Morningstar DBRS Changes Trends on Republic of Italy to Positive, Confirms Ratings at BBB (high)

DBRS Ratings GmbH (Morningstar DBRS) changed the trends on the Republic of Italy (Italy)'s Long-Term Foreign and Local Currency - Issuer Ratings to Positive from Stable and confirmed the 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 Short-Term ratings remains Stable.

KEY CREDIT RATING CONSIDERATIONS
The Positive trend reflects Morningstar DBRS' view that the improvement in Italy's expected medium-term fiscal path mitigates the risks associated with its public debt ratio, which remains very high. This is reinforced by Italy's better-than-expected recovery from the recent shocks, strong labour market performance, and signs of higher-than-historical potential output growth. The government has revised down its fiscal deficit projection for 2024 to 3.8% of GDP from 4.3% of GDP, mainly due to expected higher direct tax revenues and an upward revision to nominal GDP. The government commits in its medium-term fiscal-structural plan (MTP) to a net spending growth path, consistent with the new European economic governance framework, that would bring the deficit below the 3% threshold required to exit the Excessive Deficit Procedure by 2026, a year earlier than expected, and put the public debt ratio on a downward path from 2027. Morningstar DBRS views Italy's fiscal plan as credible but highlights that the improvement of the fiscal position is predicated on the permanent nature of the higher revenues and a sustained fiscal adjustment over a prolonged period. Morningstar DBRS will assess the implementation of the government's medium-term plan and the Italian government's capacity to sustain the implied fiscal adjustment over time.

Morningstar DBRS' confirmation of Italy's BBB (high) credit rating is underpinned by several factors. Italy benefits from European Union (EU) membership as well as the support and high credibility of the European Central Bank (ECB). The economy is large and diversified, supported by Europe's second-largest manufacturing sector and a resilient services sector. Also, Italy's external position benefits from the rapid recovery of its current account as well as the country's positive net international investment position (NIIP). Private sector indebtedness is one of the lowest in advanced countries, and the Italian banking system is in a stronger position than in the past in terms of capitalization and impaired net assets. However, credit ratings remain constrained by a very high level of public debt, high fiscal deficits since the pandemic, weak potential GDP growth, and a political environment that has hampered Italy's ability to address economic challenges.

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

The trends on the credit ratings could be returned to Stable if the fiscal outcomes underperform relative to government plans. 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

Improved Fiscal Path Expected Under the New Medium Term Fiscal Structural Plan, Likely but With Uncertainties Attached

Italy recorded high fiscal deficits of 8.4% of GDP on average during 2020-2023, dragged down by measures related to the pandemic, the energy crisis and the large accounting impact of building renovation tax incentives. As of Q1 2024, the accumulated use of the housing renovation schemes was slightly above 10.0% of GDP. Excluding the impact of the building renovation schemes, the average net fiscal deficit was 6.2% of GDP during 2020-2023 and 3.4% of GDP in 2023. Thus, an underlying fiscal repair was already underway. The decision to tighten the conditions of the Superbonus has significantly reduced its uptake this year and the fiscal impact in accrual terms is expected to remain small in the coming years, although the associated tax credit claims concentrated during 2024-27 will put pressure on the public debt ratio.

The government projects that the fiscal deficit will decline to 3.8% of GDP in 2024 from 7.2% of GDP in 2023, driven mainly by the phasing out of the Superbonus. The 0.5% of GDP improvement in the 2024 deficit projections compared to the Stability Programme reflects the expectation of higher direct tax revenues and an upward revision to nominal GDP. The government's projections imply that these higher revenues, due to increased employment and activity, as well as higher tax compliance, are largely permanent and therefore improve the medium-term fiscal trajectory. Morningstar +DBRS considers this to be likely but will have to be confirmed by future revenue flows. The primary balance is expected to return to a small surplus of 0.1% of GDP in 2024 for the first time since 2019.

The medium-term fiscal-structural plan (MTP) submitted to the European Commission confirms Italy's commitment to fiscal discipline and to the new European economic governance framework. The government committed to a net spending growth path of 1.5% on average over the proposed seven-year adjustment plan, consistent with European Commission's reference trajectory. This is estimated to be consistent with a seven-year average correction of the structural primary balance of 0.53% of GDP between 2025-31. In the policy scenario included in Italy's 2025 Draft Budgetary Plan the deficit is expected to fall to 3.3% of GDP in 2025, 2.8% in 2026, and 2.6% in 2027. This includes the net fiscal impact of the government measures of 0.4% of GDP in 2025, 0.2% in 2026, and 0.4% in 2027. The government plans to use this fiscal space mainly to make structural the cut in the contribution wedge and the personal income tax targeted relief, as well as other business and labour support measures, compensated by temporarily higher taxes collection on banks and insurance companies, spending cuts in ministries, and some measures still not fully detailed. Morningstar DBRS will assess the implementation and ability of the Italian government to sustain the required fiscal adjustment over time.

Public Debt Ratio to Increase Due to the Impact of Tax Credits in the Next Couple of Years, But Planned Fiscal Consolidation Could Improve Debt Dynamics

Italy's very high public debt ratio, the second highest in the EU, constrains its credit ratings. The country's public debt ratio and interest burden make the country vulnerable to shocks and limit fiscal space for further government measures. Public debt to GDP stood at 134.8% in 2023, below the 137.3% previously estimated, mainly due to the upward revision of nominal GDP. This is only slightly higher than the pre-pandemic level (133.8% of GDP) and well below the peak of 154.3% in 2020. Strong nominal growth, in part due to high inflation, contributed to this significant decline in the debt ratio. The government projects that the public debt ratio will gradually increase during 2024-2026 despite the reduction in fiscal deficits, as tax credits accrued in previous years will be used to offset taxes, especially during 2024-2027. The MTP forecasts the public debt ratio to reach 137.8% of GDP in 2026, before falling to 134.9% in 2029 and 132.5% in 2031. This downward path of the medium-term public debt ratio will depend on the government's ability to return it to levels close to Italy's pre-pandemic primary surplus at 1.9% in 2028 and then to 2.4% in 2029 as outlined in its medium-term plan. A progressive reduction in Treasury liquidity deposits and asset sales worth 1.0% of GDP over a three-year horizon should contribute to debt reduction. These are ambitious goals, but possible in the opinion of Morningstar DBRS.

The interest bill as % of GDP, after moderating because of lower inflation to 3.7% in 2023 from 4.1% in 2022, is projected to increase to 3.9% during 2024-2026 and then gradually to increase over time. This reflects the gradual increase in the average cost of debt due to the ECB's monetary policy hikes between July 2022 and September 2023 and Italy's high borrowing needs. This impact is mitigated by Italy's average maturity of 7.0 years and the ECB's recent and expected rate cuts in the coming months. Moreover, a large share of debt is held by the euro system and 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 gradual reduction in the euro-system's holdings of Italian sovereign debt has been offset by increased demand from households and non-resident investors, a trend that Morningstar DBRS does not rule out continuing in coming years. Given the still considerable financing needs, Italy's success in reducing its fiscal deficit and implementing investment and reforms in its National Recovery and Resilience plan (NRRP, or the Plan) will remain important to preserve investor confidence.

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 credit ratings. Italy's manufacturing sector, although under pressure due to a weaker external environment, is expected to remain resilient. Labour market conditions have also improved. Employment has surpassed a record level of 24.1 million and the unemployment rate of 6.2% in August 2024 is near its lowest point in more than a decade.

Italy's post-pandemic recovery has been stronger than expected, with real GDP (seasonally and working day adjusted, SWDA) in Q2 2024 5.5% above its pre-pandemic level. Investment, especially in construction, and exports have been supportive. The impulse from the NextGen EU funds also played a key role. Still, higher interest rates, high inflation, and weaker external demand have led to significant deceleration in real growth to 0.7% in 2023 from 4.7% in 2022. Annual growth in 2024 could slightly underperform the government's projected 1.0% given the lower carry-over at 0.4% resulting from the national accounts revision. From a sectoral perspective, moderate growth is driven by the services sector, while the slowdown in the manufacturing sector appears to be bottoming out and construction is proving more resilient than feared to phase out of building renovation tax credits. The government expects activity to expand by 1.2% in 2025, 1.1% in 2026 and 0.8% in 2027. Household consumption is expected to regain momentum thanks to the recovery of purchasing power of households, while an acceleration of the implementation of the recovery plan boosts public investment and machinery and equipment investment. The main uncertainties on the external side are related to geopolitical developments and 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. 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 0.9% over 2024 to 2028, which compares favourably with an estimate of 0.1% over 2010 to 2023. Italy's ability to successfully implement its NRRP will determine whether this investments and reforms can have long-lasting effects on GDP potential. Italy has already received EUR 113.5 billion in loans and grants, which is 58.4% of the EUR 194.4 billion in its revised plan, after achieving around 43% of planned milestones and targets. As of end of June 2024, Italy's actual expenditures reached EUR 51.4 billion, corresponding to 26% of the plan or 45% of the funds already received. 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. In addition, Italy included in its medium-term structural fiscal plan additional reforms and investments after 2026 to request the extension to a seven-year plan.

Policymaking 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 has made progress on the implementation of Italy's recovery plan and has presented a responsible MTP, in Morningstar DBRS view. The Next Generation EU resources available for Italy remain a strong incentive to follow through with the associated milestones and targets. While actual spending has been sluggish, as in other countries, Italy received the first five instalments of the Plan and was the first country to request the sixth instalment, having achieved 269 milestones and targets out of a total of 617. In addition, Italy's MTP includes a plan to strengthen reforms and investments in some of the key areas of Italy's PRNR from 2027 onwards. This includes reform of justice, public administration, the business environment, taxation, and spending planning and management.

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. Morningstar DBRS does not expect a material credit impact on Italian banks and insurers as result of the proposed freeze to the deductibility of banks' deferred tax assets (DTAs) in 2025 and 2026, among other target measures to the financial sector (please see Italian Banks and Insurers Called to Contribute to Government's Budget Plan; Broadly Manageable Impact). Their overall good profitability prospects and robust capitalisation, as well as the temporary nature of the measure, mitigate the impact.

The asset quality metrics remain stable despite higher interest rates and a slowing economy. Low household and firm debt ratios, amongst the lowest in the euro area, and the predominance of fixed-rate mortgages mitigate the risks from higher interest rates. Impaired assets are expected to increase over time, albeit gradually and from a lower base. Loan growth remained sluggish given the still-high level of interest rates and lower investment needs in a decelerating environment, however, the annual contraction of loans to the private sector has receded. The ongoing reduction in interest rates should help support loan growth in the next quarters. The sizeable stock of NPLs in the economy, now largely in the hands of specialised investors, still burdens debtors and could curb new credit flows and 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 number of public guarantees provided since 2020. The total stock of guarantees stood at 13.3% of GDP as of June 2024, having dropped from 16.1% of GDP in 2021, and is projected to steadily fall as guaranteed loans provided during the pandemic are reimbursed. Unless a substantial and prolonged deterioration in the economic environment occurs, Morningstar DBRS does not expect the value of claims to diverge significantly from the provisions set aside by the government. From a macroprudential perspective, Italy's central bank activated 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 1.8% of GDP over the last 10 years. The current account turned negative to 1.7% of GDP in 2022 due to the sharp rise in the cost of energy imports, before virtually rebalancing benefiting from the improvement in the terms of trade 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 10.5% of GDP in Q2 2024 compares favourably with a trough of -25.2% 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. Italy's manufacturing sector remains flexible and diversified, and in recent years, has benefited from growth in the size of companies and the improvement of external competitiveness, including a high degree of internationalization. Real exports (SWDA) were 9.0% higher in Q2 2024 compared with pre-pandemic levels, despite stagnating in 2023 amid a challenging external environment. Going forward, the government projects current account surpluses on average of 2.1% during 2024 to 2027.

ENVIRONMENTAL, SOCIAL, AND GOVERNANCE CONSIDERATIONS

ESG Considerations had a significant effect on the credit analysis.

Social (S) Factors
The following Social factor had a significant effect on the credit analysis: Human Capital and Human Rights. According to the International Monetary Fund, Italy's GDP per capita of USD 39,012 in 2023 was relatively low compared with its euro area peers. Morningstar DBRS has taken these considerations into account within the "Economic Structure and Performance" building block.

Governance (G) Factors
The following Governance factor had a significant effect on the credit analysis: Institutional Strength, Governance, and Transparency. 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 67th percentile in 2022. The following factor had a relevant effect on the credit analysis: Bribery, Corruption and Political. This reflects weak scores in the Rule of Law and in the Control of Corruption, according to the World Bank. Morningstar DBRS has taken these considerations into account these considerations into account within the "Fiscal Management and Policy" and "Political Environment" building blocks.

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

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 Factors in Credit Ratings (13 August 2024) https://dbrs.morningstar.com/research/437781

For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments: https://dbrs.morningstar.com/research/441771/.

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 (15 July 2024) https://dbrs.morningstar.com/research/436000. In addition Morningstar DBRS uses the Morningstar DBRS Criteria: Approach to Environmental, Social, and Governance Factors in Credit Ratings https://dbrs.morningstar.com/research/437781 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 these credit ratings include Istat, Ministero dell'Economia e Finanza (Documento programmatico di bilancio 2025, October 2024; Piano strutturale di bilancio di medio termine 2025-2029, September 2024; Documento di Economia e Finanza, April 2024), Ministero dell'Ambiente e della Sicurezza Energetica (Updated NECP 2021-2030, June 2024), Bank of Italy (Bollettino Economico, October 2024; Audizione preliminare all'esame del Piano strutturale di bilancio di medio termine 2025-29, October 2024; Financial Stability Report, April 2024; Activation of the systemic risk buffer, April 2024), Ufficio Parlamentare di Bilancio (Audizione nell'ambito dell'esame del PSB 2025-29, October 2024), ECB, EC (2024 Country Report - Italy, June 2024), Eurostat, IMF (WEO, IFS, 2024 Article IV Consultation staff report), BIS, World Bank, Social Progress Imperative, Macrobond, and Haver Analytics. Morningstar DBRS considers the information available to it for the purposes of providing these credit ratings to be of satisfactory quality.

With respect to FCA and ESMA regulations in the United Kingdom and European Union, respectively, these are unsolicited credit ratings. These credit ratings were 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 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 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/441772/.

These credit ratings are 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: April 26, 2024

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