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

DBRS Ratings GmbH (Morningstar DBRS) confirmed the Republic of Italy (Italy)'s Long-Term Foreign and Local Currency -- Issuer Ratings at BBB (high). The trend on all Long-Term ratings remains Positive. 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 the better-than-expected fiscal results in 2024 and the government's continued commitment to its medium-term fiscal adjustment plans despite a more challenging macroeconomic and geopolitical environment. The strong labour market performance, signs of higher-than-historical potential output growth, a healthier banking system, and the stability of the government also support the Positive trend. Italy recorded a fiscal deficit of 3.4% of GDP in 2024, below the 4.3% originally budgeted and the 7.2% in 2023. The improvement reflects the phase out of the residential building renovation schemes and the strength of fiscal revenues. The continuation of the positive trend incorporates the increasing trade and geopolitical tensions that could pose some challenges to Italy's fiscal consolidation efforts via lower growth, higher defence expenditure needs and higher funding costs. The escalation of global trade tensions has led to revisions in Italy's growth outlook and heightened uncertainty. While the economic impact via the direct trade channel is expected to remain contained for now, the impact could be more severe if global trade and investment confidence becomes sustained and significantly lower as consequence, so we are continuing to monitor the situation. Morningstar DBRS views positively the government's commitment to continue with their planned fiscal consolidation path despite the weaker macroeconomic assumptions. The fiscal outperformance in 2024 provided some room to absorb the deterioration triggered by the tariff shock. Furthermore, we expect Italy to step up its defence spending only gradually over time and without compromising its public debt sustainability.

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 of structural improvement in the economy leading to higher economic growth or enhanced resiliency or (2) a durable fiscal consolidation placing the debt-to-GDP ratio on a downward trajectory over the medium term.

The trend 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

The Escalation of Trade Tensions Dampens Italy's Growth Outlook, But Economic Diversification Mitigates the Risks

Italy's post-pandemic economic performance has been stronger than expected with real GDP (seasonally and working day adjusted, SWDA) 5.9% above its pre-pandemic level at the end of 2024. Still, the Italian economy has slowed down over the past two years, with real GDP growth of 0.7% in both years, dragged by the downturn in the manufacturing sector. The sector has been hit by weakness in Germany, the crisis in the European automotive sector, and rising energy costs. The labour market conditions continue to be strong from a historical perspective, with employment over 24.3 million in February 2025, compared to 23.0 million in December 2019, and the unemployment rate at 5.9%, one of the lowest points in more than a decade.

The escalation of global trade tensions has led to revisions in Italy's growth outlook and heightened uncertainty. Incorporating the U.S. tariff announcements on April 2, the Bank of Italy (BdI, Italy's central bank) revised downward its projections for real GDP growth to 0.5% in 2025 (-0.2%), 0.9% in 2026 (-0.3%), and 0.7% in 2027 (-0.2%). The central bank notes that the downward revision mainly reflects more unfavourable assumptions on the international situation due to the tightening of trade policies. The impact appears contained for Italy despite its large exposure to the U.S. economy. However, the central bank notes that the growth forecast is subject to significant uncertainty with possible retaliatory measures, materially weaker sentiment and investor confidence, or the emergence of prolonged financial tensions risking a more severe impact. The Ministry of Economy and Finance (MEF) in its new 2025 Public Finance Document released on the April 11 assumed a similar baseline with real GDP growth at 0.6% in 2025 and 0.8% both for 2026 and 2027, although its downward revision was more pronounced for 2025. Household consumption is expected to be the main driver of growth over this period on the back of a recovery of purchasing power of households. The ramp-up in the implementation of its National Recovery and Resilience Plan (NRRP, or the Plan), spurring infrastructure, machinery and equipment investment, should help offset the weaker developments in residential investments. Exports will be affected by the U.S. tariffs and recovery only gradually. While the 90-day pause on reciprocal tariffs, except for China, could offer some temporary reprieve, the large, broad-based, and rapid increase in U.S. tariffs to 10%, and to 25% on key manufacturing sectors, still represents a disruption to global trade.

A high degree of economic diversification, coupled with a strong manufacturing sector and a large economy, support credit ratings. On the other hand, 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 2025 to 2028, which compares favourably with an estimate of 0.2% over 2010 to 2024. Italy's ability to successfully implement its NRRP will determine whether the investments and reforms can have long-lasting effects on GDP potential. Italy has been at the forefront in implementing the national recovery plan. Italy was the first country to receive the sixth and request the seventh instalment of the plan, having reached 337 milestones and targets out of a total of 621, although actual spending has been slow as in other countries. At the end of 2024, it received about 63% of the EUR 194.4 billion of the total NRRP and spent 33% of the total plan or 52% of the money received. There is still a large amount of NRRP resources left to be spent in a short period of time, which elevates implementation risk. Authorities have implemented corrective actions to accelerate the timeline and address bottlenecks and are currently considering options to secure financing for projects at higher risk of not being implemented by the August 2026 deadline.

The Government Remains Committed to its Medium Term Fiscal Structural Plan Despite Increased Headwinds

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. The cumulative fiscal impact from the building renovation schemes (e.g. Superbonus) reached 9.1% of GDP between 2020 and 2024. The decision to tighten the conditions of the Superbonus has significantly reduced its uptake in 2024 and the fiscal impact is expected to remain muted going forward. Even so, the use of the tax credits related to the building incentives will raise state borrowing needs and continue to pressure the public debt ratio especially during 2025-2027.

The fiscal deficit declined markedly to 3.4% of GDP in 2024 from 7.2% in 2023 mainly reflecting the phase out of the Superbonus scheme. Italy recorded a primary surplus of 0.4% of GDP, for the first time since 2019, following a primary deficit of 3.6% in 2023. The headline deficit in 2024 was lower than the government's projections of 3.8% of GDP in October 2024 and the 4.3% of GDP originally budgeted. The better-than-expected results mainly reflect positive surprises on the revenue side, especially the increase in direct taxes. If higher revenues, linked to higher employment and activity, as well as higher tax compliance turn out to be largely permanent, this could help the government meet its commitment to reduce the fiscal deficit to below 3.0% of GDP by 2026.

The European Commission endorsed Italy's medium-term fiscal-structural plan (MTP). The government committed to a net spending growth path of 1.5% on average over the proposed seven-year adjustment period, with an implied average correction of the structural primary balance of 0.53% of GDP over the same period. In line with this, the main fiscal policy measures included in the 2025 budget were linked to making the cut in the contribution wedge and the personal income tax targeted relief permanent, as well as other business and labour support measures, compensated by temporarily higher tax collection on banks and insurance companies as well as spending cuts across ministries. The 2025 Public Finance Document confirmed the fiscal path outlined in Italy's MTP and foresees a gradual reduction in the fiscal deficit to 3.3% of GDP in 2025, 2.8% in 2026, and 2.6% in 2027. The better-than-expected fiscal result in 2024 is a good starting point for this path. On the other hand, a more challenging external environment could complicate the government's efforts to implement its fiscal consolidation objective. Weaker growth and greater pressures to increase defence spending could lead to a slower pace of fiscal consolidation than projected. Morningstar DBRS will assess the implementation and ability of the Italian government to sustain the required fiscal adjustment over time.

Public Debt Ratio Pressured by the Impact of Tax Credits, 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 rose to 135.3% of GDP in 2024 from 134.6% in 2023 driven by stock-flow adjustment related to the Superbonus. Compared to the peak of 154.3% in 2020, the public debt ratio has fallen due to strong nominal GDP growth. The snow-ball effect is now expected to be debt-increasing in the coming years for Italy and will need to be balanced with higher primary surpluses for the debt path to stabilise or trend down. The government projects that the public debt ratio will gradually increase during 2025 and 2026 despite the envisaged reduction in fiscal deficits, as tax credits accrued in previous years will be used to offset taxes, especially during 2025-2027. The MTP forecasts the public debt ratio to reach 137.8% of GDP in 2026, before falling thereafter to 132.5% by 2031. The debt ratio projections, only available for 2025-2027, are slightly better in the 2025 Public Finance Document. The downward path of the medium-term public debt ratio will depend on the government's ability to return to primary surpluses of 1.9% in 2028 and then of up to 2.4% in 2029, as indicated in its medium-term plan. Such primary surpluses would be close to Italy's pre-pandemic level. Now, the escalation of trade and geopolitical tensions pose risks to the government's public debt ratio projections. Planned asset sales over a 3-year period could also partially help contain debt pressures, although progress has been moderate so far.

Italy's interest payments, which stood at 3.9% of GDP in 2024, remain relatively high compared to other eurozone countries, due to Italy's large debt stock and comparatively higher financing costs. The government projects a gradual increase to 4.2% of GDP by 2027 driven by the effects from the ECB's still tight monetary policy and Italy's high borrowing needs. The average debt maturity of 7.0 years means that higher financing costs will gradually be passed on to the average cost of debt. Given Italy's large public financing needs and the ECB's quantitative tightening, the private sector will need to continue to absorb significant amounts of public debt. In this context, Italy's success in rebalancing public finances and implementing the investments and reforms in its NRRP will remain key to avoiding swings in investor confidence and to increasing investor appetite for Italian bonds. Morningstar DBRS notes that the still large share of debt that is held by the euro system and European authorities 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.

Current Government Thus Far Bucking the Trend of Frequent Turnover of Governments in Italy

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 impair 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 government led by Giorgia Meloni (Brothers of Italy) that took office in October 2022 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. This government continued the efforts from the previous administration to fulfil Italy's recovery plan milestones and targets and Italy's MTP includes a plan to strengthen reforms and investments in some of the key areas of Italy's NRRP from 2027 onwards. This includes reforms of the justice system, public administration, business environment, taxation as well as spending planning and management.

Italian Banks Face Macroeconomic Headwinds with Stronger Credit Fundamentals Than in the Past

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. Liquidity remains adequate despite reduced reliance on central bank funding. The pass-through from the ongoing normalisation of ECB's monetary policy will pressure banks' net interest income, following the strong results in 2023 and 2024, although this might be partially compensated by higher loan volumes as borrowing costs decline. Private sector loan growth is on track to return to positive territory, driven by the recovery in household credit, but geopolitical tensions and threats to global trade via tariffs pose risks to this trend for the remainder of the year. Banks' stronger risk profiles and sustained capital accumulation have fostered merger and acquisition (M&A) activity in recent times as Italian banks seek to improve their competitiveness in Europe and to ensure they can succeed in a lower interest rate environment by creating synergies and scale as well as enhancing revenue diversification (please see Large Italian Banks: Strong 2024 Results Are Helping M&A to Succeed in a Lower Interest Rate Environment: https://dbrs.morningstar.com/research/447926).

The asset quality metrics remained stable in 2024 despite higher interest rates, moderate economic growth, and vulnerabilities in certain sectors such as the automotive sector. Impaired assets are expected to increase over time, albeit gradually and from a lower base. A potential trade war could put additional pressure on Italian banks' asset quality, especially if prolonged (please see Italy: U.S. Tariffs Pose Some Risks to Economic Growth and Banks' Asset Quality: https://dbrs.morningstar.com/research/451181). Nonetheless, Italian banks enter this phase of uncertainty with stronger balance sheets, more robust capital buffers over supervisory requirements than in the past. Furthermore, household and firm debt ratios are among the lowest in the euro area. 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 13.4% of GDP in 2024, down from 15.7% of GDP in 2021, and is projected to continue falling 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.

Escalating Trade Tensions Pose Risks to Italian Exports, But Italy's External Position and Flexibility Act as Mitigants

The imposition of U.S. tariffs, with the risk of escalation due to retaliation measures, could significantly affect Italian export performance over the next couple of years. Italy exported goods worth EUR 64.8 billion to the United States and recorded a bilateral trade surplus of goods of EUR 38.9 billion in 2024. Italy, alongside Germany, had the highest share of merchandise exports destined to the U.S. as a share of total goods exports among the four largest EU economies, both at 10.4% in 2024. Despite its high exposure to the U.S. market, Italy's goods exports to the U.S. market tend to be of high quality and potentially less sensitive to price changes/tariffs, as noted by the BdI in its April Economic Bulletin. The main risk is that the escalation in trade tensions could lead to a more severe global demand shock and rising financial tensions, impacting the EU and Italy.

Although external risks have increased, Italy's external position supports the credit ratings. 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 because of the trade war. 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. Italy's current account surplus averaged 1.7% of GDP over the last 10 years on the back of comfortable goods trade surpluses. The current account surplus stood at 1.1% of GDP in 2024 as the effects of the sharp rise in the cost of energy imports in 2022 have largely reversed. 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 15.3% of GDP at Q4 2024 compares favourably with the Q1 2014 low of -25.2% of GDP.

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 40,287 in 2024 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. According to the World Bank Worldwide Governance Indicators in 2023, Italy ranked for Government Effectiveness (70.3 percentile) below its euro area peers. The following factor had a relevant effect on the credit analysis: Bribery, Corruption and Political. This reflects Italy's weak scores in the Rule of Law (60.8 percentile) and in the Control of Corruption (67.9 percentile), according to the World Bank. Morningstar DBRS has taken these considerations into account within the "Fiscal Management and Policy" as well as "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://www.dbrsmorningstar.com/research/452178.

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 di finanza pubblica 2025, April 11; Medium-Term Fiscal-Structural Plan 2025-2029, October 2024; Quarterly Issuance Programme - II Quarter 2025, March 2025; Presentations - April 2025), Ministero dell'Ambiente e della Sicurezza Energetica (Updated NECP 2021-2030, June 2024), Bank of Italy (Macroeconomic projections for the Italian economy, April 2025; Bollettino Economico, April 2025; Financial Stability Report, November 2024), Ufficio Parlamentare di Bilancio (Nota sulla congiuntura, February 2025), European Central Bank, European Commission (Council recommendation endorsing the national medium-term fiscal-structural plan of Italy, January 2025; Debt Sustainability Monitor 2024, March 2025), Eurostat, International Monetary Fund (WEO and IFS), BIS, World Bank, Social Progress Imperative, and Macrobond. 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, 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://www.dbrsmorningstar.com/research/452179.

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: 03 February 2011
Last Rating Date: 25 October 2024

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