DBRS Morningstar Confirms Republic of Italy at BBB (high), Trend Remains NegativeSovereigns
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 remains Negative on all ratings.
KEY RATING CONSIDERATIONS
Despite signs of resilience in gross domestic product (GDP) growth since the trough in April, the Negative trend reflects the still considerable uncertainty over the economic repercussions from the impact of the Coronavirus Disease (COVID-19). The recent escalation in new infections if not contained could lead to more stringent than expected restrictions hampering the recovery with likely a subsequent further deterioration in the fiscal accounts. Although the current economic shock does not reflect large imbalances, a slower recovery might result in a prolonged loss in output capacity. This could undermine Italy’s already fragile potential growth and ability to significantly reduce the very high public debt level in the medium term. The IMF projects the debt-to-GDP ratio to rise to 161.8% in 2020 from 134.7% in 2019. This rise is also the result of support measures triggering a large fiscal deficit in the absence of which the fall in GDP would have been even more dramatic leading to an even higher debt ratio than currently expected. DBRS Morningstar positively assesses Italy’s opportunity to benefit from the Next Generation EU (NGEU) programme, as it could address some structural weaknesses by supporting reform implementation and increasing public investment.
The confirmation of the BBB (high) rating reflects several factors. Italy benefits from the European Central Bank’s (ECB) current extraordinary financial backstop and is effectively managing the sharp increase in funding requirements with historical low interest cost. A large part of Italy’s public debt increase is purchased in the secondary market by the ECB, and in addition 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. Moreover, Italy is a wealthy and diversified economy, and the manufacturing sector has provided signs of resilience so far. 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 and the household savings ratio has reached a record level in recent months. Italy’s banking system is in a stronger position than in the past in terms of capitalisation and has made progress in reducing substantially net impaired assets, even though the economic fallout of the coronavirus pandemic will affect asset quality and the cost of risk.
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 public investment and 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 occurs undermining the government’s ability to meet its financing needs.
The Second Wave of the Virus is a Risk but A Resilient Manufacturing Sector and NGEU Opportunity Provide Comfort
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 in the world and with a GDP per capita of around EUR 30,000 in 2019 in purchasing power standards (PPS) it compares well with rating peers.
Prior to the outbreak, the country’s real GDP had not yet recovered to its 2007 level, and there is considerable uncertainty over Italy’s pace of recovery from the pandemic shock. After a GDP contraction of 18.0% year-on-year in the second quarter, the Italian Statistical Office (ISTAT) estimates a rebound of 16.1% quarter-on-quarter in Q3, and for the whole 2020 the Bank of Italy projects a GDP decline of around 9.5%. Despite the good performance of the industry sector in Q3 , however, risks remain on the downside for the whole of 2020 should the new infection levels not be contained, leading to restrictions on activity both in Italy and abroad. A GDP contraction in Q4 could have also important implications on 2021 when Italy’s economic performance will continue to depend on the evolution of the pandemic including the availability and distribution of a potential vaccine. A sharp contraction in hours worked has not been accompanied by a significant rise in the number of unemployed thanks to government measures. But the full ban on laying off workers is expected to be lifted next year leading to an increase in the unemployment rate in the first half of 2021. In DBRS Morningstar’s view, given the loosening fiscal stance allowed by the EU fiscal framework, the government will remain cautious in drastically removing fiscal support including the ban to lay off workers, even though this would have an adverse impact on the fiscal deficit, on job reallocation among sectors and firms and the appetite for strengthening active labour policies.
That said, recent economic indicators are better than expected and the EU’s recent decision on the NGEU bodes well for Italy’s economic outlook. In August, industrial production returned back to average levels registered in 2019, thanks to a high degree of resilience in the manufacturing sector. Previous shocks have been quite selective, leaving the corporate sector stronger in aggregate. Moreover, with EUR 205 billion (11.5% of 2019 GDP), the country is expected to be the largest gross beneficiary of EU resources from the NGEU program in coming years, but the government is required to design good projects and reforms to address country-specific recommendations with a focus on the green and digital transition. This could enable Italy to tackle some of the structural weaknesses that have undermined its GDP growth potential in the past and weighed on the negative qualitative assessment of the “Economic Structure and Performance” building block. The Italian government has the chance to revive economic growth by increasing public investment and effectively reforming and improving the management of the public administration, justice service, and education along with the announced tax reform. DBRS Morningstar will monitor in the coming months Italy’s national recovery plan and whether or not there are perspectives for a change from a poor historical performance in implementation of public investment and a generally weak appetite for reform.
The Improvement in the Fiscal Trajectory is Highly Dependent on the Pandemic and on Government Support Measures
Despite a prolonged weak economic performance, Italy’s past fiscal profile has on average seen primary surpluses higher than the majority of euro area countries since 1992. In recent 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, as the nominal economic performance has been weak compared with the interest cost.
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 while the structural deficit dropped to 1.9% from 2.3% the year before. However, in response to the pandemic the government has implemented a sizeable support package this year amounting to around EUR 100 billion, one of the largest in Europe. Discretionary measures, mainly including short-time work schemes, higher expenditure for healthcare, tax deferrals, resources to local entities, support for firms and the impact of automatic stabilisers will bring the fiscal deficit to 10.5% of GDP in 2020. The government aims to counteract the recent spread in the virus by gradually imposing new restrictive measures that will be accompanied by additional income support policies amounting to around EUR 5.4 billion.
Looking forward, DBRS Morningstar is aware that a reining in significantly of public expenditures would constrain the recovery, but fiscal targets in coming years might be ambitious if Italy will register a weak nominal economic performance as has happened in the past. A more selective wage supplement programme, tax relief for firms hiring in the south of the country, the refinancing of the cut in the tax wedge and EUR 14 billion grants from EU funds should provide a fiscal impulse of 2.1% of GDP next year. This should help the decline in the deficit as a share of GDP due to also the temporary nature of some measures implemented this year. After a decline to 7.0% of GDP next year the government projects a further drop to 4.7% and 3.0% in 2022 and 2023, respectively. But the government could struggle to shift from temporary demand-focused policies to more supply-side reforms and public investment, especially if the pandemic shock persists for longer than expected. At the same time, higher pressure on public finances might rise in the event that a large amount of guarantees to the private sector are activated in the future years.
The Government Is Expected to Serve Until 2023 but the Management of the Virus Second Wave is a Concern
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 weak appetite for reforms. 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 qualitative assessment of the “Political Environment” building block. On the other hand, eurosceptic rhetoric, in particular from the leading opposition party, League, has moderated significantly also in response to the lower than expected latest regional election results and the EU authorities’ response to the pandemic. This has further reduced the perception of the likelihood of Italy exiting the euro area.
Despite a fragmented and slim majority, particularly in the Senate, DBRS Morningstar projects the current government to serve its full term until March 2023. The approval of the constitutional reform to reduce the number of MPs would require an agreement on a new electoral law that might take time. Moreover, the Presidential election in 2022, along with the opportunity to use new EU funds, are important deterrents to a snap political election. However, following good approval ratings in the management of the first wave of the pandemic, the significant rise in new cases in recent weeks is a concern and could generate some frictions in the majority. Over recent weeks, the number of people treated in intensive care units is increasing quickly, from five at the end of September to more than ninety over the last few days on a seven-day average basis. The perception of long bureaucratic processes and weak coordination with the regions in the management of the recent rise in infections is mounting. The government is gradually imposing restrictive measures but they could take time to be effective, and localised lockdowns are likely. DBRS Morningstar is of the view that the government will do whatever it takes to avoid a full lockdown, but this risk is increasing.
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 broadly stabilised since 2016 but at 134.7% of GDP at end-2019 was at a very high level and it is expected to rise to a record level this year, positioning the country even more vulnerable to future shocks. The IMF projects the sharp economic contraction along with the sizeable increase in the fiscal deficit to bring public debt to 161.8% of GDP. DBRS Morningstar is aware that without a sizeable deficit increase and rapid support of the economy, the impact on the debt ratio could likely have been larger this year. The government projects debt as a share of GDP to start to decline next year to 155.6% but a high degree of uncertainty surrounds its strategy to bring the debt ratio close to 2019 levels in ten years. Elevated nominal growth rates in coming years together with gradual fiscal consolidation appear ambitious even including the use of NGEU funds. Recent historical evidence, points to Italian governments having difficulty in placing 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. A productive use of EU funds from the NGEU along with a credible agenda of reforms are therefore key elements in particular in light of the temporary ECB higher quantitative easing along with the current suspension of the Stability and Growth Pact due to the escape clause.
Nevertheless, Italy’s weighted-average interest service cost is expected to benefit from the ECB’s current extraordinary support in 2021 as well. According to the Italian fiscal watchdog (Ufficio Parlamentare di Bilancio), the ECB’s total purchases in the secondary market, by considering a capital key of around 17%, and EU funds from NGEU will result in only a marginal increase of the amount of Italy’s net public debt issuances required to be absorbed by the private sector compared with 2020. 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 rise to 3.5% of GDP this year from 3.4% in 2019, despite the sharp nominal GDP contraction before dropping to 3.3% next year. At the same time, the debt profile is sound reflecting the relatively long average maturity of securities at 6.79 years in September 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.
The Banking System is in a Better Position Than In The Past but A Rise in NPLs is Expected
Italian banks are stronger than in the past as both credit quality and capitalisation have improved but the wide scale of the economic recession and a potential slow recovery will likely translate into a deterioration in banks’ profitability and asset quality. Prior to the pandemic, the gross NPL ratio was on a declining trend and the flow of new non-performing loans (NPLs) was at pre-financial crisis level. However, despite the significant reduction in the gross NPL ratio to 6.1% as of Q2 2020 down from 18.2% in Q3 2015, the stock remains high and it is expected to increase, particularly when government support measures are withdrawn. Furthermore, some small and medium-size banks, which are implementing restructuring and cost efficiency programmes, are less diversified and still show 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.
In aggregate, government support measures, including debt moratoria and government guarantees, despite initial delays, have contributed to support business viability. Funding needs were met with large liquidity thanks to a marked increase in credit growth provided by the banking system. The lending growth rate rose to 10.2% year-on-year on average over the August and July period compared with around 1.0% in this first half of the year. This will contribute to further a increase in the debt of non-financial corporations that at 73% of GDP in Q2 2020, however, still remains below the Euro Area average of around 115% of GDP and benefits from favourable financing conditions. Similarly, household debt is one of the lowest in the EU and the savings ratio (the ratio of gross savings to gross disposable income), due to the lockdown and for precautionary reasons, increased significantly achieving a record level of 19.3% in Q2 2020 compared with around 10% in 2019. This 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 August 2020 amounted to 3.1% of GDP. The surplus in primary income has since 2017 followed strong export performance reflected in a reversal in the decline in Italy’s market share since 2013. This, in turn, has contributed to the decline of the country’s negative NIIP, (now close to balance at 1.5% of GDP as of Q2 2020), following the trough of -25.9% of GDP registered in Q1 2014.
The pandemic appears not to have significantly weakened the resilience of Italian exports so far, while the contraction in tourist flows has been marked. Goods exports after the significant decline during the second quarter by around 23.0% quarter-on-quarter has seen a renewed impetus since May 2020. In August at around EUR 38.8 billion the goods balance surplus remains one of the highest in Europe in the year-to-date. On the other hand, despite the easing of restrictions, the travel balance surplus recovered only partially, albeit being sustained by domestic tourism. The travel balance surplus was approximately EUR 5.3 billion year-to-date in August compared with EUR 12.2 billion in the same period of 2019; future prospects do not bode well considering the surge in infections globally. This adds to geopolitical risks, including the UK possibly leaving its Brexit transition period without a trade agreement, that cloud Italy’s external performance outlook. However, despite a high degree of uncertainty and a narrowing in the trade surplus in 2020, the external sector should remain a key strength for Italy in the medium term. Over the years, Italian exporters have been able improve their competitiveness by adapting to a changing environment.
Institutional Strength, Governance & Transparency (G) and Human Capital and Human Rights (S) are 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 in 2019 and according to the IMF, Italy’s GDP per capita at 33,200 USD in 2019 was comparatively low with its euro area peers. These factors have been taken into account in the “Economic Structure and Performance” and” 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/369132.
EURO AREA RISK CATEGORY: LOW
All figures are in Euros unless otherwise noted. Public finance statistics reported on a general government basis unless specified.
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 principal methodology is the Global Methodology for Rating Sovereign Governments https://www.dbrsmorningstar.com/research/364527/global-methodology-for-rating-sovereign-governments (July 27, 2020)
The sources of information used for this rating include Ministero dell’Economia e Finanza, Documento di Economia e Finanza (NADEF) October 2020, Draft Budgetary Plan 2021 October 2020, Bank of Italy – Economic Bulletin October 2020, Bank of Italy, Italian Statistical office (ISTAT), Ufficio Parlamentare di Bilancio (Audizione dell’UPB nell’ambito dell’esame del NADEF 2020), European Central Bank, Ministry of Health, European Commission, Eurostat, 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.
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With Access to Internal Documents: NO
With Access to Management: NO
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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:
The sensitivity analysis of the relevant key rating assumptions can be found at: https://www.dbrsmorningstar.com/research/369131.
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: Roger Lister, Managing Director, Chief Credit Officer - Global FIG and Sovereign Ratings
Initial Rating Date: February 3, 2011
Last Rating Date: May 8, 2020
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