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 on all ratings remains Stable.
KEY RATING CONSIDERATIONS
The Stable trend reflects DBRS Morningstar’s view that risks to the ratings are balanced. The progress in diversifying the country’s gas supply, and the expectation that the new government will not deviate significantly from a prudent fiscal stance offsets the deterioration in the country’s growth outlook. So far, Italy’s economy has experienced a rapid post-pandemic recovery but its reliance on gas imports makes it vulnerable to high energy prices and lower gas supply in coming quarters. DBRS Morningstar does not rule out a modest recession in 2023, but long-lasting implications are expected to be limited as severe gas rationing, if any, are expected to be moderate. The government has started to make progress with public investment and also with reforms in its National Recovery and Resilience Plan (NRRP), which aims at raising potential growth, although some planned expenditures have already been postponed. If successful, the NRRP would boost what has been historically weak economic growth. Fiscal accounts have been improving more than expected and keeping a conservative fiscal stance remains key to restoring fiscal space and reducing the debt-to-GDP ratio. This should continue to decline to around 145.4% this year, which would represent a cumulative decline of almost ten percentage points in two years from the peak of 154.9% in 2020.
DBRS Morningstar’s confirmation of Italy’s BBB (high) rating is underpinned by several factors. Italy benefits from European Union (EU) membership as well as from the European Central Bank (ECB)’s support and high credibility. The economy is large and diversified and the important manufacturing sector has demonstrated a high degree of resilience so far, albeit signs of deterioration are already visible in the energy intensive sector due to high energy prices. The current account is shifting to a negative position, but Italy’s export capacity remains a supportive factor as does the country’s positive net international investment position (NIIP). Moreover, private-sector debt is one of the lowest among advanced countries. Household savings and corporate deposits in aggregate have risen substantially, both of which bode well for absorbing the impact of high inflation and energy costs. Italy’s banking system is in a stronger position than in the past in terms of capitalisation and progress has been made in markedly reducing net impaired assets. Nonetheless, the consequences of the pandemic and of the conflict in Ukraine will likely negatively affect asset quality going forward, although gradually.
Ratings could be upgraded if one or a combination of the following factors occurs: (1) fiscal consolidation placing the debt-to-GDP ratio on a firm downward trajectory over the medium term; or (2) evidence that progress with reforms leads to higher economic growth.
Ratings could be downgraded if one or a combination of the following factors occurs: (1) economic prospects weaken materially, causing a significant increase in the public debt ratio trend; (2) the government shows significantly weaker commitment to reducing the debt-to-GDP ratio in the medium term; or (3) a crystallisation of a sizable amount of contingent liabilities, leading to a material deterioration in public accounts.
Significant Tensions With EU Are Unlikely and Risks to the Reform Effort Are Mitigated by EU Funds
Political uncertainty has traditionally been a challenge with respect to policy continuity in Italy, weighing 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, political defection and parties’ fragmentation. Moreover, there is usually little cross-party consensus on how to address structural problems in the context of generally low electoral support for reforms and volatile polls. Combined, these factors hinder the government’s ability to address economic challenges, implement forward-looking policies, and underpin the negative qualitative adjustment of the “Political Environment” building block.
The right-wing coalition secured a majority in both chambers in the political election held at the end of September, and this reduces political uncertainty for now. Nevertheless, frictions within the government coalition, led by the Brothers of Italy, are likely to emerge, reflecting possible divergences on policies, which could intensify when electoral dates are close. The new government will likely be less reformist and more protectionist than Mr. Draghi’s cabinet. Nevertheless, DBRS Morningstar does not see particular risks to policy continuity in light of the amount of NGEU resources that Italy is expected to receive. Reforms are likely to be implemented even though these will be diluted (see https://www.dbrsmorningstar.com/research/403101/italy-a-right-wing-government-will-not-alter-significantly-italys-economic-fundamentals). The new government seems keen to revise some measures within the NRRP but fundamental changes are unlikely, although some funds can be reallocated in agreement with the European Commission (EC) to reflect the impact of the energy crisis if objective reasons exist. Therefore, a significant confrontational relationship with the EC is unlikely.
Energy-Related Support is the Priority and the New Government is Not Expected to Deviate Significantly From a Prudent Fiscal Strategy
Italy’s overall fiscal performance has been sound during the pre-pandemic years even though more efforts in reducing the deficit when interest costs were declining would have likely placed the country in a less vulnerable debt position. Returning to a prolonged and sound primary surplus is a challenge now in light of the ongoing energy crisis, elevated cost of living and economic slowdown. Nevertheless, the very high debt-to-GDP ratio and the increase in interest costs along with financial market discipline mitigate the risk of a significant increase in discretionary spending in the medium term.
DBRS Morningstar views positively the improvement in the fiscal accounts registered since 2020, despite the sizeable amount of resources allocated to counteract, first, the impact of the pandemic, and then the energy crisis. Assuming no change in policy, fiscal government projections point to a deficit reduction to 5.1% of GDP in 2022 from 7.2% of GDP last year, and a further decline to 3.4% of GDP next year. This reflects mainly higher fiscal revenues, a scaling back of pandemic-related support measures, and higher nominal GDP growth. Over time, however, the impact of rising inflation will likely affect expenditures, therefore higher pensions, public wages, and intermediate goods as well as rising interest costs are projected to weigh more heavily on the fiscal accounts. This would likely require further fiscal consolidation to lower the headline deficit in the years to come.
The new government is expected to secure the passage of the 2023 Budget Law by the end of the year to avoid a provisional budget. Currently, there is no clarity on the new government’s appetite to implement costly promises announced during the electoral campaign, even though a slower improvement in fiscal accounts is likely in the years to come. Nevertheless, DBRS Morningstar believes that the challenge to extend further fiscal support to shelter the economy from the ongoing energy crisis will take priority and that implementation of costly tax reforms will, if any, be gradual (see https://www.dbrsmorningstar.com/research/402812/italys-2023-fiscal-deficit-target-outlook-clouded-by-elections-and-recessionary-energy-crisis-risk). Therefore, DBRS Morningstar does not anticipate a significant deviation from prudent fiscal strategy in the medium term. Should the new government remain committed to past fiscal deficit targets of 5.6% of GDP this year and 3.9% of GDP in 2023 (compared with the projections of 5.1% of GDP and 3.4% of GDP, respectively, in 2022 and in 2023 with no policy change), this fiscal leeway could be used to provide additional aid to the economy to ease the cost-of-living crisis. Since September 2021, the government has allocated one of the largest support packages in the EU to counteract the energy shock. In DBRS Morningstar’s view, further support should be temporary and selective. Should the government instead opt for a significant increase in spending, including structural and non-selective measures, it is likely to face both a higher primary deficit and a rise in funding costs, which would reduce the positive impact of the support.
Lower External Demand and Russian Gas Shortage Cloud Italy’s Economic Outlook but Negative Structural Implications Are Expected to Remain Limited
A high degree of economic diversification, coupled with a strong manufacturing sector and a large economy, support the ratings. Nevertheless, historically low GDP potential growth, largely due to weak labour productivity, low participation of women in the work force, and adverse demographics constrain Italy’s economic perspectives. This weighs on the qualitative assessment of the “Economic Structure and Performance” building block.
The bright post-pandemic recovery has been weakened by the effects of the Russian invasion of Ukraine, and Italy will likely post slower economic growth in coming quarters. Nevertheless, structural implications arising from the energy crisis are expected to be limited. The economy was rebounding solidly from the pandemic shock with GDP expanding by 6.7% in 2021—better than expected after a severe contraction of 9.0% in 2020. Robust growth in the first half of this year will enable economic activity to expand by around 3.3% this year, faster than Italy’s Euro Area peers including France and Germany, despite weaker activity projected in the last two quarters of 2022. The government significantly revised its GDP growth projections for 2023 downward to 0.6% from the forecast 2.4% in April 2022, reflecting lower external demand and gas consumption, and higher interest and living costs. DBRS Morningstar does not rule out a mild recession next year, particularly if inflation squeezes real incomes more than expected in tandem with lower gas supplies and/or a cold winter, which will likely trigger some gas rationing in the important manufacturing sector. Nevertheless, gas storage is at around 95%, and the government has made significant progress in diversifying Italy’s gas supply and has introduced a plan to moderately reduce gas usage. These factors, along with a high aggregate amount of savings and likely further fiscal support for vulnerable households, should mitigate the risk of economic scarring, albeit corporates with low profit margins and weaker capacity to pass through higher costs to customers are expected to suffer.
DBRS Morningstar also views positively the Italian government’s strategy to raise public investment and make progress with reforms included in the NRRP. If successful, this should support Italy’s economic potential as well as the rebound in growth in 2024 and 2025. Public investment has been subdued for a long period of time, eroding the capital stock and weighing on potential growth. Italy has been able to continue to make progress with milestones and targets despite the government collapse in July. So far, the government has received around EUR 46.0 billion of grants and loans out of a planned EUR 191.5 billion agreed with the EU. Despite some delays, execution risks, and the rising cost of building materials, the successful implementation of the NRRP could enable Italy to tackle some of the structural weaknesses that have undermined its GDP growth potential. This is key to debt sustainability.
Debt-to-GDP Ratio on a Declining Trajectory This Year but Further Falls Could be Hampered by Less Prudent Fiscal Spending and Lower Growth
Italy’s high level of public debt and gross borrowing requirement make the country vulnerable to shocks and constrain its ratings. Nevertheless, a large share of debt held by the Eurosystem and EU institutions reduces the susceptibility of Italy’s debt to a shift in investor confidence. Past declines in the cost of funding, as well as the improvement in the debt maturity profile, contain the impact of the increase in the cost funding.
Lower primary deficits, higher inflation, and robust growth are contributing to the decline in the public debt-to-GDP ratio since the peak of 154.9% in 2020. Latest government projections, assuming no policy change, point to a better debt trajectory compared with the Stability Programme published in April. The public debt-to-GDP ratio should decline this year to 145.4% from 150.3% in 2021 and fall to 143.2% next year. Further improvements are likely to depend on a prudent fiscal policy as the interest-growth differential will likely narrow because the cost of funding is rising and nominal growth will recede. In DBRS Morningstar’s view, returning to primary surpluses while making further progress with the NGEU are key to improving Italy’s credibility, containing funding costs, and enhancing the potential growth prospects for the economy. As inflationary pressures ease, the positive contributions of these factors should maintain the debt ratio on a declining trajectory.
Debt affordability has been improving for several years, but now increasing interest costs, mainly due to the impact of inflation, are reversing this trend. Despite the low share of bonds indexed to inflation amounting to around 12%, its absolute value, which has been subject to revaluation due to the rise in inflation, is boosting the overall interest cost. This is expected to rise to 4.0% of GDP this year from 3.6% in 2021. While elevated inflation is expected to peter out going forward, this would likely more than compensate for new issuances at higher yields, maintaining the overall funding cost slightly below 4.0% of GDP in the coming years, still an elevated level for a country with historical low nominal growth. Italy’s government deposits and liquid assets are sizeable at an average of EUR 86 billion (5% of GDP) over the last twelve months and this lowers the risk of large issuances during periods of high volatility. Moreover, debt is predominantly at fixed rates with an average maturity of 7.34 years as of September 2022, which contains the current impact of a rapid increase in interest rates. Moreover, the ECB’s Transmission Protection Instrument reduces the risk of a deviation from a prudent fiscal strategy as well as from a strong commitment to the reforms and, if activated, is expected to narrow spreads. These factors lend to a positive qualitative assessment on the “Debt and Liquidity” building block.
The Banking System is in a Stronger Position Than in the Past but a Rise, Albeit Gradual, in New Nonperforming Loans (NPLs) is Expected
Italian banks are stronger than in the past as both credit quality and capitalisation have improved. Nevertheless, the economic slowdown in tandem with the economic consequences of the pandemic and the energy crisis will likely cause impaired assets to rise, although gradually. DBRS Morningstar notes that some small and medium-size banks are still implementing restructuring and cost-efficiency programmes and remain less diversified and more vulnerable. This factor, along with the still-sizeable stock of NPLs, weighs on the “Monetary Policy and Financial Stability” building block assessment.
The rapid increase in interest rates is not expected to weigh significantly on financial stability although it will likely negatively affect loan demand. The share of households with mortgages is moderate in Italy. Both households and non-financial corporations show relatively low levels of indebtedness and, in aggregate, savings are cushioning the impact of higher energy costs. Moreover, the increase in interest rates positively affects banks’ interest margins in the near term, while the high share of public debt accounted at amortised costs reduces the banks’ capital sensitivity to the increase in sovereign yields (see https://www.dbrsmorningstar.com/research/398992/italian-banks-an-analysis-of-sovereign-exposures).
Corporate-sector viability as well as investments have benefitted from the relief provided by the large amount of public guarantees, which however, are increasing the amount of public-sector contingent liabilities. The total stock of guarantees stood at around EUR 300 billion (15.8% of GDP) as of June 2022 and will likely continue to rise until the end of this year. However, DBRS Morningstar does not expect significant claims unless a substantial and prolonged deterioration in the economic environment occurs.
The Worsening in the Energy Balance Weighs on the Current Account but Italy’s Goods Export Performance is Expected to Remain Supportive
Italy’s external position supports the ratings. On the back of a sustained export performance and a sound primary income surplus, the current account surplus has averaged around 3.1% of GDP over the last five years. This, in turn, has contributed to a sustained decline in the country’s negative NIIP. Since September 2020, Italy has returned to being a net external creditor and, as of June 2022, the positive NIIP amounted to 5.7% of GDP, slightly lower than the peak of 8.1% at the end of 2021. This represents a significant improvement since the trough of -25.2% of GDP in Q1 2014.
Italy’s large dependency on energy imports and their higher price is weighing on the energy balance. This is pressuring the country’s overall current account balance which, despite the gradual recovery in the tourism sector, will shift to a negative position of 0.2% of GDP this year according to the International Monetary Fund, from a surplus of 3.1% of GDP last year. The goods balance surplus shifted from a surplus of EUR 72.7 billion to a deficit of EUR 3.2 billion in the twelve months ending in August. Nevertheless, as energy prices fall and external demand resumes at sound growth rates, the overall current account position is expected to normalise, but only gradually over time. DBRS Morningstar views Italy’s capacity to export as a key strength and does not expect a weakening in the competitiveness of the manufacturing export-oriented sector. The country is not projected to experience a material fall in export market shares despite the large impact of high energy costs.
ENVIRONMENTAL, SOCIAL, GOVERNANCE CONSIDERATIONS
Social (S) Factors
The Human Capital and Human Rights factor effects the ratings. According to the IMF WEO, Italy’s GDP per capita of USD 35,473 in 2021 was low compared with its euro area peers. This factor is considered as significant and it has been taken into account primarily in the “Economic Structure and Performance” building block.
Governance (G) Factors
The Institutional Strength, Governance & Transparency factor effects the ratings. This reflects particularly Italy’s institutional arrangements which affect government effectiveness and the government’s capacity to address economic challenges and implement forward-looking policies. According to the World Bank, Italy ranked for Governance Effectiveness at 64.9th percentile in 2021. This factor is considered as significant and it has been taken into account primarily in the “Fiscal Management and Policy” and “Political environment” building blocks. At the same time, DBRS Morningstar views the Bribery, Corruption and Political Risks factor as relevant reflecting also weak scores in the rule of law and in the perception of corruption.
There were no Environmental factors that had a significant or relevant effect on the credit analysis.
A description of how DBRS Morningstar considers ESG factors within the DBRS Morningstar analytical framework can be found in the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings at https://www.dbrsmorningstar.com/research/396929/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings (May 17, 2022).
For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments: https://www.dbrsmorningstar.com/research/404507.
EURO AREA RISK CATEGORY: LOW
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 https://www.dbrsmorningstar.com/research/401817/global-methodology-for-rating-sovereign-governments (August 29, 2022). In addition DBRS Morningstar uses the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings, https://www.dbrsmorningstar.com/research/396929/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings (May 17, 2022) in its consideration of ESG factors.
The sources of information used for this rating include Istat, Ministero dell’Economia e Finanza (MEF), MEF – Nota di Aggiornamento al Documento di Economia e Finanza (NADEF, September 2022), Draft Budgetary Plan (October 2022), Investor presentation (October 2022), – Treasury account and investment of the treasury liquidity (September 2022), Bank of Italy, Bank of Italy – Economic Bulletin (October 2022), Balance of Payment and International Investment Position (October 2022), ECB, EC, Eurostat, IMF, Gas infrastructure Europe, BIS, World Bank, Haver Analytics, Transparency International, MITE, Social Progress Imperative. DBRS Morningstar considers the information available to it for the purposes of providing this rating to be of satisfactory quality.
With respect to FCA and ESMA regulations in the United Kingdom and European Union, respectively, this is an unsolicited credit rating. This credit rating was not initiated at the request of the issuer.
With Rated Entity or Related Third Party Participation: YES
With Access to Internal Documents: YES
With Access to Management: NO
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.
The conditions that lead to the assignment of a Negative or Positive trend are generally 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: https://cerep.esma.europa.eu/cerep-web/statistics/defaults.xhtml. DBRS Morningstar understands further information on DBRS Morningstar historical default rates may be published by the Financial Conduct Authority (FCA) on its webpage: https://www.fca.org.uk/firms/credit-rating-agencies.
The sensitivity analysis of the relevant key rating assumptions can be found at: https://www.dbrsmorningstar.com/research/404506.
This rating is endorsed by DBRS Ratings Limited for use in the United Kingdom.
Lead Analyst: Carlo Capuano, Senior Vice President, Global Sovereign Ratings
Rating Committee Chair: Nichola James, Managing Director, Co-Head of Sovereign Ratings, Global Sovereign Ratings
Initial Rating Date: February 3, 2011
Last Rating Date: April 29, 2022
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