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 remains Stable.
KEY RATING CONSIDERATIONS
The Stable trend reflects DBRS Morningstar’s view that risks to the ratings are balanced. The economy’s high degree of diversification and the government’s commitment to a prudent fiscal trajectory mitigate against the deterioration in Italy’s growth outlook, intensified by Russia’s invasion of Ukraine. Italy was experiencing a better than expected recovery after the severe COVID-19 shock and registered a fiscal deficit significantly lower than anticipated. In parallel, Italy’s public sector debt-to-GDP ratio fell more than expected to 150.8% in 2021 from 155.3% in 2020, and unless the economy slows down significantly it is expected to continue its downward trend to 145.7% in 2025, according to the IMF. Nevertheless, there is high uncertainty around the duration and impact of the conflict in Ukraine, as well as from possible tougher sanctions or counter sanctions. The government has started to make progress with public investment and reforms included in its National Recovery and Resilience Plan (NRRP) aimed at raising potential growth. If successful, this would boost economic growth that has historically been weak. Risks to policy continuity after the political elections in 2023 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 European Union (EU) membership as well as from the support of the European Central Bank (ECB), which is expected to continue to reinvest Italy’s maturing government bonds and to normalise monetary policy only gradually. Over time, Italy’s public debt profile and affordability have improved reducing the vulnerability to an abrupt increase in interest rates. Moreover, Italy has a wealthy and diversified economy, and the manufacturing and construction sectors have good fundamentals. The current account surplus, despite the expected declining trend because of a high energy deficit, will remain solid likely supporting the positive net international investment position (NIIP) which reached record levels at the end of 2021. At the same time, private sector debt is among the lowest among advanced countries. Household savings and corporate deposits in aggregate have risen substantially, both of which bode well for absorbing the impact of high inflation and energy costs. 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 consequences of the pandemic and of the conflict in Ukraine will affect asset quality in coming years.
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; (2) evidence that progress with reforms leads to higher economic growth.
Ratings could be downgraded if one or a combination of the following factors occur (1) economic prospects weaken materially causing a significant increase in the public debt ratio trend; (2) the government shows significantly weaker 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.
The Russian Invasion of Ukraine is Clouding Italy’s Economic Outlook but Fundamentals Are Expected to Remain Solid
A high degree of economic diversification, coupled with a strong manufacturing sector and a wealthy economy, support the ratings. Nevertheless, historical low GDP potential growth, largely due to weak labour productivity, constrains Italy’s economic perspectives weighing on the qualitative assessment of the “Economic Structure and Performance” building block.
The bright recovery has been weakened by the effects of the Russian invasion of Ukraine, but Italy’s growth is expected to be supported by the positive impact of the NRRP over the medium term. The economy was rebounding solidly from the pandemic shock with GDP expanding by 6.6% in 2021 - better than expected, after a severe contraction of 9.1% registered in 2020. Nevertheless, Italy’s economic performance was already losing some momentum in the last quarter of 2021, when economic growth slowed down to 0.7% quarter-on-quarter from 2.5% in Q3 because of a continuation of input shortages, higher inflation, and the spread of COVID-19 variants.
The military escalation of Russia has significantly clouded Italy’s economic outlook with the IMF projecting GDP growth to decelerate to 2.3% in 2022 from 4.2% projected in October last year. Risks are tilted to the downside as the conflict in Ukraine might be more prolonged than anticipated leading to further sanctions and/or energy supply shortages. The country is dependent on Russian natural gas which exceeds 45% of Italy’s total gas imports and contributes to around 19% for production purposes, 14% to generate electricity and 11% for domestic use. In a severe scenario of a full stoppage of Russian gas supplies, if Italy were not able to replace all imports from Russia, some rationing would occur and energy price increases would intensify fuelling inflation, which already reached 6.8% (HICP) in March. This would translate into materially lower economic growth. In this regard, DBRS Morningstar views positively the government’s steps to diversify gas imports through other partners, but it will take time to fully replace imports from Russia and further efforts at the EU level to cushion the impact could occur.
Notwithstanding the risks, Italy’s economic fundamentals are expected to remain sound over the medium term. The economy is highly diversified and benefits from a construction and manufacturing sector which showed resilience during the COVID-19 shock. Moreover, the service sector is expected to gradually recover as the economy fully reopens. DBRS Morningstar views also positively the Italian government’s strategy to raise public investment and make progress with reforms included in the NRRP. Public investment has been subdued for a long period of time, eroding the capital stock and weighing on potential growth. The government achieved the fifty-one milestones and targets for 2021 under the NGEU and was among the first countries to receive the first net installment of EUR 21 billion (1.1% of GDP) in April this year, after having already received EUR 24.9 billion (1.4% of GDP) as prefinancing last year. Despite some delays, execution risks, and the rising cost of building materials, the successful implementation of the NRRP could enable Italy to tackle some of the structural weaknesses that have undermined its GDP growth potential.
The Government’s Commitment to an Improvement in the Fiscal Accounts is Strong And Well-Targeted Support Is Key To Mitigate the Risk of Higher Deficits
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.
DBRS Morningstar views positively the government’s decision to commit to headline fiscal targets set out in September 2021, albeit the economy is slowing down more than expected. The headline deficit came out more than two percentage points lower than the government’s previous projection at 7.2% of GDP in 2021, reflecting largely stronger tax revenues the trend of which remains favourable in the first months of 2022. The headline deficit should continue to fall to 5.6% of GDP this year and to 3.9% in 2023, according to the government.
DBRS Morningstar views well-targeted support as important to reduce the risk of a material rise in the deficit should the conflict in Ukraine continue for a long period of time or the impact of sanctions and counter-sanctions become tougher for Italy. The government has already provided support particularly to compensate for high energy costs with measures amounting to around 0.7% of GDP in 2022, for the first half of this year. The government plans additional measures totalling 0.5% of GDP, but already included in the fiscal targets. These include restoring some budgetary funds previously reduced to offset the measures to contain the cost of energy, refinancing guarantees, providing further support for higher energy and fuel costs, the healthcare system, for Ukrainian refugees and measures to compensate for the increasing costs of materials in public works. DBRS Morningstar, however, does not rule out further support measures that would raise the deficit. In this context, higher than expected borrowing needs in the context of less policy accommodation from the ECB, with new EU funding to mitigate the effect of Russia’s invasion not under discussion, would require well-targeted government support to continue the improvement in the fiscal deficit.
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 adjustment 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. Mr 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 continuity provided by President of the Republic Mattarella’s re-election has reassured investors over the risk of snap elections and DBRS Morningstar expects Mr Draghi’s cabinet to rule until the end of the legislative term in early 2023. However, as the next elections are approaching, political parties are expected to look to support in their constituencies and this could undermine the government’s position and in turn the progress with reforms (see the commentary “Italy's Presidential Elections: Uncertainty on Reform Timing” https://www.dbrsmorningstar.com/research/390558/italys-presidential-elections-uncertainty-on-reform-timing). Over the medium term, however, DBRS Morningstar views risks to policy continuity being mitigated by the commitment to reforms included in the plans, which are conducive to a sizeable amount of EU resources.
A Better End of 2021 Bodes Well For The Debt-to-GDP Trajectory But Sound Nominal Growth and Fiscal Discipline Are Key Factors
Italy’s high level of public debt makes the country vulnerable to shocks and constrains the ratings. Nevertheless, the large share of debt held by the Eurosystem and EU institutions as well as the increase in its average maturity have reduced the susceptibility of Italy’s debt to a shift in investor confidence and contains the expected rise in interest costs.
Lower than expected borrowing needs enabled the public debt ratio to decline by 4.5 percentage points to 150.8% of GDP in 2021, positioning the debt trend on a more favourable trajectory compared with the latest government estimates in September 2021. The IMF projects the public debt ratio to fall to 145.7% of GDP in 2025, around two percentage points lower than projected in October 2021. DBRS Morningstar anticipates a slight decline in the debt-to-GDP ratio this year despite lower growth, but an improvement in the fiscal accounts along with sound nominal growth remain key factors in the medium term. This is because maintaining a declining debt ratio hinges on the primary deficit continuing to decrease along with a favourable differential between interest cost and the nominal growth. Over the last two decades except for last year this differential has been persistently negative therefore a continuation of sustained economic growth is an important element when interest rates are rising. This explains why making progress with NRRP and in turn raising GDP potential would mitigate risk to the debt sustainability. A higher growth rate would also facilitate improving fiscal accounts which would free fiscal space to absorb future shocks, including ageing costs, as well as reassure investors typically concerned about historical political instability and its adverse impact on economic potential.
DBRS Morningstar assesses positively Italy’s public debt affordability and debt profile despite the sizeable stock of debt. As of the end of 2021, almost one third of debt is held by the Eurosystem and EU institutions, which makes the debt less sensitive to shifts in investor confidence and translates into a large amount of interest returned to the Italian Treasury. ECB net asset purchases are expected to end some time in the third quarter but a sizeable amount of Italy’s bonds will continue to be reinvested by the Eurosystem in the coming years, indirectly accommodating a part of gross borrowing needs. After peaking at 4.2% in 2012, the effective interest cost of Italian debt has been on a declining trend for several years, even though it slightly increased to 2.44% in 2021 from 2.38% in 2020. This was largely due to the impact of increasing inflation which is expected to peter out in coming years. After issuing new debt at an all-time low yield of 0.1% in 2021, Italy’ average yields at issuances are increasing but remain below the implicit cost of debt, albeit this differential is expected to narrow over time. Italy’s government deposits and liquid assets are sizeable at EUR 94.4 billion (5% of GDP) as end of March 2022 and this lowers the risk of large issuances during high volatility. Moreover, debt is predominantly at fixed rates and its average maturity stood at the comfortable level of 7.18 years as of March 2022, which mitigates against the further expected rise in interest rates. These factors lend to a positive qualitative assessment on the “Debt and Liquidity” building block.
The Banking System is in a Stronger Position Than In The Past but a Rise in New 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 3.0% in Q4 2021 from a peak of around 17.0% registered in Q4 2014, and it is steadily declining towards the EU average of 2.0%. DBRS Morningstar projects the impact stemming from the Russian invasion to be manageable for the Italian banking system as the largest exposures are concentrated on well capitalised banks. However, as the consequences of the pandemic and the Russian invasion unfold, including the high impact of energy prices on Italy’s corporates, some asset quality deterioration is likely to occur. At the same time, DBRS Morningstar expects Italian banks to continue to reduce the stock of legacy NPLs. DBRS Morningstar notes that some small and medium-size banks are still 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 282 billion (15.9% of GDP) as of December 2021 and will continue to rise likely until the end of this year. However, DBRS Morningstar does not expect a significant call of guarantees unless a substantial and prolonged deterioration in the economic environment occurs. Despite the large amount of credit provided to the economy, private sector indebtedness remains at one of the lowest levels among advanced countries with the non-financial corporate and household debt ratio at 73% and 44% of GDP, respectively, in December 2021. These levels are well below euro average levels of 111% and 60% 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.
The Deterioration in the Energy Balance Will Reduce The Current Account Surplus but Italy’s Goods Export Performance is Expected to Remain Supportive
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 December 2021 the positive NIIP amounted to 7.4% of GDP. This represents a significant improvement since the trough of -25.2% of GDP registered in Q1 2014.
Italy’s large dependency on energy imports and their higher price is weighing on the trade balance. Despite the gradual recovery of the tourism sector, the current account surplus is expected to further decline this year after the drop to 2.5% of GDP in 2021 from 3.7% registered in 2020. This will reflect largely high energy import prices. While the share of exports to Russia is modest at 1.5%, total imports from Russia account for around 3.7% of the total. A large share of imports from Russia include energy products, which are vulnerable to further price increase or shortages. DBRS Morningstar views Italy’s capacity to export as a key strength and does not expect a weakening in the competitiveness of the manufacturing export-oriented sector.
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 35,473 in 2021 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 blocks.
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/395948.
EURO AREA RISK CATEGORY: LOW
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 (3 February, 2021)
The sources of information used for this rating include Istat, Ministero dell’Economia e Finanza (MEF), MEF –Documento di Economia e Finanza (DEF, April 2022) – Treasury account and investment of the treasury liquidity (March 2022), Bank of Italy, Bank of Italy – Economic Bulletin (April 2022), ECB, European Commission (EC), Eurostat, IMF, BIS, EBA, World Bank, Haver Analytics, Transparency International, MISE, 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/395944.
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 29, 2021
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