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

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

KEY CREDIT RATING CONSIDERATIONS
The Stable trend reflects Morningstar DBRS' view that risks to the credit ratings are balanced. Italy's post-pandemic recovery was stronger than anticipated and outpaced other large euro area economies. The effects from tighter monetary policy and a weaker external environment are weighing on economic activity, but growth is expected to pick up gradually as households' purchasing power and financial and external conditions improve. The implementation of Italy's National Recovery and Resilience plan (NRRP, or the Plan) should help mitigate weaker residential investments in the next couple of years as generous house renovation tax credits (Superbonus) are phased out. The fiscal deficit reached 7.4% of GDP in 2023, well above the 5.3% of GDP projected by the government, with the slippage largely explained by a greater-than-expected impact from the Superbonus tax credits. On the other hand, Italy's public debt ratio fell faster than expected and stood at 137.3% of GDP in 2023 thanks to nominal GDP growth. The fiscal impact of these tax incentives is expected to be much lower going forward; however, their claims will lead to higher financing needs and push Italy's public debt ratio higher in coming years. The government projects the public debt ratio to increase towards 139.8% of GDP by 2026 and then start a gradual decline on a current legislation scenario. This is broadly in line with its previous projections thanks to a better-than-anticipated starting point. The likely extension of temporary tax cuts to 2024 could exert some additional pressure, if not accompanied by compensatory measures. The government's medium-term national fiscal structural plan, to be presented by mid-September this year in the context of the impending new fiscal rules, should reconfirm its commitment to bringing down Italy's fiscal deficit.

Morningstar DBRS' confirmation of Italy's BBB (high) credit rating is underpinned by several factors. First, Italy benefits from European Union (EU) membership as well as from the European Central Bank's (ECB) support and high credibility. Second, the economy is large and diversified, and the important manufacturing sector has demonstrated a high degree of resilience despite the energy price shock. Third, Italy's external position benefits from the rapid recovery in its current account as well as the country's positive net international investment position (NIIP). Private-sector debt is one of the lowest amongst advanced countries, and Italy's banking system is in a stronger position than in the past in terms of capitalisation and net impaired assets. However, the credit ratings remain constrained by a very high level of public debt, weak potential GDP growth, and a political environment that hinders government stability and ability to address economic challenges.

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

Credit ratings could be downgraded if one or a combination of the following factors occur: (1) the government fails to reduce the fiscal deficit ratio in the medium term; (2) economic prospects worsen materially, causing a significant increase in the public debt ratio trajectory; or (3) a material rise in sovereign funding costs undermining the government's ability to meet its financing needs.

CREDIT RATING RATIONALE

Fiscal Repair Is Slower and Surrounded by Some Uncertainty; Past Track Record of Fiscal Prudence Provides Reassurance

Italy's headline deficit has remained elevated at 8.9% of GDP on average during 2020 to 2022, dragged down by pandemic-related measures, the energy crisis, and the large impact from the tax incentives. The fiscal deficit started to decline but remained elevated at 7.4% of GDP in 2023 due to the Superbonus and energy support measures. The estimated impact on the deficit from the Superbonus amounted to 3.9% of GDP in 2023 (2.1% of GDP higher than anticipated), 2.9% of GDP in 2022, and 0.9% in 2021. Going forward, the impact of the Superbonus scheme on the fiscal deficit should be much smaller given the tighter conditions and the end of its transferability. Still, there is a risk that past tax credits could be higher than expected or that a reclassification from Eurostat could change the fiscal deficit profile.

The Stability Programme 2024 projects a reduction in the fiscal deficit ratio, under a current legislation scenario, largely in line with the policy scenario laid out in the Draft Budgetary Plan (DBP) 2024. The DBP included the extension of the social contribution cuts and a targeted cut on the income tax rate for low- to middle-income earners with a combined estimated fiscal cost of 0.7% of GDP for 2024. The fiscal deficit is projected to decline to 4.3% of GDP in 2024, helped by the significantly lower impact from the house renovation tax credits and energy support measures, which together added up to 5.1% of GDP in 2023. While the projected improvement in the primary balance is slower than anticipated, this is broadly compensated by a lower than previously projected interest burden thanks to the improvement in Italy's cost of funding in recent months. The government projects the headline deficit to reach 3.0% of GDP by 2026 and fall to 2.2% of GDP by 2027. The implied structural adjustment under a current legislation scenario appears consistent with the new fiscal rules. Still, the improvement in the fiscal trajectory is accompanied by some uncertainty as it remains unclear whether the government will re-extend tax cuts with or without offsetting measures after 2024. A public spending review and an improvement in tax compliance might not be sufficient, and a cumulative improvement in the primary surplus of 2.6% of GDP from 2024 and 2027 appears challenging. The government will need to present its medium-term fiscal plan to the European Commission no later than September 20, 2024. This should detail the measures behind the government's commitment to significantly reduce the structural deficit and limit the growth of net primary spending in the future. Italy's track record of strong primary balances before the pandemic offers reassurance.

Impact of Tax Credits Expected to Lead to a Gradual Increase in the Debt Ratio

Italy's high public debt ratio, the second-highest in the EU, makes the country vulnerable to shocks and constrains its credit ratings. Still, the public debt ratio declined faster than expected and stood at 137.3% in 2023, slightly above its pre-pandemic level, despite considerable fiscal deficits since the pandemic began. Robust nominal growth, also as a result of high inflation, contributed to a significant decline in the public debt-to-GDP ratio following the peak of 155.0% in 2020. The impact of the tax incentives for building renovation on the cash balance and the stock flow adjustment will likely lead to gradual increases in the public debt-to-GDP ratio over the coming years. The government projects public debt to increase to 139.8% of GDP by 2026, broadly in line with its October 2023 projections, and then start to decline gradually. The government's projected path also hinges on the assumption that the government will deliver on 1.0% of GDP of asset sales over the next three years and a more pronounced structural fiscal adjustment in 2027. These are ambitious targets, but possible in Morningstar DBRS' view. Thus far, the Ministry of Economy and Finance sold 37.5% of the share capital of Banca Monte dei Paschi di Siena's (rated BB (high), Positive) capital for a total of around EUR 1.6 billion in two transactions in November 2023 and March 2024, lowering its share of the bank's capital to just below 27%.

Elevated borrowing needs along with high yields will put pressure on interest costs in coming years. Italy's public debt gross issuances are sizeable, at around 24% of GDP on average over the last three years, and are expected to remain elevated going forward. The interest bill, after moderating because of lower inflation to 3.8% in 2023 from 4.2% in 2022, is projected to reach 4.4% of GDP in 2027 because of large debt issuances in the context of high interest rates. However, the average maturity of 7.0 years as of March 2024 should attenuate the increase in funding costs. Moreover, a large share of debt is held by the European authorities, which mitigates the risk of a shift in investor confidence, including a significant adverse impact on yields. This factor lends to a positive qualitative assessment of the "Debt and Liquidity" building block.

The impact on yields from the gradual reduction in the ECB's Italian sovereign debt holdings have been mitigated by higher demand from households. In this direction, according to the central bank, the narrowing in spreads with the German bonds in recent months reflects the support from small investors as well as the strengthened perception of Italy's political stability by market operators. Between June 2022 and December 2023, the increase in holdings from other domestic residents (households and corporates) more than compensated for the increase in the stock of debt, a trend that Morningstar DBRS does not rule out could continue in light of a large amount of household deposits. Households' demand has been subdued for years and, if it remains supportive, it could improve the diversification of funding.

Italy's Economic Fundamentals Remain Resilient, NRRP Expected to Support Growth

A high degree of economic diversification, coupled with a strong manufacturing sector and a large economy, support the credit ratings. Italy's manufacturing sector, although under pressure because of a weaker external environment, is expected to remain resilient. Over the last years, the sector has benefitted from growth in the size of firms and an improvement in external competitiveness, including a high degree of internationalisation. Labour market conditions have improved as well. Employment has surpassed a record level of 23.8 million and the unemployment rate at 7.5% in February 2024 is close to its lowest point in more than a decade.

Italy's post-pandemic recovery has been stronger than expected and better than those of other large euro area economies, with real GDP (seasonally and working-day adjusted, SWDA) in Q4 2023 4.2% above its pre-pandemic level. Exports and investments, particularly in the construction sector, have been supportive. Still, the impact from higher interest rates, high inflation, and weaker external demand have led to significant deceleration in growth to 0.9% in 2023 from 4.0% in 2022. Growth is expected to remain subdued at the start of the year before picking up, driven by an improvement in households' purchasing power and external demand, potentially in a less restrictive monetary policy environment in the euro area. The government projects growth to average 1.1% during 2024 to 2027, slightly above the central bank's 1.0% for 2024 to 2026. Purchasing power is expected to recover as inflation stays relatively low and a strong labour market leads to moderate wage gains. The impulse from the recovery plan on public investment should help mitigate the drag on residential investment due to the winding down of tax incentives, although this is subject to high uncertainty. The main uncertainties on the external side are linked to geopolitical developments and the weak economic conditions in Europe.

Italy's adverse demographics, low participation of women in the workforce, and weak labour productivity are expected to continue to limit growth potential. This weighs on the qualitative assessment of the "Economic Structure and Performance" building block. That said, some improvements are occurring thanks to higher real investment and stronger employment figures. The European Commission (EC) estimates that Italy's potential real GDP growth will average 0.8% over 2024 to 2028, which compares favourably with an estimate of 0.1% over 2010 to 2023. In this direction, despite the delays on actual expenditures, Morningstar DBRS continues to view Italy's NRRP as an opportunity to raise its GDP potential and improve the public debt trajectory. As of end-2023, Italy's actual expenditures reached around EUR 43.0 billion of the EUR 194.4 billion in its revised plan. There is still a large amount of NRRP resources that remain to be spent in a short period of time, which elevates implementation risk. However, Morningstar DBRS takes the view that this more streamlined plan, coupled with the fact public works are expected to pick up after the necessary legislative and bureaucratic hurdles have been surpassed, could help unlock funds and accelerate spending growth going forward.

Policy-Making Hindered by Frequent Government Turnover; Current Government Might Have a Window of Stability to Implement Policies

Italy's frequent turnover of governments has hampered the country's ability to address its structural challenges. Unstable governments, typically with short-lived mandates, have faced difficulties and fewer incentives to implement politically costly reforms to address Italy's growth and debt challenges. These institutional features impairing government effectiveness, coupled with concerns over the rule of law and control of corruption, are reflected in weaker governance indicators compared with peers. That said, the right-wing coalition currently in power appears more stable than previous governments and perhaps could have an opportunity to implement its policy agenda. The European parliamentary elections might elevate tensions within the coalition but appear unlikely to derail it given a fragmented opposition. The Next Generation EU resources available for Italy remain a strong incentive to follow through with the associated milestones and targets. On this front, the current government achieved the EC's endorsement for its revised NRRP plan, streamlining the projects included and introducing a REPowerEU chapter amounting to EUR 11.2 billion to speed up the energy transition and renewable energy deployment. While actual spending has been sluggish, as in other countries, Italy received the first four instalments of the Plan and was the first country to request the fifth instalment, having achieved 230 milestones and targets out of a total of 617.

Banks 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. Italy's banks have benefitted from an improvement in credit quality and capitalisation over the years, and profitability increased strongly because of the rise in net interest income and lower credit costs. Nevertheless, the economic slowdown and higher debt servicing costs of borrowers are expected to cause impaired assets to increase, albeit gradually and from a lower base. Low household and firm debt ratios, amongst the lowest in the euro area, and the predominance of fixed-rate mortgages (65.5% of total outstanding loans in September 2023) mitigate the impact of the sharp increase in interest rates and tighter credit standards. Loan growth is expected to remain sluggish given the still-high level of interest rates and lower investment needs due to the slowdown in economic activity. Morningstar DBRS 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 and the likely deterioration in credit quality, weighs on the "Monetary Policy and Financial Stability" building block assessment.

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 that are expected to gradually decline. The total stock of guarantees stood at around 14.4% of GDP as of December 2023, having dropped from 16.1% of GDP in 2021, and is projected to steadily fall as guaranteed loans provided during the pandemic are reimbursed. While claims on the COVID-19 guarantees are expected to pick up in 2024, as the grace period expired, Morningstar DBRS does not expect the value of claims to diverge significantly from the provisions set aside by the government unless a substantial and prolonged deterioration in the economic environment occurs. From a macroprudential perspective, Italy's central bank indicated its intention to activate a systemic risk buffer (or SyRB) of 1.0% with the aim of enhancing the resiliency of the Italian banking sector to adverse shocks that could undermine its capitalisation and lending capacity.

Current Account Balance Returned to Positive Territory After the Energy Shock; Italy's Export Performance to Remain Supportive

Italy's external position supports the credit ratings. On the back of comfortable goods trade surpluses, coupled with a stream of primary income surpluses, Italy's current account surplus averaged 2.0% of GDP over the last 10 years. The current account turned negative to 1.6% of GDP in 2022 due to the sharp rise in the cost of energy imports, before returning to positive territory at 0.5% of GDP as the terms of trade improved in 2023. The almost uninterrupted positive external balances have led to a sustained improvement in the country's NIIP. Since September 2020, Italy has returned to being a net external creditor, and the positive NIIP at 7.4% of GDP in Q4 2023 compares favourably with a trough of -25.3% of GDP in Q1 2014. Morningstar DBRS views the country's capacity to export as a key strength and does not expect a weakening in the competitiveness of the export-oriented manufacturing sector despite the slowdown of global trade growth and increasing unit labour costs. Real exports (SWDA) were 10.9% higher in Q4 2023 compared with pre-pandemic levels, despite stagnating in 2023 amid a challenging external environment. Going forward, the government projects current account surpluses of 1.9% during 2024 to 2027.

ENVIRONMENTAL, SOCIAL, AND GOVERNANCE CONSIDERATIONS

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

Social (S) Factors
The following Social factors had a significant effect on the credit analysis: The Human Capital and Human Rights factor affects the credit ratings. According to the International Monetary Fund's World Economic Outlook, Italy's GDP per capita of USD 38,326 in 2023 was relatively low compared with its euro area peers. This factor is considered significant and it has been taken into account primarily in the "Economic Structure and Performance" building block.

Governance (G) Factors
The following Governance factors had a significant effect on the credit analysis: The Institutional Strength, Governance, and Transparency factor affects the credit 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 at the 67th percentile for Government Effectiveness in 2022. This factor is considered significant and it has been taken into account primarily in the "Fiscal Management and Policy" and "Political Environment" building blocks. At the same time, Morningstar DBRS views the Bribery, Corruption, and Political Risks factor as relevant, also reflecting weak scores in the Rule of Law and in the Control of Corruption, according to the World Bank.

A description of how Morningstar DBRS considers ESG factors within the Morningstar DBRS analytical framework can be found in the Morningstar DBRS Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings (January 23, 2024) at https://dbrs.morningstar.com/research/427030/morningstar-dbrs-criteria:-approach-to-environmental,-social,-and-governance-risk-factors-in-credit-ratings.

For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments: https://dbrs.morningstar.com/research/431649.

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 (October 6, 2023) https://dbrs.morningstar.com/research/421590/global-methodology-for-rating-sovereign-governments. In addition Morningstar DBRS uses the Morningstar DBRS Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings https://dbrs.morningstar.com/research/427030/morningstar-dbrs-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://dbrs.morningstar.com/about/methodologies.

The sources of information used for this credit rating include Istat, Ministero dell'Economia e Finanza (Documento di Economia e Finanza, April 2024; Nota di aggiornamento al Documento di Economia e Finanza, September 2023; Draft Budgetary Plan 2024, October 2023; Press Releases N°44 of 03/26/2024 and N°169 of 11/20/2023), Ministero Affari europei, politiche di Coesione e Piano Nazionale di Ripresa e Resilienza (Quarta relazione al Parlamento sullo stato di attuazione del Piano Nazionale di Ripresa e Resilienza, February 2024), Bank of Italy (Economic Bulletin, April 2024; Macroeconomic Projections for the Italian Economy, April 2024; Financial Stability Report November 2023; Launch of Consultation - Systemic Risk Buffer, March 2024), Ufficio Parlamentare di Bilancio, ECB, EC ("Effort sharing 2021-2030: targets and flexibilities"), Eurostat, IMF (WEO April 2024, IFS), BIS, World Bank, Haver Analytics, and Social Progress Imperative. Morningstar DBRS considers the information available to it for the purposes of providing this credit 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

Morningstar DBRS does not audit the information it receives in connection with the credit 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. Morningstar DBRS' outlooks and credit ratings are under regular surveillance.

For further information on Morningstar DBRS historical default rates published by the European Securities and Markets Authority (ESMA) in a central repository, see: https://registers.esma.europa.eu/cerep-publication. For further information on Morningstar DBRS 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 credit rating assumptions can be found at: https://dbrs.morningstar.com/research/431648.

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

Lead Analyst: Javier Rouillet, Senior Vice President, Global Sovereign Ratings
Rating Committee Chair: Nichola James, Managing Director, Global Sovereign Ratings
Initial Rating Date: February 03, 2011
Last Rating Date: 27 October, 2023

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