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

DBRS Ratings GmbH (DBRS Morningstar) confirmed the Republic of Italy (Italy)’s Long-Term Foreign and Local Currency – Issuer Ratings at BBB (high). At the same time, DBRS Morningstar confirmed 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 government’s commitment to a prudent fiscal stance, along with sound nominal growth, bode well for a continuation in the debt-to-GDP ratio reduction over the medium-term. Italy’s public debt came in better than expected at 144.4% of GDP last year, cumulatively declining by more than ten percentage points from the peak of 154.9% in 2020. The debt ratio is expected to continue to decline to 140.9% of GDP in 2025, but the material rise in interest costs will require further progress on fiscal consolidation as well as sustained growth to put the debt ratio on a durable declining trend. Delays in the execution of the Recovery and Resilience Plan (NRRP, the plan) are gradually emerging and a possible reshuffle of some projects towards those of more rapid implementation could hamper the plan’s impact on GDP growth. DBRS Morningstar views continuing to raise public investment and progress with reforms as key to raise potential GDP growth and in turn improve Italy’s public debt sustainability.

DBRS Morningstar’s confirmation of Italy’s BBB (high) rating is underpinned by several factors. Italy benefits from European Union (EU) membership as well as from the European Central Bank (ECB)’s support and high credibility. The economy is large and diversified and the important manufacturing sector has demonstrated a high degree of resilience despite the energy shock. The current account shifted temporarily to a deficit position owing to high energy prices, but Italy’s export capacity remains a supportive factor as does the country’s positive net international investment position (NIIP). Moreover, private-sector debt is one of the lowest among advanced countries. Corporate profit margins accumulated bode well for absorbing the impact of high inflation and rising interest rates. Italy’s banking system is in a stronger position than in the past in terms of capitalisation and progress has been made in markedly reducing net impaired assets. Nonetheless, the consequences of the economic slowdown and the impact of the tightening in financial conditions will likely negatively affect asset quality going forward, although gradually. Ratings remain constrained by a very high level of public debt and weak GDP potential growth amid unstable governments.

RATING DRIVERS

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

Ratings could be downgraded if one or a combination of the following factors occurs: (1) economic prospects worsen materially, causing a significant increase in the public debt ratio trend; (2) the government shows significantly weaker commitment to reducing the debt-to-GDP ratio in the medium term; or (3) a crystallisation of a sizable amount of contingent liabilities, leading to a material deterioration in public accounts.

RATING RATIONALE

Government Remains Committed to a Prudent Fiscal Stance, Prolonged Primary Surpluses Is a Challenge

Italy’s gradual improvement in fiscal performance during pre-pandemic years has been interrupted by sizeable government support measures in 2020. The energy shock has slowed down the public finance repair and the expected rise in interest costs requires a rapid return to sound primary surpluses. The very high debt-to-GDP ratio along with the risk of widening spreads reduce the probability of a significant deviation from a prudent fiscal strategy.

Last year the deficit at 8.0% of GDP came in worse than expected (5.6%) reflecting the statistical reclassification of some tax credits for construction projects deemed payable by Eurostat. But the government remains committed to the same declining fiscal trajectory envisaged in the update to the Stability Programme in November. This is also because the impact of these tax credits should have been mostly accounted in previous years and the deficit is expected to improve rapidly. The government projects it to decline to 4.5% of GDP this year and 3.7% in 2024 reflecting mainly lower spending to shelter households and firms from high energy prices, and still sound nominal growth. These targets incorporate very limited cuts in social contributions amounting to 0.15% of GDP in 2023 and about EUR 4.0 billion (0.2% of GDP) dedicated to reduce the tax wedge next year. However, these measures are temporary and, if re-introduced, along with further efforts to reduce the tax wedge and the impact of the unchanged-policies, would need additionally compensatory measures. Efforts from the spending review and potentially reducing tax expenditures might not be enough also in light of ageing costs weighing on pensions and long-term care expenditures.

Italy’s Economic Outlook Improved In the Near-Term But Challenges Remain Ahead

A high degree of economic diversification, coupled with a strong manufacturing sector and a large economy, support the ratings. Nevertheless, historically low GDP potential growth, largely due to weak labour productivity growth, low participation of women in the work force, and adverse demographics, constrain Italy’s economic perspectives. This weighs on the qualitative assessment of the “Economic Structure and Performance” building block.

The economy has recovered more strongly from the pandemic than most of Italy’s Eurozone peers. Moreover, it has shown a better than expected resilience to the energy shock, despite the large reliance on Russian gas imports. GDP increased 3.7% last year after the remarkable recovery of 7.0% in 2021. The diversification in gas supply, the sizeable gas storage and the fall in energy prices bode well for economic growth in 2023. Moreover, the recent legislative measures, aimed at limiting the generous construction sector incentives, are likely to weigh on the sector’s performance only gradually. Activity in the construction sector has expanded by more than 25% in terms of real gross value added since the end of 2019. DBRS Morningstar anticipates a steady decline in the momentum mitigated by additional investment stemming from the NRRP, if successfully implemented. Inflation will erode households’ real purchasing power this year while the tightening in monetary policy will negatively affect growth in 2024. The government expects GDP to expand by 1.0% this year, slightly higher than the Eurozone (0.8%), before peaking up to 1.5% next year. These projections are surrounded by a high degree of uncertainty and are dependent on both the execution of the NRRP’s investments as well as the impact of monetary policy tightening. Geopolitical tensions add to near term risk making more challenging the contribution of the export-oriented manufacturing sector to Italy’s economic activity.

DBRS Morningstar views positively the Italian government’s strategy to raise public investment and to make progress with reforms included in the NRRP, but delays in project implementation could constrain the expected positive impact of growth. Insufficient public investment for a long period of time translated into an erosion of capital stock and weighed on potential growth. The government is expected to receive the third installment of the Recovery and Resilience Facility and clarifications requested by the European Commission are not expected to constrain the disbursement. But as time goes by, delays in the implementation of projects could become material if not addressed. This could hamper the plan and lead to lower EU resources.

Debt-to-GDP Ratio Continues To Decline But The Rise In Interest Costs Requires More Progress on Fiscal Consolidation

Italy’s high level of public debt and gross borrowing requirements make the country vulnerable to shocks and constrain its ratings. Nevertheless, a large share of debt held by the Eurosystem and EU institutions reduces the susceptibility of Italy’s debt to a rapid shift in investor confidence. The comfortable average maturity contains the impact of the increase in funding costs.

Robust nominal growth, as a result of high inflation, particularly in 2022, has been contributing to the decline in the public debt-to-GDP ratio since the peak of 154.9% in 2020. The debt ratio came in better than expected at 144.4% of GDP last year, and the government projects a further fall to 142.1% of GDP this year. Solid, although declining nominal growth, should more than compensate for the increase in the average cost of debt at least until 2025 according to the government. The reclassification of the tax credits for construction, leading to higher past deficits, did not modify the size of the debt ratio due to the application of different accounting terms. But lower fiscal revenues in cash terms will translate into a more adverse stock-flow adjustment, partially compensating for the improvement in the primary balance in coming years. A declining debt-to-GDP ratio hinges on the assumptions that the Next Generation EU (NGEU) is successful in boosting Italy’s GDP growth, that interest costs remain contained, while the government registers increasing primary surpluses. DBRS Morningstar will monitor the government’s commitment to reforms and investment, and prudent fiscal policy, which are key also to reassure investors and contain the cost of funding.

Elevated borrowing needs along with high yields put pressure on interest costs in coming years. On the other hand, the comfortable average maturity mitigate this impact. Despite the relatively low share of inflation-indexed bonds, amounting to 12.8%, its absolute value, which has been subject to revaluation due to the rise in inflation, mainly contributed to the rise in the interest cost to 4.4% of GDP in 2022 from 3.6% in 2021. A lower inflation rate should help a moderate decline to 3.7% of GDP this year before a persistent increase to 4.5% in 2026, reflecting the elevated borrowing needs and yields. Nevertheless, debt is predominantly at fixed rates with an average life of 7.02 years as of March 2023, which contains the impact of the rapid increase in yields. Moreover, the ECB’s Transmission Protection Instrument reduces the risk of a deviation from a prudent fiscal strategy as well as from a strong commitment to the reforms and, if activated, is expected to contain spreads. A large share of debt is held by the European authorities, this should mitigate the shift in investor confidence. Recent data hint at a potential additional demand for holding Italy’s debt from households going forward. This has been subdued for years and, if prolonged, it could improve the diversification of funding, which is important in light of the gradual reduction in Italy’s debt holdings from the ECB. These factors lend to a positive qualitative assessment on the “Debt and Liquidity” building block.

Risks to the Reform Effort Are Mitigated by EU Funds While Government Instability Will Be Contained in the Near Term

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, political defection and parties’ fragmentation. Moreover, there is usually little cross-party consensus on how to address structural problems in the context of generally low electoral support for reforms and volatile polls. Combined, these factors hinder the government’s ability to address economic challenges, implement forward-looking policies, and underpin the negative qualitative adjustment of the “Political Environment” building block. This is also reflected by weaker governance indictors compared with peers.

The right-wing coalition secured a majority in both chambers in the political election held at the end of September last year, and tensions within the government coalition have been contained so far, although these can intensify when main electoral dates are close. Government instability is unlikely in the near term while opposition parties remain divided. DBRS Morningstar does not view a complete reversal or a significant dilution of reforms, although the current government is less keen on important reforms, including the reform of competition. The amount of NGEU resources that Italy is expected to receive remains a strong incentive for making progress with reforms. In light of the delays with investments, the rise in the cost of building materials and the energy shock, the new government seems keen to reshuffle some of the NRRP projects towards RepowerEU and the EU Structural programe. The latter would allow the government to benefit from a longer time horizon to execute investments, but would require additional co-financing, weighing on the fiscal deficit. Opting potentially for easier projects but with a lower fiscal multiplier is a risk as it could lead to higher public debt but lower economic growth.

Banks Are in a Stronger Position Than in the Past but a Rise, Albeit Gradual, in New Nonperforming Loans (NPLs) Is Expected

The banking system is in a stronger position than in the past and financial stability risks are contained. The banking sector has benefitted from an improvement in credit quality and capitalization over the years, and profitability increased strongly due to the rise in net interest income in 2022. Nevertheless, the economic slowdown in tandem with the elevated funding costs will likely cause impaired assets to rise, although gradually. Italian banks benefit from sound liquidity ratios and a sticky deposit base and the impact from volatility arising from some bank failures in the US and the emergency sale of Credit Suisse has been contained. 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 the “Monetary Policy and Financial Stability” building block assessment.

The rapid increase in interest rates is not expected to weigh significantly on financial stability although it will likely negatively affect loan demand while credit standards could continue to tighten in coming months. Despite a relatively high amount of mortgages with variable rates, the overall share of housing borrowers is moderate in Italy. This reassures as the tightening in monetary policy could be more prolonged than expected. Moreover, non-financial corporations’ profit margins accumulated should enable them to accommodate the tightening in financial conditions. The increase in interest rates is positively affecting banks’ interest margins, while the high share of public debt accounted at amortised cost reduces the banks’ capital sensitivity to the change in sovereign yields. On the other hand, should rapid and large liquidity stresses occur, unrealised losses stemming from the high share of non-marked-to-market government debt securities might not be negligible. However, DBRS Morningstar see it unlikely that Italian banks experience material funding and liquidity shocks considering the high share of granular insured deposits in the system.

Corporate-sector viability as well as investments have benefitted from the relief provided by the large amount of public guarantees provided since 2020. This translated into an increase in the amount of public-sector contingent liabilities, which, however, are expected to gradually decline. The total stock of guarantees stood at around EUR 15.8% of GDP as of December 2022, which slightly dropped from 16.1% of GDP in 2021, and is expected to steadily fall as guaranteed loans provided during the pandemic are reimbursed. DBRS Morningstar does not expect significant claims to emerge unless a substantial and prolonged deterioration in the economic environment occurs.

The Worsening in the Energy Balance Weighs on the Current Account 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 averaged around 2.1% of GDP over the last ten years. This, in turn, has contributed to a sustained improvement in the country’s NIIP. Since September 2020, Italy has returned to being a net external creditor and, despite the recent decline from the peak of 8.3% of GDP in Q4 2021, the positive NIIP at 3.9% in Q4 2022 remains noteworthy compared with the trough of -25.3% of GDP in Q1 2014.

Italy’s large dependency on energy imports and their higher price weighed on the energy balance last year. But the improvement in the terms of trade, lower energy prices and the resilience of Italy’s exporters should reverse the deterioration in the current account balance, although gradually. For the first time since 2012, the current account balance shifted to a negative position of 1.3% of GDP in 2022 from the surplus of 3.1% in 2021, due to the sharp increase in energy prices only partially compensated by the recovery in tourism. Recent data on net exports point to an improvement in the trade balance owing to lower energy imports and prices over the last few months. This reflects also exporters’ capacity to diversify energy imports geographically since Russia’s invasion of Ukraine. The global economic slowdown should not constrain Italy’s current account balance from improving this year. 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 despite the slowdown of global trade growth. However, sound surpluses above 3% of GDP registered in the 2019-2021 period seem difficult to be achieved soon.

ENVIRONMENTAL, SOCIAL, GOVERNANCE CONSIDERATIONS
Social (S) Factors
The Human Capital and Human Rights factor effects the ratings. According to the IMF WEO, Italy’s GDP per capita of USD 34,113 in 2022 was relatively low compared with its euro area peers. This factor is considered as significant and it has been taken into account primarily in the “Economic Structure and Performance” building block.

Governance (G) Factors
The Institutional Strength, Governance & Transparency factor effects the ratings. This reflects particularly Italy’s institutional arrangements which affect government effectiveness and the government’s capacity to address economic challenges and implement forward-looking policies. According to the World Bank, Italy ranked for Government Effectiveness at 64.9th percentile in 2021. This factor is considered as significant and it has been taken into account primarily in the “Fiscal Management and Policy” and “Political environment” building blocks. At the same time, DBRS Morningstar views the Bribery, Corruption and Political Risks factor as relevant reflecting also weak scores in the rule of law and in the perception of corruption.

There were no Environmental factors that had a significant or relevant effect on the credit analysis.

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 https://www.dbrsmorningstar.com/research/396929/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings (17 May 2022).

For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments. https://www.dbrsmorningstar.com/research/413243.

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 methodology is the Global Methodology for Rating Sovereign Governments https://www.dbrsmorningstar.com/research/401817/global-methodology-for-rating-sovereign-governments (29 August 2022). In addition, DBRS Morningstar uses the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings https://www.dbrsmorningstar.com/research/396929/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings, in its consideration of ESG factors.

The credit rating methodologies used in the analysis of this transaction can be found at: https://www.dbrsmorningstar.com/about/methodologies.

The sources of information used for this rating include Istat, Ministero dell’Economia e Finanza (MEF), MEF –Documento di Economia e Finanza (DEF, April 2023), Bank of Italy, Bank of Italy – Economic Bulletin (April 2023), ECB, EC, Eurostat, IMF (WEO April 2023, IFS), BIS, World Bank, Haver Analytics, Transparency International, 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: YES
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.

The conditions that lead to the assignment of a Negative or Positive trend are generally 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: https://cerep.esma.europa.eu/cerep-web/statistics/defaults.xhtml. For further information on DBRS Morningstar historical default rates published by the Financial Conduct Authority (FCA) in a central repository, see https://data.fca.org.uk/#/ceres/craStats.

The sensitivity analysis of the relevant key rating assumptions can be found at: https://www.dbrsmorningstar.com/research/413244.

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

Lead Analyst: Carlo Capuano, Senior Vice President, Global Sovereign Ratings
Rating Committee Chair: Nichola James, Managing Director, Co-Head of Sovereign Ratings, Global Sovereign Ratings
Initial Rating Date: 3 February 2011
Last Rating Date: 28 October 2022

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