DBRS Morningstar Confirms Republic of Italy at BBB (high), Trend changed to Negative

DBRS Ratings GmbH (DBRS Morningstar) confirmed the Republic of Italy’s Long-Term Foreign and Local Currency – Issuer Ratings at BBB (high). At the same time, DBRS Morningstar confirmed the Republic of Italy’s Short-Term Foreign and Local Currency – Issuer Ratings at R-1 (low). The trend has been revised from Stable to Negative on all ratings.

KEY RATING CONSIDERATIONS

The negative trend reflects the considerable uncertainty over the economic repercussions from the impact of the coronavirus disease (COVID-19) in an already weak economic environment. This brings the risk that a prolonged loss of production capacity further weakens Italy’s fragile growth potential, weighing on Italy’s ability to improve its public debt sustainability in the future. As other leading economies, the unprecedented economic shock is prompting an extraordinary level of government support to mitigate the adverse economic impact, but this comes at a cost to the government’s financial balance sheet. As a consequence, public debt will likely soar from 134.8% of GDP at the end of 2019 to 155.5% of GDP by the end of this year, according to the latest IMF projections.

The confirmation of the BBB (high) rating reflects several factors. DBRS Morningstar expects Italy to effectively manage the sharp increase in funding requirements in a low interest rate environment. Not least, as with other Euro system members Italy stands to benefit from the current European Central Bank (ECB’s) extraordinary financial backstop. A large part of Italy’s public debt increase will likely be purchased in the secondary market by the ECB, and a higher flow of interest will be likely returned to the Italian government from the Bank of Italy’s net income related to the ECB’s bond buying programmes. Recent higher uncertainty following the German constitutional court ruling is not expected to undermine the programmes in the near term and EU institutions appear committed to provide support. Moreover, Italy is a wealthy and diversified economy. With a current account surplus and a close to balance Net International Investment Position (NIIP), the country’s external position is good. At the same time, both households and corporations are facing this shock with one of the lowest levels of private sector debt among advanced countries. Italy’s banking system is in a stronger position than the past in terms of capitalization and has made progress in reducing substantially net impaired assets, even though the economic fallout of the coronavirus disease will affect asset quality and cost of risk .

RATING DRIVERS

An upgrade is unlikely in the near term. However, the ratings could be upgraded if the economic outlook improves dramatically, supporting a very rapid fiscal consolidation and reduction in corporate and financial sector stresses. The ratings trend could return to Stable: (1) if evidence arises of a successful policy response for example by revamping the reform effort and/or (2) the Italian economy performs better than currently expected.

Ratings could be downgraded if one or a combination of the following factors should occur (1) Italy’s economic prospects become structurally weaker (2) the government fails to implement a strategy to reduce the debt-to-GDP ratio in the medium-term (3) a material rise in sovereign funding costs undermining the government’s ability to meet its financing needs.

RATING RATIONALE

The Pandemic to Test Italian Economic Resilience

A high degree of economic diversification, coupled with a strong manufacturing sector and wealthy economy support the ratings. Italy is one of the largest manufacturing exporters and with a GDP per capita of around EUR 31,000 in 2019 in purchasing power standards (PPS) it compares well among rating peers. However, the consequences of the pandemic will test Italian economic resilience and more lasting structural effects may occur.

Prior to the outbreak, the country’s GDP had not recovered from the 2008-09 and 2012-2013 recessions, and a marked and potential long-lasting drop in firms’ turnover, if followed by a solvency crisis may lead to a prolonged loss in production capacity and hamper the recovery. Preliminary GDP estimates from the Italian statistical office point to a 4.7% quarter-on-quarter contraction in Q1 2020, and despite being lower than the government’s expected 5.5%, provides some early impact of the imposed restrictions. Growth will likely rebound but it could be uneven as some sectors could quickly recover whilst others could struggle to manage social distancing measures. The government expects GDP to fall by 8% in 2020 before recovering to 4.7% in 2021. That said, there is a high degree of uncertainty and risks are tilted to the downside, especially if households and firms are less inclined to spend and invest. On the other hand, the government projections do not incorporate the positive impact of upcoming new support measures nor the second round effects of the legislated bills since March.

Overall, DBRS Morningstar takes the view that Italy could mimic past recoveries after previous large shocks with a slower rebound. The IMF expects GDP to contract by 9.1% this year with a partial recover of 4.8% next year. The country already suffers from a weak structural growth, due to sluggish productivity dynamics and poor demographic trends, which reflect the negative qualitative assessment of the “Economic Structure and Performance” building block.

DBRS Morningstar continues to monitor the recovery of the Italian economy given the possible structural implications including in the important tourist sector that accounts for about 6% of total employees and contributed to an overall 13% of GDP in 2017, according to the World Travel and Tourism Council. This sector along with the retail trade, art, the automotive and transport services sectors may suffer the most from the social distancing measures. Historical evidence points to a slow reaction of the labour market to severe GDP contractions in Italy compared with other advanced countries. The unemployment rate is expected to rise to 12.7% by the end of 2020 from the 9.5% registered prior to the pandemic in January 2020, but this projection may be affected by the increase in the number of inactive people as well as those befitting from the wage supplement. DBRS Morningstar projects instead a substantial fall of working hours.

Rapid liquidity support from the banking system along with measures to strengthen the firms’ capital may soften the negative impact of the shock in particular in the competitive manufacturing sector, which will benefit from the easing of the lockdown. Moreover, in DBRS Morningstar’s view, although in the country the number of micro and small firms is large and in general more vulnerable, overall Italy’s firms show some degree of resilience compared with previous crises. Leverage levels have declined, profitability and debt servicing cost have improved along with a lengthening of debt maturities. Taking advantage of the best practices, including the digitalization process boosted by the lockdown, and with a credible long-term view on growth enhancing reforms, Italy’s structural growth could be preserved and even improved. Conversely, the country’s growth prospects could become weaker, and this would have a negative impact on ratings.

The Fiscal Support Package is Sizeable But Additional Measures May Be Needed

Despite a prolonged weak economic performance, Italy’s past fiscal profile has mostly seen primary surpluses higher than the majority of the eurozone countries since 1992 on average. Over the last years, however, Italy’s governments, in spite of some attempts to introduce spending reviews and the benefit of low sovereign funding costs, have failed to substantially reduce the headline deficit. Governments have attempted to strike a balance between gradual fiscal consolidation and support to growth but fiscal room has been predominantly used for social transfers or sometimes for tax reductions without a significant boost to the economy. The complexity of reactivating public investment constrained by the high administrative burden, and unstable majorities have played a key role.

Prior to the coronavirus outbreak, stronger fiscal revenues had resulted in better than expected improvements in both the structural and the fiscal deficits. In 2019 the headline deficit declined to 1.6% of GDP, the lowest level since 2007 from 2.2% in 2018. However, as in other economies, the prolonged lockdown is prompting substantial budgetary support. Main government measures include: (i) loan guarantees for micro, Small and Medium Enterprises (SMEs) and large corporations of around 40% of GDP, (ii) tax deferrals, (iii) the broadening of the wage supplement and the freeze of layoffs, (iv) debt moratoria, and (v) higher spending on the healthcare sector. Additional measures may include the refinancing of the wage supplement, further support for households and self-employees, recapitalization of the national aviation company and acceleration in both the repayment of public administration debt arrears and in planned public investment. The government estimates an increase in the deficit to 10.4% of GDP in 2020 before a substantial drop to 5.7% next year due to the temporary features of several measures in combination with a partial recovery of the economy.

DBRS Morningstar views positively the government’s decision to permanently sterilize the VAT increases already legislated. This will improve fiscal credibility targets. On the other hand, the fiscal support measures may turn out larger than expected depending on the size of the downturn, and additional tax deferrals may be deemed necessary, leading to an even higher 2020 deficit and increase in the public debt ratio. Moreover, some forms of income support could remain in place for a long time should the recovery be weaker than expected delaying the repair in fiscal accounts. At the same time, higher pressure on public finance might rise in the event that a large amount of guarantees to the private sector are activated in the future. All these factors cloud Italy’s fiscal outlook and contribute to a negative qualitative adjustment in the “Fiscal Policy and Management” building block.

Tensions Unlikely to Destabilize the Government in the Near Term but Much Could Depend on the Relaxation Stage

Political uncertainty traditionally remains a concern in Italy and weighs on the ratings. In DBRS Morningstar’s view, this reflects both a structural feature of the Italian political system characterised by the frequent change in governments, and the recent political rhetoric which appears incompatible with a coherent and affective reform effort. Moreover, there is little cross party consensus on how to address structural problems in the context of generally low electoral support for reforms. All these factors contribute to a weak capacity of the government to address economic challenges and provide support for a negative adjustment in the “Political Environment” building block.

The strategy to place the economy in a strict lockdown has resulted in good approval ratings for Mr. Conte, the Prime Minister, thus far. The government has also benefitted from inconsistent messaging from the opposition which has led to the leading party, League, slightly declining in opinion polls. The number of new infected cases is falling as is the number of intensive care cases. Although there are still important difference among some regions, nationally new daily cases are around 1,400 in the first week of May compared with more than 6,000 registered at the end of March. Hospitals have increased capacity and the government is gradually easing the lockdown. Nevertheless, the relaxation stage, “Phase two” may prove challenging should the economy not rebound and/or a resurgence of the infection materialize causing a reversion to lockdown. This scenario may risk destabilizing the government.

Tensions within the government majority might rise regarding the potential use of Pandemic Crises Support Line (PCS) of the European Stability Mechanism (ESM, rated AAA, Stable Trend). However, in DBRS Morningstar’s view, risks to government stability remain contained in the near term as Forza Italia might support the government in any decision to seek euro system support lines. Beyond the use of the ESM, the temporary Support to mitigate Unemployment Risks in an Emergency (SURE), the guarantees provided by the European Investment Bank (EIB, rated AAA, Stable Trend) and the expected Recovery fund, could cushion Italy’s funding needs and help the recovery, albeit the timing, the conditions and the overall size have not agreed yet.

The Public Debt-to-GDP Ratio Will Rise to a Record Level but Debt Service is Expected to Remain Affordable

The public debt-to-GDP ratio has broadly stabilized since 2016 but at 134.8% of GDP is very high and it is expected to rise to a record level this year positioning the country even more vulnerable to future shocks. The government projects the sharp economic contraction along with the sizeable increase in the fiscal deficit to increase public debt to 155.7% of GDP this year before declining to 152.7% in 2021. There is a considerable uncertainty due to the impact of the recession, but without a sizeable deficit increase and a rapid support of the economy, the impact on the debt ratio could be larger. Looking forward, a temporary economic shock and a credible strategy to phase out fiscal support measures, would mitigate risks to debt sustainability. Recent historical evidence, however, points to a weak ability of Italian governments to place the debt ratio on a declining trajectory, even though sovereign funding costs have declined over time. This is largely due to Italy’s structural growth which has remained poor for decades.

Nevertheless, Italy’s weighted average interest service cost is expected to benefit from the current ECB’s extraordinary support. The debt stock will increase substantially, but according to the Italian fiscal watchdog (Ufficio Parlamentare di Bilancio), total ECB’s purchases in the secondary market, also by considering a capital key of around 17%, could reduce the amount of Italy’s public debt required to be absorbed by the private sector in 2020 compared with last year. The ECB’s policy is therefore an important safety net in the near term. This will help to contain the level of Italy’s sovereign interest costs, which the government projects only to slightly increase to 3.7% of GDP this year, the same level as in 2018, despite the sharp drop in nominal GDP. At the same time, the debt profile is sound reflecting the relatively long average maturity of securities at 6.96 years in March 2020, and the large share of fixed-rate total debt. These features should help limit the potential impact of shocks on yields, should investor confidence again deteriorate, or monetary policy become tighter.

Banking System is in a Better Position Than In The Past but A Rise in NPLs is Expected

Italian banks are stronger than the past as both credit quality and capitalization have improved but the wide scale of the economic recession will translate into a deterioration in banks’ profitability and asset quality. Medium term implications will depend on the evolution of the outbreak, the length of the economic shutdown, as well as the transition phase of the recovery and government measures. Prior to the pandemic, the gross NPL ratio was on a declining trend and the flow of new NPLs was at the pre-crisis levels. However, despite the significant reduction in the gross NPL ratio to 6.7% as of Q4 2019 down from 18.2% in Q3 2015, the stock remains high and it is expected to increase. Furthermore, some small and medium sized banks, which are implementing restructuring and cost efficiency programmes are less diversified and show still high levels of impaired assets. These factors are likely to weigh on banking support to Italy’s economy and led to a negative qualitative assessment in the “Monetary Policy and Financial Stability” building block. However, total household and non-financial private-sector debt of 109.6% of GDP in Q4 2019 compared with 165.5% in the Euro Area on average is one of the lowest among advanced economies and mitigates risks to financial stability.

The Ratings Benefit from Italy’s Sound External Position, although the Tourism Sector is Being Dented

The improvement in Italy’s external position in recent years supports the ratings. Since 2013, the current account has shifted into surplus and in the twelve months ending February 2020, amounted to 3.1% of GDP. Stronger export performance, reflected in a reversal in the decline in Italy’s market share since 2013, along with the surplus in the income balance, have supported the improvement in the current account position. This, in turn, has contributed to the decline of the country’s negative NIIP, which is close to being balanced (-1.7% of GDP at end of 2019), following the worst point of -25.1% of GDP registered at in Q1 2014.

The global spread of the epidemic has resulted in a sharp contraction in tourist flows and global trade. In addition, geopolitical risks, including the U.K’s departure from the EU, and underlying trade tensions cloud Italy’s external performance outlook. Although the shock may prove temporary, the surplus in the travel balance of around 1.0 % of GDP in 2019 will be eroded as Italy’s tourist attractiveness is likely to be reduced even when travel restrictions are eased. On the other hand, in DBRS Morningstar’s view, in the absence of a second wave of the COVID-19, the relaxation of the restrictive measures both in Italy and abroad should provide a renewed impetus to exports. With a considerable level of uncertainty, the surplus in the trade balance will narrow but in the medium-term should remain a key strength. Over the years, Italian exporters have been able to adapt to a changing environment by improving their competitiveness. At the same time, the fall in oil prices as well as the contraction in demand will likely mitigate the sharp decline in exports.

ESG CONSIDERATIONS

Institutional Strength, Governance & Transparency (G) is among the key drivers behind this rating action. According to the latest World Bank Governance Indicators, Italy ranks in the 62nd percentile for Rule of Law. This factor has been taken into account in the Political Environment building block. A description of how DBRS Morningstar considers ESG factors within the DBRS Morningstar analytical framework and its methodologies can be found at: https://www.dbrsmorningstar.com/research/357792.

For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments: https://www.dbrsmorningstar.com/research/360821/.

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 (17, September, 2019): https://www.dbrsmorningstar.com/research/350410/global-methodology-for-rating-sovereign-governments.

For more information regarding rating methodologies and Coronavirus Disease (COVID-19), please see the following DBRS Morningstar press release: https://www.dbrsmorningstar.com/research/357883.

The sources of information used for this rating include Ministero dell’Economia e Finanza, Documento di Economia e Finanza (DEF) April 2020, Bank of Italy - Financial Stability Report April 2020, Bank of Italy – Economic Bulletin April 2020, World Travel and Tourism Council, Bank of Italy, Italian Statistical office (ISTAT), Ufficio Parlamentare di Bilancio (Audizione dell’UPB nell’ambito dell’esame del DEF 2020), European Central Bank, Ministry of Health, European Commission, IMF WEO (World Economic Outlook October 2019 and April 2020), Eurostat, IMF Fiscal Monitor (April 2020), BIS, World Bank, UNDP, Haver Analytics. DBRS Morningstar considers the information available to it for the purposes of providing this rating to be of satisfactory quality.

This is an unsolicited rating. This credit rating was not initiated at the request of the issuer.

With Rated Entity or Related Third Party Participation: YES
With Access to Internal Documents: NO
With Access to Management: YES

DBRS Morningstar does not audit the information it receives in connection with the rating process, and it does not and cannot independently verify that information in every instance.

Generally, the conditions that lead to the assignment of a Negative or Positive trend are resolved within a 12-month period. DBRS Morningstar’s outlooks and ratings are under regular surveillance.

For further information on DBRS Morningstar historical default rates published by the European Securities and Markets Authority (ESMA) in a central repository, see:
http://cerep.esma.europa.eu/cerep-web/statistics/defaults.xhtml.

The sensitivity analysis of the relevant key rating assumptions can be found at: https://www.dbrsmorningstar.com/research/360820/.

Ratings assigned by DBRS Ratings GmbH are subject to EU and U.S. regulations only.

Lead Analyst: Carlo Capuano, Vice President, Global Sovereign Ratings
Rating Committee Chair: Chair: Roger Lister, Managing Director, Chief Credit Officer, Global FIG and Sovereign Ratings
Initial Rating Date: February 3, 2011
Last Rating Date: November 15, 2019

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