Scope affirms Italy’s rating at A- and revises the Outlook to Negative
Scope Ratings GmbH has today affirmed the Republic of Italy’s long-term local- and foreign-currency issuer and senior unsecured debt ratings at A- and revised its Outlook to Negative. The agency has also affirmed the short-term issuer rating of S-1 in both local and foreign currency and revised the Outlook to Negative.
The revision of the Outlook to Negative from Stable on Italy’s A- sovereign ratings reflects the following two drivers:
Progressive shifts in Italy’s political landscape in favour of anti-establishment groups, raising political uncertainty and instability – developments which may persist beyond a single new administration, with potential long-term implications for the direction of policy setting in the resolution of Italy’s significant structural challenges; and
- The policy programme of this singular new Italian government formed by the Five Star Movement (M5S) and Lega – which seeks to undo a series of fiscal, pension and banking system reforms. Although many programme elements are unlikely to be implemented in their current forms, even the adoption of some of the suggested measures may have significant consequences, in the absence of offsetting factors, given pre-existing debt sustainability concerns.
The assignment of a Negative Outlook reflects changes in Scope’s assessments in the ‘public finance risk’ and ‘domestic economic risk’ categories of its sovereign methodology. In Scope’s view, the economic and fiscal policy platform of the new government poses considerable challenges to sustainability. Moreover, the anticipated alteration in stance on economic and non-economic issues may test Italy’s relationship with European institutions. The affirmation of Italy’s A- sovereign rating reflects continued meaningful credit strengths including euro area membership, a large, diversified economy, a track record of primary surpluses, and moderate private debt.
The first driver underpinning Scope’s decision to assign a Negative Outlook is the shift in Italy’s political landscape since the global financial crisis in favour of anti-establishment groups, and the associated implications for the nation’s longer-term economic policymaking. The relevant groups have made gains even in the midst of an economic rebound. A change in expectations regarding domestic policymaking extends potentially beyond this current administration to future Italian governments – for instance, even in a scenario of early elections if this coalition meets internal divisions, anti-establishment parties may similarly be competitive in a repeat election scenario. Lega achieved its best-ever result in the March 2018 elections (with 17.4% of the votes) and has seen gains in the polls since.
This situation will give rise to a lengthy phase of political instability, the likelihood of prolonged inaction in areas requiring reform, and the risk of policy reversals. Italy’s elevated debt stock and weak growth potential are just two reasons why the Italian government can ill afford to be idle with regard to fiscal and structural policies. Over the coming period, Scope will seek to gain greater clarity on the degree to which policies moderate once the group is in government, and the impact on sovereign creditworthiness. This will include a review of the constitutional, European-level and financial system-predicated checks that exist to prevent governments from implementing unsustainable programmes.
The second driver of the outlook change is the new government’s programme. The coalition agreement includes Lega’s proposed tax reduction to a rate of as low as 15% for companies and individuals, the repeal of the 2011 pension reform, the cancellation of a VAT hike due in January 2019, as well as the introduction of a universal basic income. Estimates have placed these actions at a cost of more than EUR 100bn (more than 5.8% of GDP) per annum, and they would largely be uncovered by revenue increases or spending rationalisation elsewhere. The programme also suggests the review of Basel bank regulations, reform of bail-in rules, and the reimbursement of retail shareholders of banks for earlier losses imposed. While many such proposals are unlikely to be enacted in their current forms, and will probably continue to be moderated, if not blocked, the implementation of even some of the suggested measures may have significant consequences, in the absence of offsetting measures, given pre-existing challenges.
Even prior to the new administration, Italy’s budgets have successively been neutral to expansionary (including the 2018 budget) with structural deficit adjustments weaker than anticipated. Moreover, bail-in rules have been bypassed due to domestic concerns, resulting in the recurrent use of government monies to assist bank rescues instead. In recent years, these factors have contributed to a stagnation in Italy’s debt ratio at about the 131.8% of GDP level as of Q4 2017 (32pp higher than Q4 2007 levels and the second-highest in the euro area, after Greece), even though the economy is recovering (including current above-potential growth). In Scope’s view, owing to Italy’s low medium-run growth potential, the pursuit of pro-cyclical fiscal policies and the limited improvement in debt levels during expansionary economic times raise debt sustainability risks in a future downturn. Consequently, Scope will assess the implementation of the new government’s programme, and its impact on Italy’s fiscal consolidation and growth potential. This approach is consistent with the rating-change drivers noted in Scope’s last rating action, which named risks to debt sustainability, a weaker commitment to fiscal consolidation and structural reforms, and more sluggish growth as downside drivers.
Italy’s A- rating is underpinned by euro area membership with a strong reserve currency and an independent European Central Bank effectively acting as a lender of last resort, alongside access to European financial facilities. However, such regional assistance, critical to easing market panic and avoiding sovereign default in extreme moments of stress, depends nonetheless on a government agreeing to established economic governance norms. Scope will assess the new government’s stance vis-à-vis European institutions and evaluate the degree to which it impacts the availability of and willingness to resort to European support in times of stress.
Italy’s economy has experienced a sustained recovery since 2014, with YoY growth of 1.4% as of Q1 2018. The European Commission sees the budget balance improving to -1.7% of GDP in 2018 (from -2.3% of GDP in 2017), but mostly due to cyclical effects. While it is by and large still too soon to judge the economic impact of recent post-election uncertainties, some high-frequency survey data suggest some adverse effects in the early stages following the March elections. More importantly, the long-term growth picture is fragile: Scope estimates medium-run potential growth at 0.75%, speaking to the need for proactive structural reforms. Here, Scope will review the policies underscoring the government’s objective of eliminating the growth differential with the rest of the European Union.
In contrast to these factors, Italy’s ratings are supported by the nation’s euro area membership within a large common market. Scope believes that institutional developments and the adjustments of past years have increased euro area member states’ protection from adverse shocks, underpinning their sovereign creditworthiness. Italy’s ratings are, moreover, supported by its large and diversified economy (with nominal GDP in 2017 of EUR 1.72tn). In addition, non-financial private debt is moderate at 159% of GDP as of Q4 2017 – comparing well with that of European peers, down from peaks of 176% of GDP in Q4 2011. With the exception of 2009, Italy has maintained a significant track record of primary surpluses in past decades, and the combined European-level and domestic fiscal framework, enhanced during the debt crisis – which obligates Italy to adhere to a balanced budget – is a credit strength, in Scope’s view.
The relatively long 6.9-year average maturity of Italy’s debt stock shields the government’s interest costs to a certain extent from the impact of higher government market yields, in the face of recent market turbulence. The current account is estimated to have reached a surplus of 2.8% of GDP in 2017, compared with a deficit of 3.4% of GDP as of 2010. Italian banks’ stock of non-performing loans is still very high compared with the European average (Italy’s at 14.5% of total loans in Q4 2017, though this is down from 17.4% a year earlier and compared with 18.2% during a 2015 peak). Risks in the banking sector are a continued rating constraint, though Scope views positively the increase in tier 1 capital ratios to 13.8% of risk-weighted assets in Q4 2017. However, significant action still needs to be taken to improve insolvency and debt enforcement procedures, facilitate bank rationalisation and consolidation, and make timely and consistent use of the resolution framework.
Core Variable Scorecard (CVS) and Qualitative Scorecard (QS)
Scope’s Core Variable Scorecard (CVS), which is based on relative rankings of key sovereign credit fundamentals, signals an indicative “A” (“a”) rating range for the Republic of Italy. This indicative rating range can be adjusted by the Qualitative Scorecard (QS) by up to three notches depending on the size of relative credit strengths or weaknesses versus peers based on qualitative analysis.
For Italy, the QS signals relative credit strengths for the following analytical categories: i) market access and funding sources; and ii) vulnerability to short-term external shocks. Relative credit weaknesses are signalled for: i) the growth potential of the economy; ii) the economic policy framework; iii) the fiscal policy framework; iv) debt sustainability; v) recent events and policy decisions; and vi) banking sector performance.
The combined relative credit strengths and weaknesses generate a downward adjustment and signal an A- sovereign rating for Italy.
The results have been discussed and confirmed by a rating committee.
For further details, please see Appendix 2 of the rating report.
Outlook and rating-change drivers
The ratings could be downgraded if: i) significant questions exist with relation to the direction of economic policymaking over an extended time window, casting doubt on the long-term trajectory of the debt ratio; and/or ii) the implementation of aspects of the new government’s policy programme exhibits a weaker political commitment to fiscal consolidation and growth-enhancing structural reform. Scope will in addition assess the degree to which discord with European institutions could impact the accessibility of European facilities.
By contrast, the ratings could be affirmed at A- and the Outlook revised to Stable if: i) debt sustainability is supported via a renewed attention to fiscal consolidation and structural reform that strengthens sustainable growth and public finances; and ii) relations with Europe prove less confrontational than anticipated, and there is little reason to question the contingent timely support from European facilities in an adverse scenario.
In Scope’s view, an upgrade or positive outlook change is highly unlikely in the near term.
The main points discussed during the rating committee were: i) the political environment outlook; ii) Italy’s low productivity and growth potential; iii) macroeconomic stability and sustainability; iv) fiscal consolidation outlook; iv) public debt sustainability and vulnerability to shocks; v) banking sector resilience; vi) peers considerations.
The methodology applicable for this rating and/or rating outlook, ‘Public Finance Sovereign Ratings’, is available on www.scoperatings.com.
The historical default rates used by Scope Ratings can be viewed in the rating performance report on https://www.scoperatings.com/#governance-and-policies/regulatory-ESMA. Please also refer to the central platform (CEREP) of the European Securities and Markets Authority (ESMA): http://cerep.esma.europa.eu/cerep-web/statistics/defaults.xhtml. A comprehensive clarification of Scope’s definition of default and definitions of rating notations can be found in Scope’s public credit rating methodologies at www.scoperatings.com.
The rating outlook indicates the most likely direction in which a rating may change within the next 12 to 18 months. A rating change is, however, not automatically a certainty.
This credit rating and/or rating outlook is issued by Scope Ratings GmbH.
Rating prepared by Dennis Shen, Lead Analyst
Person responsible for approval of the rating: Dr Giacomo Barisone, Managing Director, Public Finance
The ratings/outlook were first assigned by Scope as a subscription rating in January 2003. The ratings/outlooks were last updated on 30.06.2017.
The senior unsecured debt ratings as well as the short-term issuer ratings were last updated by Scope on 30.06.2017.
Solicitation, key sources and quality of information
The rating was initiated by Scope and was not requested by the rated entity or its agents. The rated entity and/or its agents did not participate in the ratings process. Scope had no access to accounts, management and/or other relevant internal documents for the rated entity or related third party.
The following material sources of information were used to prepare the credit rating: public domain and third parties. Key sources of information for the rating include: Ministry of Economy and Finance (MEF), Banca d’Italia, ISTAT, European Commission, Eurostat, ECB, IMF, and Haver Analytics.
Scope considers the quality of information available to Scope on the rated entity or instrument to be satisfactory. The information and data supporting Scope’s ratings originate from sources Scope considers to be reliable and accurate. Scope does not, however, independently verify the reliability and accuracy of the information and data.
Prior to publication, the rated entity was given the opportunity to review the rating and/or outlook and the principal grounds upon which the credit rating and/or outlook is based. Following that review, the rating was not amended before being issued.
Conditions of use / exclusion of liability
© 2018 Scope SE & Co. KGaA and all its subsidiaries including Scope Ratings GmbH, Scope Analysis, Scope Investor Services GmbH (collectively, Scope). All rights reserved. The information and data supporting Scope’s ratings, rating reports, rating opinions and related research and credit opinions originate from sources Scope considers to be reliable and accurate. Scope cannot, however, independently verify the reliability and accuracy of the information and data. Scope’s ratings, rating reports, rating opinions, or related research and credit opinions are provided “as is” without any representation or warranty of any kind. In no circumstance shall Scope or its directors, officers, employees and other representatives be liable to any party for any direct, indirect, incidental or otherwise damages, expenses of any kind, or losses arising from any use of Scope’s ratings, rating reports, rating opinions, related research or credit opinions. Ratings and other related credit opinions issued by Scope are, and have to be viewed by any party, as opinions on relative credit risk and not as a statement of fact or recommendation to purchase, hold or sell securities. Past performance does not necessarily predict future results. Any report issued by Scope is not a prospectus or similar document related to a debt security or issuing entity. Scope issues credit ratings and related research and opinions with the understanding and expectation that parties using them will assess independently the suitability of each security for investment or transaction purposes. Scope’s credit ratings address relative credit risk, they do not address other risks such as market, liquidity, legal, or volatility. The information and data included herein is protected by copyright and other laws. To reproduce, transmit, transfer, disseminate, translate, resell, or store for subsequent use for any such purpose the information and data contained herein, contact Scope Ratings GmbH at Lennéstraße 5, D-10785 Berlin.
Scope Ratings GmbH, Lennéstrasse 5, 10785 Berlin, District Court for Berlin (Charlottenburg) HRB 161306, Managing Director(s): Torsten Hinrichs (CEO), Dr. Stefan Bund.