DBRS Morningstar Revises Italy’s Trend to Stable, Confirms BBB (high) Rating

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 on all ratings has been changed to Stable from Negative.

KEY RATING CONSIDERATIONS

The Stable trend reflects DBRS Morningstar’s view that the improvement in the economic outlook as well as the expected progress with the reforms included in Italy’s National Recovery and Resilience Plan (NRRP) will facilitate the repair of the public accounts over the medium term. Public debt rose sharply to 155.6% of GDP last year from 134.3% in 2019 but its affordability and profile are expected to keep improving. The debt ratio will start to decline this year, sooner than expected, and DBRS Morningstar considers a GDP ratio below 150% by 2023 to be achievable, driven mainly by sustained growth rates and favourable interest costs. Moreover, the country is projected to experience a rapid recovery supported by investments leading to a GDP level in 2023 higher than that projected pre-Covid. The government has started to make progress with public investment and reforms included in its NRRP aimed at raising potential growth. If successful, this would boost economic growth that has historically been weak. Risks to policy continuity in case of snap elections in 2022 are mitigated by the conditions attached to the Next Generation EU (NGEU) funds.

The confirmation of the BBB (high) rating is underpinned by 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. Moreover, Italy has a wealthy and diversified economy, and the manufacturing and construction sectors have continued to demonstrate a high resilience. The current account surplus is one of the largest among the advanced countries and the net international investment position (NIIP) last year returned to positive and continues to grow. At the same time, both households and corporations are facing this pandemic shock with one of the lowest levels of private sector debt among advanced countries. Both household savings and corporate deposits in aggregate have risen substantially, both of which bode well for releasing pent-up demand and investment going forward. Italy’s banking system is in a stronger position than in the past in terms of capitalisation and has made progress in markedly reducing net impaired assets, even though the consequence of the pandemic will affect asset quality in coming years.

RATING DRIVERS

Ratings could be upgraded if one or a combination of the following factors occur (1) fiscal consolidation placing the debt-to-GDP ratio on firm downward trajectory over the medium term or (2) evidence that progress with reforms leads to a higher economic trend growth.

Ratings could be downgraded if one or a combination of the following factors occur (1) economic prospects weaken materially (2) the government shows significantly lower commitment to reduce the debt-to-GDP ratio in the medium term (3) a crystallisation of a sizable amount of contingent liabilities leading to a material deterioration in public accounts.

RATING RATIONALE

A Better Than Expected Post-Pandemic Economic Recovery Bodes Well For The Ratings

A high degree of economic diversification, coupled with a strong manufacturing sector and a wealthy economy, support the ratings. 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 and GDP will likely exceed the pre-pandemic level in 2022, sooner than expected. Compared with the previous crisis, Italy appears better equipped to recover rapidly thanks to a resilient manufacturing sector, high investment in the construction sector, a supportive fiscal stance, pent-up demand, and sizeable EU resources.

This year, the economic recovery has been materially better than the government expected, driven by both the easing of restrictions at the beginning of Q2 2021 and the good performance of investments and consumption. In April, the government expected a GDP recovery of 4.5% in 2021 but economic growth should reach 6.0%, after a decline of 8.9% in 2020. This reflects the overperformance of the manufacturing and construction sectors compared with euro area peers. In the short term, however, the current shortage of inputs, as well as bottlenecks in value chains and higher inflation are likely to weigh on Italy’s economic recovery, but DBRS Morningstar takes the view that this impact will be transitory until the first half of 2022. After years of very low inflation, should it be moderately higher than expected, higher nominal GDP growth would be positive for debt sustainability provided that second round effects and interest costs remain moderated.

The country’s economic performance over the medium term is expected to be stronger than following the post-Global Financial Crisis shock. Italy is expected to experience very sound real growth rates in coming years, with GDP expanding by 4.7% and 2.8% in 2022 and 2023, respectively. This reflects a combination of still expansionary fiscal policy, recovery of the tourism sector and employment as well as sustained consumption and investment. The real GDP level should be 1.6 percentage points higher in 2024 than what was projected pre-pandemic. The main risks to economic projections stem from a possible resurgence of Covid cases as a result of a more aggressive and vaccine-resistant variant. DBRS Morningstar views positively the Italian government’s strategy to raise public investment and make progress with reforms included in the NRRP. Public spending on investment is projected to grow by 16% this year and as a share of GDP achieve 3.4% in 2024 from 2.3% in 2019. A successful implementation of the NRRP 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 of the “Economic Structure and Performance” building block.

The Improvement in the Fiscal Accounts Will Be Largely Cyclical But More Effort is Needed from 2024

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 headline fiscal deficit was very gradual and the impact of the pandemic caused the public sector accounts to markedly deteriorate. Nevertheless, the brighter economic outlook and the resources from the NGEU will facilitate a recovery in the public accounts.

Higher budgetary revenues reflecting improved tax compliance and the rapid economic recovery, along with lower expenditures will lead to an improvement in the fiscal deficit this year, relative to the 11.8% of GDP previously expected. The government projects a deficit of 9.4% of GDP, but the dynamic of the central government cash requirement points to a lower deficit for 2021. The government aims to provide additional stimulus to the economy until 2024 without a deterioration in the structural deficit targets. This is because the economic recovery, as well as the phasing out of COVID-19 support measures, should contribute to the improvement in the fiscal trajectory. DBRS Morningstar views positively the planned introduction of the first stage of the tax reform implying a reduction of the tax wedge as well as the end of the “quota 100” pension reform. The government intends also to refinance incentives to investments and additional spending on the healthcare sector and on the citizenship income to provide further support. According to the government, the deficit will decline to 5.6% next year, to 3.9% in 2023 and to 3.3% in 2024. The improvement in public accounts is expected to be largely cyclical and a firm decline in the structural deficit would require additional effort. The government has already in August received prefinancing of EUR 24.9 billion of its NRRP from the European Commission (EC). Nevertheless, milestones and targets need to be achieved to receive the full EUR 191.5 billion of EU funds, of which EUR 68.9 billion is in the form of grants and DBRS Morningstar takes the view that despite the challenge due to administrative inefficiencies the government is well positioned to be successful. The size of these resources is likely to mitigate risks of a resurgence of confrontation with EU authorities.

The Government Has Started to Make Progress on Reforms And Risks To Policy Continuity Are Mitigated By the NGEU Funds

Political uncertainty has traditionally been a challenge with respect to policy continuity in Italy, weighing 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 underpin the negative qualitative assessment of the “Political Environment” building block.

Since early 2021, a large but heterogeneous majority supports a new cabinet led by Prime Minister, Mario Draghi. DBRS Morningstar believes that this development interrupts a period of high uncertainty and slow policy implementation. Draghi’s government has started to make important progress with reforms, particularly on the public administration and the judicial system, and has showed a strong commitment to the management of the pandemic. The total vaccination rate is among the highest in the world and it could reach 90% of the population older than aged 12 by the end of the year. The government has also introduced a “green pass”, requiring proof of a negative test result or vaccination for several activities and places including the work place, indoor recreational activities, travel, restaurants, and universities.

In the event that Mr Draghi becomes the next President of the Republic early next year and a new Prime Minister and government needs to be found, DBRS Morningstar view risks to policy continuity being mitigated by the commitment to reform plans and by Mr Draghi’s position as President of the Republic maintaining a high credibility. At the same time, DBRS Morningstar views snap elections before the end of the term in March 2023 as unlikely as some parties supporting the Draghi government might not see a strong incentive for early elections in light of the current electoral law and the reduction of MPs, which has already been approved. A large share of current MPs will likely not be reelected as the new parliament will have a lower number of MPs.

The Public Debt-to-GDP Ratio is Expected to Decline, Supported by Higher Growth and The Improvement in Debt Affordability

The impact of the pandemic and the sizeable fiscal package implemented by the government led the debt ratio to rise to a record level of 155.6% of GDP in 2020. The government expected a further increase in the public debt to close to 160% this year, but the improvement in fiscal accounts as well as in the economic performance will lead to a decline to 153.5%. For the first time in several years, Italy’s public debt will benefit from a positive snowball effect as nominal growth is expected to be higher than the cost of debt in coming years. This factor, along with a further reduction in the primary deficit, supports the gradual decline of the debt-to-GDP ratio over the medium term. The IMF projects public debt to continue to fall to around 146% of GDP by 2026. Debt-to-GDP stabilisation and future reduction hinge mainly on the assumption that the total interest costs continues to decline as well as on a sustained GDP growth trajectory. In DBRS Morningstar’s view, a clear strategy to implement fiscal consolidation, particularly from 2024 onwards, is key to keeping the public debt trajectory on a firm declining trend and in light of the reimposition of the EU fiscal framework likely from 2023 onwards.

Nevertheless, despite a sharp increase in the level of public debt, the debt profile and affordability have improved. First, a large and growing share of the Italian public debt, estimated at around 29% at the end of 2021, will be held by the euro system and EU institutions. Moreover, a large amount of interest borne on the debt held by the euro system is returned to the Italian treasury. Second, debt affordability is expected to improve as long as older debt is refinanced at a lower cost of debt. Since January 2021, Italy’s weighted-average debt yield at issuance has been 0.1% while the total debt cost is expected to reach 2.35% by the end of this year and to decline to 1.73% in 2024. This reflects the expectation that ECB’s support will be removed only gradually. With the end of the pandemic emergency purchase programme (PEPP) in March 2022, the ECB is expected to continue to provide support especially since maturing bonds proceeds will continue to be reinvested. These factors, along with the sound debt profile because of the relatively long average maturity at 7.06 years as of September 2021 and the large share of the fixed-rate total debt, should help limit any potential impact of shock on yields and lend for a positive assessment on the “Debt and Liquidity” building block.

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

Italian banks are stronger than in the past as both credit quality and capitalisation have improved. According to the European Banking Authority (EBA) the gross nonperforming loans (NPLs) ratio has decreased to 3.7% in Q2 2021 from a peak of around 17.0% registered in Q4 2014, and it is steadily declining towards the EU average of 2.3%. The amount of moratoria is trending down but as government support is ultimately phased out, DBRS Morningstar expects some asset quality deterioration. However, the rise of NPL inflows is projected to be manageable and DBRS Morningstar expects Italian banks to further reduce of the stock legacy NPLs. Nevertheless, some small and medium-size banks are implementing restructuring and cost efficiency programmes and remain less diversified and more vulnerable. This factor along with the still sizeable stock of NPLs weighs on a negative qualitative assessment in the “Monetary Policy and Financial Stability” building block.

Corporate sector viability as well as investment have benefitted from the relief provided by the large amount of public guarantees which, however, are increasing the amount of public sector contingent liabilities. The total stock of guarantees stood at EUR 257 billion (14.5% of GDP) as of June 2021 and will continue to rise likely until the second half of 2022, but DBRS Morningstar does not expect a significant call of guarantees should the economy continue to recover steadily. Nevertheless, the recapitalisation and the possible sale of Banca Monte dei Paschi di Siena will require additional government resources. Despite the large amount of credit provided to the economy, private sector indebtedness remains one of the lowest among advanced countries with the non-financial corporate and household debt ratio at 74% of GDP and 44% of GDP, respectively, in June 2021. These levels are well below euro average levels of 112% and 61% of GDP, respectively. Moreover, in aggregate, although not uniformly both households and corporates have seen their savings and deposits rising. This mitigates risks to financial stability.

Bottlenecks and the Rise in Commodity Prices Not Expected to Significantly Impair Italy’s Goods Export Performance In The Medium Term

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 sustained decline in the country’s negative NIIP. Since September 2020, Italy has returned to being a net external creditor and in June 2021 the positive NIIP achieved 5.2% of GDP. This represents a significant improvement since the trough of -25.1% of GDP registered in Q1 2014.

With the recovery in global trade, Italy’s goods exports have been more reactive than peers and are expected to post a sound, although less dynamic, performance over the medium term. This reflects the ability to maintain market shares by relying on dynamic markets as well as adapting to price and quality competition. According to the Bank of Italy, in the twelve months ending in August 2021, the current account surplus amounted to 4.0% of GDP (EUR 69.5 billion) and was supported by a large surplus in the trade balance (EUR 74.6 billion) despite a worsening in the energy balance. Despite current bottlenecks, the shortage of inputs, and the rise in commodity prices are likely to weigh on Italy’s external performance in the near term, but DBRS Morningstar expects that these factors will be transitory and that the recovery in the tourism sector should support the country’s strong external performance in coming years. Imports will likely rise as a result of large investments 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 31,604 in 2020 was low compared with its euro area peers. At the same time, Italy ranks in the 60.6 and 67.3 percentile for Rule of Law and Government effectiveness, respectively in 2020 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 at https://www.dbrsmorningstar.com/research/387039.

EURO AREA RISK CATEGORY: LOW

Notes:
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/381451/global-methodology-for-rating-sovereign-governments (July 9, 2021). 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 Ministry of the Economy and Finance (Ministero dell’Economia e Finanza, MEF), MEF – Nota di Aggiornamento al Documento di Economia e Finanza (NADEF, September 2021), MEF – Draft Budgetary Plan 2022 (October 2021), Bank of Italy, Bank of Italy – Economic Bulletin (October 2021), Bank of Italy - Balance of Payments and International Investment Position (October 2021), Ufficio palrmentare di Bilancio (UPB) – Audizione UPB nell’ambito dell’esame della NADEF 2021 (October 2021), European Central Bank, European Commission (EC), Eurostat, BIS, EBA, World Bank, UNDP, Haver Analytics, Transparency International, Italy’s NRRP (April 2021), 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/387040.

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: April 30, 2021

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