar press release: https://www.dbrsmorningstar.com/research/357883.

All figures are in Euros (EUR) unless otherwise noted. Public finance statistics reported on a general government basis unless specified.

The principal methodology is the Global Methodology for Rating Sovereign Governments https://www.dbrsmorningstar.com/research/364527/global-methodology-for-rating-sovereign-governments
(July 27, 2020). Other applicable methodologies include the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings https://www.dbrsmorningstar.com/research/373262/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings (February 3, 2021).

The sources of information used for this rating include the Ministry of the Economy and Finance (Ministero dell’Economia e Finanza, MEF), MEF – Documento di Economia e Finanza (DEF, April 2021), MEF – Press Release N° 76 del 21/04/2021, Bank of Italy, Bank of Italy – Economic Bulletin (April 2021), Bank of Italy - Balance of Payments and International Investment Position (April 2021), ISTAT – La competitivita’ dei settori Produttivi (April 2021),Ufficio palrmentare di Bilancio (UPB) – Audizione nell’ambito dell’esame del DEF 2021 (April 2021) European Central Bank, European Commission (EC), EC - Assessment of the final national energy and climate plan of Italy (October 2020), Eurostat, BIS, World Bank, UNDP, Haver Analytics, Transparency International, Italy’s NRRP (April 2021), Ministero della Transizione Ecologica, World Economic Forum and Social Progress Imperative. DBRS Morningstar considers the information available to it for the purposes of providing this rating to be of satisfactory quality.

With respect to FCA and ESMA regulations in the United Kingdom and European Union, respectively, this is an unsolicited credit rating. This credit rating was not initiated at the request of the issuer.

With Rated Entity or Related Third Party Participation: YES
With Access to Internal Documents: NO
With Access to Management: NO

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 12-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. DBRS Morningstar understands further information on DBRS Morningstar historical default rates may be published by the Financial Conduct Authority (FCA) on its webpage: https://www.fca.org.uk/firms/credit-rating-agencies.

The sensitivity analysis of the relevant key rating assumptions can be found at: https://www.dbrsmorningstar.com/research/377804.

This rating is endorsed by DBRS Ratings Limited for use in the United Kingdom.

Lead Analyst: Carlo Capuano, Vice President, Global Sovereign Ratings
Rating Committee Chair: Nichola James, Managing Director, Co-Head of Sovereign Ratings, Global Sovereign Ratings
Initial Rating Date: February 3, 2011
Last Rating Date: October 30, 2020

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