Scope downgrades Italy’s sovereign rating to BBB+ and changes Outlook to Stable
Scope Ratings GmbH has today downgraded the Republic of Italy’s long-term local- and foreign-currency issuer and senior unsecured debt ratings to BBB+, and changed the Outlook to Stable. The agency has also downgraded the short-term issuer rating to S-2 from S-1 in both local and foreign currency with the Outlook revised to Stable.
The downgrade of Italy’s sovereign ratings to BBB+ from A- reflects the following two drivers:
Re-alignments in Italy’s policy landscape in favour of anti-establishment groups, raising political and policy uncertainty – developments which may persist beyond just this one administration, with implications for the longer-term direction of policy setting as well as the likelihood of a coherent agenda taking shape aimed at tackling Italy’s significant structural challenges; and
- The policy programme of the present administration of the Five Star Movement and Lega – which has embarked on a series of fiscal, pension and economic reforms. Although the extent to which many programme measures are ultimately implemented remains unclear, in view of ongoing changes to programme elements alongside early election risk, the government’s expansionary budget and confrontation with the EU have stressed macro-financial conditions, market rates and pre-existing debt sustainability issues.
The downgrade to BBB+ reflects changes in Scope’s assessments in the ‘public finance risk’ and ‘domestic economic risk’ categories of its sovereign methodology. The Stable Outlook considers Italy’s credit strengths including euro area membership and likelihood of multilateral support in severe crisis scenarios, a track record of primary surpluses and a favourable debt structure, a large, diversified economy, and moderate private debt. In addition, the Outlook reflects key recent signs of moderation in the government’s policy objectives. Scope notes that negotiations are ongoing between Italy and Europe in seeking compromise on Italy’s violations of EU budget rules, with constructive signs including current discussions around the lowering of a 2.4% of GDP 2019 deficit target. In Scope’s opinion, the inadequate convergence around a sustainable reform programme that balances the government’s core pro-growth agenda with greater fiscal discipline, or a pronounced weakening in Italy’s debt sustainability, could be grounds for a downside revision to the outlook and/or ratings.
The first driver underlying Scope’s decision to downgrade Italy’s long-term ratings to BBB+ is the progressive shift in the policy landscape since the global financial crisis in favour of anti-establishment groups, with related implications for the country’s longer-run economic reform agenda. The combining of Lega and M5S for about 60% of voting intentions in opinion polls suggests longevity of a more populist stance in Italian policy making. Lega’s popularity has increased since the election – with about 32.5% of current voting intentions (compared with 17.4% in the March election), with the party in a strong position to lead a new centre-right government were early elections called. This potentially more-lasting role of non-traditional parties in government, with platforms favouring spending increases, tax cuts and roll-backs of earlier structural reforms to different degrees, is as important as the specifics of the present government’s economic programme and confrontation with EU rules, as the former challenges the probability of a policy trajectory emerging longer-term that goes steadfastly towards the resolution of significant challenges in Italy’s high public debt and low growth potential.
The second driver of the rating downgrade is the coalition government’s expansionary fiscal programme and reversal of earlier structural reforms, which raise debt sustainability concerns. Even before the 2019 fiscal programme is finalised, uncertainty since the government’s formation has stressed economic conditions, financing rates and weakened fiscal dynamics. Moderation of authorities’ original intent on a budget deficit goal of 2.4% of GDP in 2019 is presently under discussion. However, the European Commission has estimated a 2019 deficit of 2.9% of GDP (after 1.8% of GDP in 2018), with a 1.2% of GDP structural deterioration, on the basis of the government’s draft outline. This represents a significant 1.8% of GDP deviation from the structural adjustment of 0.6% of GDP originally planned for 2019 under progress towards Italy’s medium-term objective. While the EU may be willing to accommodate a level of deviation from the 0.6% of GDP structural adjustment originally sought absent recourse to sanctions, the significant size of the current deviation means a much greater degree of compromise from both sides will be needed, beyond the modest changes to the underlying programme contemplated to date.
Even prior to this administration, Italy’s budgets have successively been neutral to expansionary as a result of weaker-than-anticipated structural deficit adjustments. Moreover, bail-in rules have been bypassed due to domestic concerns, resulting in the recurrent use of government monies to assist bank rescues instead. These factors have contributed to a stagnation in Italy’s debt ratio at about the 131.2% of GDP level as of end-2017 (31pp higher than 2007 levels) since 2014, despite a growing economy. In Scope’s view, owing to Italy’s low medium-run growth potential, estimated at 0.75%, a failure to significantly reduce debt ratios during a global expansion raises the risk of greater debt sustainability challenges in a future global or regional downturn.
For example, in a scenario with wider budget deficits over 2019-21 of 2.9% of GDP, lower economic growth and holding prevailing market financing rates constant, debt-to-GDP would increase modestly to 134.9% by 2021. However, in Scope’s stressed scenario, under conditions of a global economic shock with the effect of two years of recession in Italy (and a hypothetical 5.9% cumulative contraction in output) and associated deterioration in the fiscal balance (with the primary surplus reaching a deficit of 1.5% of GDP at a trough), alongside a simultaneous spike in market financing rates, the debt ratio would climb to above 145% of GDP by 2021. In consideration of such scenarios, Scope considers the likelihood of Italy’s debt ratio taking an overall upward slope over a five-year horizon to be non-negligible – a rating risk.
In this context, Scope notes the risk associated with a slowing Italian economy, evidenced by real GDP growth softening to -0.1% QoQ in Q3 2018, from 0.2% in Q2 2018, equivalent to YoY growth of 0.7% – even if temporary factors played a role this Q3. Recent economic data speak to economic risks going forward absent rapid resolution of present economic and policy uncertainty. Scope projects economic growth of just 0.5% in 2019. Italian 10-year spreads stand at 285 bps, down from recent peaks but higher on lows at about 115 bps in late-April – although, even with elevated spreads, nominal yields are currently still much lower than during debt crisis peaks at 3.1% currently on 10-year BTPs. Nonetheless, higher government yields have increased costs for Italian companies, which paid a 3.5% yield on new fixed-rate debt for first-time issuers in Q3, up on 1.8% in Q1 2018, according to the Bank of Italy.
Despite these credit weaknesses, Italy’s BBB+ rating is bolstered by euro area membership with a strong reserve currency and an independent European Central Bank effectively acting as a lender of last resort. Scope believes that institutional developments and the adjustments of past years have increased euro area member states’ protection from adverse shocks, underpinning the sovereign creditworthiness of all euro area member states. In addition, Italy’s debt stock of EUR 2.3trn – the largest in Europe in nominal terms – underscores Italy’s systemic financial importance. Scope views this systemic significance to correspond to a higher likelihood that European institutions, including the ECB, would, in extremis, apply, and in case of need, further develop, the appropriate policy tools and financial instruments to facilitate conditional support ensuring Italy’s debt repayment.
In addition, 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 constitutional fiscal frameworks, enhanced during the debt crisis – which obliges Italy to adhere to a balanced budget – support fiscal moderation in the current crisis, although this framework is being tested. The relatively long 6.8-year average maturity of Italy’s debt stock with 68% of debt (as of 2017) being held by the resident sector further shields the government to an extent from market turbulence.
Finally, Italy’s ratings are supported as well by its large, diversified economy (with nominal GDP of EUR 1.8trn in 2018). Furthermore, non-financial private debt is moderate at 156% of GDP as of Q2 2018 (using Bank of Italy data) – comparing well with that of European peers, and down from peaks of 176% of GDP in Q4 2011. Moreover, the current account stands at a robust surplus of 2.7% of GDP in the year to September 2018, compared with a deficit of 3.4% of GDP as of 2010. Italian banks’ stock of non-performing loans has moreover been cut to 10.2% of total loans as of Q2 2018, compared with 17% during a 2015 peak, supported by initiatives including the authorities’ Guarantee on Securitization of Bank Non-Performing Loans (GACS). Still, risks in the banking sector are a continued rating constraint, with common equity tier 1 capital ratios slipping to 13.2% of risk-weighted assets in Q2 2018, 60 bps under levels in Q4 2017. Significant actions still need 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) vulnerability to short-term external shocks. Relative credit weaknesses are signalled for: i) growth potential of the economy; ii) economic policy framework; iii) 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 a BBB+ sovereign rating for Italy.
The results have been discussed and confirmed by a rating committee.
Factoring of Environment, Social and Governance (ESG)
Scope considers ESG sustainability issues during the rating process as reflected in the sovereign methodology. Governance-related factors are explicitly captured in Scope’s assessment of ‘Institutional and Political Risk’ in its methodology, in which Italy has an average score on a composite index of six World Bank Worldwide Governance Indicators in the CVS, earning a higher score on Voice & Accountability but a lower score on Political Stability. Qualitative governance-related assessments reflect Scope’s QS evaluation on ‘recent events and policy decisions’ of ‘poor’ compared with Italy’s sovereign peers – this negative QS governance assessment, related to the re-alignment of Italy’s policy landscape in favour of anti-establishment groups, raises political and policy uncertainty.
Socially-related factors are captured in Scope’s CVS in Italy’s high GDP per capita (USD 31,997 in 2017) compared to ‘a’-indicative-rating peers, but high levels of unemployment and weak old-age dependency ratios are comparative weaknesses against peers. The government’s programme targets tackling social issues, such as via the introduction of the citizen’s income, facilitation of early retirements and promotion of youth employment. However, these programmes can stress fiscal dynamics if not designed under a sustainable architecture, and have raised financial market concerns, weakening economic conditions. The government’s support for social inclusivity and employment are nonetheless considered in Scope’s QS evaluation via the ‘growth potential of the economy’, ‘economic policy framework’ and ‘macro-economic stability and sustainability’ categories.
Italy’s record on environmental issues compares weakly against EU peers. The government’s draft budget plans to raise investment in areas such as energy efficiency and care for green spaces. However, the figures dedicated to the green transition are small. Environmental factors are considered during the rating process, however did not play a direct role in this rating action.
Outlook and rating-change drivers
The ratings and/or outlooks could be downgraded if: i) an inadequate convergence around a sustainable economic and fiscal programme results in a non-negligible weakening in the outlook on Italy’s long-run debt sustainability, including an erosion of Italy’s primary surplus; ii) the current crisis escalates, impacting the near- and medium-term economic, fiscal and financial stability outlooks, as well as the government’s ease of market access; and/or iii) the degree of discord with European institutions heightens, questioning the contingent timely support from European facilities in stressed scenarios.
Conversely, the ratings and/or outlooks could be upgraded over the medium-run if: i) there is convergence around a sustainable reform programme that balances raising growth potential with a deeper reflection of Italy’s limited fiscal space – enhancing the debt sustainability outlook and placing debt on a durable downward trajectory; and/or ii) resolution of disagreements with the European Union regarding Italy’s budget brings about a significant reduction of current excess spread levels for Italian debt, supporting debt sustainability, domestic demand and financial stability.
The main points discussed during the rating committee were: i) developments in Italy’s budget negotiations with the EU; ii) recent deterioration in economic conditions; iii) the disparity between Italy’s fiscal objectives and anticipated results; iv) growth outlook; v) debt sustainability; vi) recent political developments and outlook; and vii) market access and financial conditions.
The methodology used for this rating and/or rating outlook, ‘Public Finance Sovereign Ratings’, is available on www.scoperatings.com.
Historical default rates of the entities rated 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 as well as 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.
Solicitation, key sources and quality of information
The rating 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 substantial 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 the issuance of the rating, 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.
This credit rating and/or rating outlook is issued by Scope Ratings GmbH.
Lead analyst Dennis Shen, Associate Director
Person responsible for approval of the rating: Dr Giacomo Barisone, Managing Director, Public Finance
The ratings/outlook were first assigned by Scope in January 2003. The ratings/outlooks were last updated on 07.12.2018.
The senior unsecured debt ratings as well as the short-term issuer ratings were last updated by Scope on 07.12.2018.
Please see www.scoperatings.com for a list of potential conflicts of interest related to the issuance of credit ratings.
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