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

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

KEY CREDIT RATING CONSIDERATIONS
The Stable trend reflects DBRS Morningstar’s view that risks to the credit ratings are balanced. The supportive impulse from the implementation of Italy’s National Recovery and Resilience plan (NRRP, or the Plan) in coming years will likely mitigate the economic slowdown mainly related to monetary policy tightening. The public debt ratio declined by around 13 percentage points from a peak of 154.9% of GDP in 2020 to 141.7% in 2022, and a further fall to 140.2% is projected by the end of this year. This fall was significantly better than expected. Nevertheless, the future debt trajectory improvement will likely be constrained by the negative impact of previous tax credits for house renovation and a slow general improvement in the fiscal accounts. The latter mainly stems from the fact that the government is planning a modest fiscal loosening by extending tax cuts that are likely to continue beyond 2024 and might not be compensated by offsetting measures, along with weaker GDP growth and high interest costs. In this context, a medium-term fiscal strategy that keeps the public debt ratio on a downward trajectory is key to preserving investor confidence over the medium term. In light of the gradual reduction in the European Central Bank (ECB)’s holdings of Italian public debt and higher amounts of debt issuance, supportive demand for Italy’s debt from Italian households should contain the increase in sovereign yields.

DBRS Morningstar’s confirmation of Italy’s BBB (high) rating is underpinned by several factors. First, Italy benefits from European Union (EU) membership as well as from the ECB’s support and high credibility. Second, the economy is large and diversified, and the important manufacturing sector has demonstrated a high degree of resilience despite the energy price shock. Third, Italy’s external position benefits from the rapid recovery in its current account as well as the country’s positive net international investment position (NIIP). Private-sector debt is one of the lowest among advanced countries and Italy’s banking system is in a stronger position than in the past in terms of capitalisation and net impaired assets. However, the ratings remain constrained by a very high level of public debt, weak potential GDP growth, and a political environment that hinders government stability and ability to address economic challenges.

CREDIT RATING DRIVERS
Ratings could be upgraded if one or a combination of the following factors occur: (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 and productive investments leads to higher economic growth.

Ratings could be downgraded if one or a combination of the following factors occur: (1) economic prospects worsen materially, causing a significant increase in the public debt ratio trajectory; (2) a material rise in sovereign funding costs undermining the government’s ability to meet its financing needs; (3) further significant fiscal relaxation leading to a material deterioration in public accounts.

CREDIT RATING RATIONALE

Fiscal Repair is Slower and Surrounded by Some Uncertainty; Past Track Record of Fiscal Prudence Reassures

The energy price shock along with the impact of generous tax credits for house renovation have slowed fiscal repair after the sizeable deficit in 2020. The government has announced just a gradual fiscal improvement over the medium term and returning to pre-pandemic fiscal primary surplus is not an easy task. After a record deficit of 9.6% of GDP in 2020, which mainly reflected the impact of the pandemic, Italy’s public finance position has improved slowly. The headline deficit recorded elevated figures both in 2021 (8.8% of GDP) and in 2022 (8.0%). The energy-related support and Eurostat accounting treatment in accrual terms of tax credits for building renovation works (i.e., Superbonus) played a major role, with the latter accounting cumulatively for 4.8% of GDP from 2020 to 2022. According to the government, the tax credits will have a further impact of 1.8% of GDP, that would put upward pressure on the deficit this year projected at 5.3% of GDP compared with 4.5% previously expected.

The government plans a modest fiscal loosening to strike the balance between supporting the economy, mainly by extending existing tax cuts, and a gradual improvement in public accounts. This would results in a slower decline in the deficit compared with that envisaged in its Stability Programme in April 2023. Maintaining the reduction in social contributions will be accompanied by other tax cuts due to fiscal reform along with the renewal of public contracts in 2024. Moreover, the government plans to shift NRRP spendings over the last years of the plan and higher interest costs will also put pressure on public accounts going forward. The headline deficit is expected to return below 3% of GDP in 2026, one year later than previously expected. In DBRS Morningstar’s view, the improvement in the fiscal trajectory is accompanied with some uncertainty. First, the impact of past tax credits for building renovation schemes could be higher than expected and their possible reclassification from Eurostat could change the fiscal deficit profile. Second, it is unclear whether the government will re-extend tax cuts with or without offsetting measures after 2024. A public spending review and an improvement in tax compliance might not be sufficient, and a cumulative improvement in the primary surplus of 1.8% of GDP from 2024 and 2026 appears challenging.

DBRS Morningstar does not rule out the possibility that the European Commission (EC)’s decides to open an Excessive Deficit Procedure against Italy in 2024. This should not generate particular tensions with the EC. The Italian government’s track record of a prudent fiscal trajectory and respect for EU fiscal rules provide reassurance. The government appears committed to reducing significantly the structural deficit and to limit the growth in primary net expenditures going forward.

Italy’s Economic Fundamentals Remain Resilient, NRRP Expected to Support Growth

A high degree of economic diversification, coupled with a strong manufacturing sector and a large economy, support the ratings. Nevertheless, historically low potential GDP growth, largely because of weak labour productivity growth, 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.

Italy’s post-pandemic recovery has been stronger than expected and better than Euro area peers, with real GDP expanding by 8.3% and by 3.7% in 2021 and 2023, respectively. Despite a stagnant economy since H2 2022, the real GDP level in Q2 2023 remained 3.3% higher than it was at the end of 2019. Exports and investments, particularly in the construction sector have been supportive, but the economic outlook is cloudy. According to the latest government projections, real GDP is expected to expand by 0.8% this year, while next year it will increase by 1.2%. However, risks are tilted to the downside as heightened geopolitical risks, the likelihood of prolonged high interest rates, and the weaker external environment are likely to weigh on next year’s economic growth. Nevertheless, DBRS Morningstar views some important mitigating factors. The decline in inflation will support consumption next year and labour market conditions have improved. Employment has surpassed a record level of 23.5 million and the unemployment rate at 7.3% of the workforce is the lowest level since February 2009. Moreover, the manufacturing sector, although under pressure because of a weaker external environment, is expected to remain resilient. Over the last years, the sector has benefitted from growth in the size of firms and an improvement in external competitiveness, including a high degree of internationalization.

Despite implementation delays, particularly with investments, DBRS Morningstar continues to view Italy’s NRRP as an opportunity to raise Italy’s GDP potential and improve the public debt trajectory. This bodes well for GDP growth. Italy received the third installment of the Recovery and Resilience Facility (RRF) amounting to EUR 18.5 billion (0.9% of GDP) in early October 2023 while the fourth amount of EUR 16.5 billion will likely be disbursed in early 2024. This would bring total Next Generation EU (NGEU) disbursements to more than EUR 100 billion or around 53% of total RRF resources allocated to Italy. But there is still a high amount of NRRP resources remaining, estimated to be around EUR 180 billion, to spend in a short period of time, and this elevates implementation risk. However, DBRS Morningstar takes the view that the strengthening of NRRP governance, including the revision of the Plan, could unlock funds and accelerate spending growth. This could counteract the expected weaker performance of private investments because of tight credit conditions and the phase out of the Superbonus.

The Impact of Tax Credits Are A Factor Preventing Material Declines in the Debt Ratio

Italy’s high level of public debt makes the country vulnerable to shocks and constrains its ratings. Despite falling more than expected, the public debt ratio as a share of GDP is above 140% and it remains the second highest in the EU. Robust nominal growth, also as a result of high inflation, contributed to a significant decline in the public debt-to-GDP ratio following the peak of 154.9% in 2020. After falling to 147.1% in 2021, the debt ratio declined more than expected to 141.7% last year, and the government projects a further drop to 140.2% of GDP this year. A slow improvement in the primary surplus, along with the impact of past tax breaks for building renovation on the stock flow adjustment, will prevent the public debt-to-GDP ratio from falling materially over the coming years. According to the government, public debt will marginally decline to 139.6% of GDP by 2026. This will also hinge on the assumption that the government will deliver on 1.0% of GDP of asset sales over the next three years. This is an ambitious target but possible, in DBRS Morningstar’s view.

Elevated borrowing needs along with high yields will put pressure on interest costs in coming years. Italy’s public debt gross issuances are sizeable, at around 27% of GDP on average over the last three years, and are expected to remain elevated also going forward. The interest bill, after moderating because of lower inflation to 3.8% in 2023 from 4.3% in 2022, is projected to reach 4.6% of GDP in 2026 because of large debt issuances in the context of high interest rates. However, the average maturity of 6.98 years as of September 2023 should attenuate the increase in funding costs. Moreover, a large share of debt is held by the European authorities and this mitigates the risk of a shift in investor confidence, including a significant adverse impact on yields. This factor lends to a positive qualitative assessment of the “Debt and Liquidity” building block.

The impact on yields from the gradual reduction in the ECB’s Italian sovereign debt holdings is expected to be mitigated by higher demand by households. Italy’s treasury has been tailor-making debt issuances for retailers that are responding well with sizeable demand. Since June 2022 household purchases have more than absorbed the increase in the stock of debt, a trend that DBRS Morningstar does not rule out could continue in light of a large amount of household deposits. Households’ demand has been subdued for years and, if it remains supportive, it could improve the diversification of funding.

Risks to the Reform Effort Are Mitigated by EU Funds And Government Instability Will Be Contained in the Near Term

Political instability has traditionally been a challenge with respect to policy continuity in Italy, weighing on the ratings. In DBRS Morningstar’s view, this reflects a structural feature of the Italian political system, characterised by the frequent change of 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 this underpin the negative qualitative adjustment of the “Political Environment” building block assessment. This is also reflected in weaker governance indictors compared with peers.

The right-wing coalition currently in government secured a majority in both chambers in the general election held at the end of September last year. Tensions within the government coalition have been contained so far, although these could intensify when main electoral dates approach. DBRS Morningstar does not foresee a complete reversal or a significant dilution of reforms, although the current government is less keen on important reforms, including the reform of competition. The amount of NGEU resources that Italy is expected to receive remains a strong incentive for making progress with reforms.

Banks Are in a Stronger Position Than in the Past but a Rise, Albeit Gradual, in New Nonperforming Loans (NPLs) Is Expected

The banking system is in a stronger position than in the past and financial stability risks are contained. Italy’s banks have benefitted from an improvement in credit quality and capitalization over the years, and profitability increased strongly because of the rise in net interest income and lower credit costs. Nevertheless, the economic slowdown, in tandem with elevated borrowing costs and the higher cost of living will likely cause impaired assets to increase, 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 and the likely deterioration in credit quality, weighs on the “Monetary Policy and Financial Stability” building block assessment.

The tightening of monetary policy, along with lower economic growth, is making banks more selective while firms are reducing their demand for credit. Nevertheless, the rapid increase in interest rates is not expected to weigh significantly on financial stability. Despite a relatively high amount of mortgages with variable rates, the overall share of housing borrowers is moderately high in Italy and most indebted households tend to have high levels of income and wealth. This is reassuring as the tightening of monetary policy could be more prolonged than expected. Moreover, DBRS Morningstar expects the impact stemming from the windfall tax on banks to be contained to the sector and to not intensify the credit standard tightening.

Corporate-sector viability as well as investments have benefitted from the relief provided by the large amount of public guarantees provided since 2020. This translated into an increase in the amount of public sector-contingent liabilities that are expected to gradually decline. The total stock of guarantees stood at around 14.9% of GDP as of June 2023, having dropped from 15.7% of GDP in 2021, and are projected to steadily fall as guaranteed loans provided during the pandemic are reimbursed. DBRS Morningstar does not expect significant claims to emerge unless a substantial and prolonged deterioration in the economic environment occurs.

The Improvement in the Terms of Trade is Supporting the Current Account Balance Recovery

Italy’s external position supports the ratings. On the back of a sustained export performance and sound primary income surplus, the current account surplus has averaged around 2.1% of GDP over the last 10 years. This, in turn, has contributed to a sustained improvement in the country’s NIIP. Since September 2020, Italy has returned to being a net external creditor and, despite the recent decline from the peak of 7.5% of GDP in Q4 2021, the positive NIIP at 5.3% of GDP in Q2 2023 remains noteworthy compared with the trough of -25.3% of GDP in Q1 2014.

After real exports grew by 13.9% and 9.9% in 2021 and 2022, respectively, Italy’s export performance is expected to moderate due to a weaker global trade. Nevertheless, the improvement in the terms of trade is leading the recovery in Italy’s goods balance. A goods trade surplus of EUR 18.7 billion was registered in August compared with a deficit of around EUR 15.9 billion last year and it is projected to continue to improve thanks to lower imports and more moderate energy prices. This should support the current account balance, which is expected to shift to a surplus of 0.8% of GDP in 2023 following a deficit of 1.2% of GDP in 2022, and is projected to continue to rise to 1.9% of GDP in 2026, according to the government. DBRS Morningstar views Italy’s capacity to export as a key strength and does not expect a weakening in the competitiveness of the export-oriented manufacturing sector despite the slowdown of global trade growth and increasing unit labour costs. However, surpluses above 3% of GDP registered in the 2019–21 period, seem unlikely to be achieved soon.

ENVIRONMENTAL, SOCIAL, GOVERNANCE CONSIDERATIONS

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

Social (S) Factors
The following Social factors had a significant effect on the credit analysis: The Human Capital and Human Rights factor affects the ratings. According to the International Monetary Fund’s World Economic Outlook, Italy’s GDP per capita of USD 34,085 in 2022 was relatively low compared with its euro area peers. This factor is considered significant and it has been taken into account primarily in the “Economic Structure and Performance” building block.

Governance (G) Factors
The following Governance factors had a significant effect on the credit analysis: The Institutional Strength, Governance & Transparency factor affects 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 at the 67th percentile for Government Effectiveness in 2022. This factor is considered 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, also reflecting weak scores in the rule of law and in the control of corruption, according to the World Bank.

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 https://www.dbrsmorningstar.com/research/416784/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings (4 July 2023).

For more information on the Rating Committee decision, please see the Scorecard Indicators and Building Block Assessments at: https://www.dbrsmorningstar.com/research/422493.

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 (6 October 2023) https://www.dbrsmorningstar.com/research/421590/global-methodology-for-rating-sovereign-governments. 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/416784/dbrs-morningstar-criteria-approach-to-environmental-social-and-governance-risk-factors-in-credit-ratings in its consideration of ESG factors.

The credit rating methodologies used in the analysis of this transaction can be found at: https://www.dbrsmorningstar.com/about/methodologies.

The sources of information used for these credit ratings include Istat, Ministero dell’Economia e Finanza (MEF), MEF –Nota di aggiornamento al Documento di Economia e Finanza (September 2023), MEF – Draft Budgetary Plan 2024 (October 2023), Bank of Italy, Bank of Italy – Economic Bulletin (October 2023), Bank of Italy – Balance of Payments and International Investment Position (October 2023), Ufficio Parlamentare di Bilancio – “Audizione della Presidente dell’Ufficio parlamentare di bilancio nell’ambito dell’attivita’ conoscitiva prelimiare all’esame della NADEF 2023” (October 2023), ECB, EC, EC – “Effort sharing 2021-2030: targets and flexibilities”, Eurostat, IMF (WEO October 2023, IFS), BIS, World Bank, Haver Analytics, and Social Progress Imperative. DBRS Morningstar considers the information available to it for the purposes of providing these credit ratings to be of satisfactory quality.

With respect to FCA and ESMA regulations in the United Kingdom and European Union, respectively, these are unsolicited credit ratings. These credit ratings were not initiated at the request of the issuer.

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

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://registers.esma.europa.eu/cerep-publication. For further information on DBRS Morningstar 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/422492.

These credit ratings are 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, Global Sovereign Ratings.
Initial Rating Date: February 03, 2011
Last Rating Date: April 28, 2023

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