Scope revises the Outlook of Italy’s BBB+ long-term credit ratings to Stable
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Scope Ratings GmbH (Scope) today affirms the Republic of Italy’s long-term local- and foreign-currency issuer and senior unsecured debt ratings at BBB+, with the Outlooks revised to Stable from Negative. The Agency has also affirmed the short-term issuer ratings at S-2 with Outlooks remaining Stable in local and foreign currency.
Summary and Outlook
The revision of the Outlooks of Italy’s long-term sovereign ratings to Stable, from Negative, reflects the pursuant two credit rating drivers:
Determined European institutional support since the Covid-19 crisis, in the form of monetary policy measures, including ECB asset purchases programmes and relaxation of collateral framework requirements, alongside EU fiscal support, after endorsement of a EUR 191.5bn Recovery and Resilience Plan for Italy, supporting Italy’s debt sustainability and creating extra fiscal space for the government to spend in support of long-run economic growth.
- Current enhanced stability of the national government and momentum behind a credible structural reform, under the Mario Draghi administration, aimed at addressing the investment gap and countering critical structural economic bottlenecks. In addition, the markedly pro-EU stance of the current Italian administration supports expectation of continued strengthened cooperation with European institutions and closer alignment of near-term European institutional reforms with Italy’s economic interests.
The Outlook change to Stable reflects updated Scope assessments of Italy under the ‘domestic economic risk’ and ‘public finance risk’ categories of its sovereign methodology.
Next, affirmation of Italy’s BBB+ long-term ratings accounts for multiple credit strengths such as a systemic economic and financial-system relevance of Italy within the euro area and associated more elevated likelihood of additional contingent support from European institutions under stressed scenarios. Furthermore, a strong external sector, moderate non-financial private sector debt and enhanced financial system cushions abet resilience and bolster the outlook for sustainable recovery.
On the other hand, Italy’s ratings are challenged by the very high government debt stock and related elevated annual gross government financing needs (GFNs), which are expected to continue increasing structurally medium term – after considering jumps in the debt ratio upon future crises – presenting to the government potential refinancing risk under scenarios of sudden market reappraisal of risk and increases of interest rates. In addition, Italy’s credit ratings are constrained by longer-run economic bottlenecks, such as a rapidly ageing population, an historically weak record of productivity growth, and low employment and labour force participation, which cut real and nominal economic growth and impair debt sustainability.
The Stable Outlook reflects Scope’s opinion that risks to the credit ratings over the next 12 to 18 months are balanced.
The ratings/Outlooks could be upgraded if, individually or collectively: i) debt-to-GDP is placed on a meaningful downward trajectory; and/or ii) effective implementation of public investment priorities and a structural reform programme results in markedly higher long-run nominal growth of the Italian economy.
Conversely, the ratings/Outlooks could be downgraded if, individually or collectively: i) support from European institutions weakens after this current Covid-19 crisis, exposing Italy’s elevated debt stock to enhanced refinancing risk and/or questioning the timely support of European institutions under adverse scenarios; ii) a material weakening in the outlook regarding debt sustainability occurs; and/or iii) the nominal growth outlook weakens significantly.
The first driver underlying Scope’s revision of Italy’s Outlook to Stable is European institutional support, in the form of EU monetary and fiscal policies that have exceeded expectations from previous to this crisis in anchoring the market access of the region’s indebted borrowers, safeguarding the sustainability of debt and supporting sustainable growth.
ECB policy changes1 in response to the crisis have been a prime anchor preserving accommodative financing conditions of Italy and reducing refinancing risk. Here, a core innovation during this crisis has been flexibility of ECB purchases across jurisdiction, time and asset classes. The central bank’s pandemic purchases have stabilised especially financing conditions of those member countries with the most significant propensity for market stress such as Italy via purchases conducted in a flexible manner based upon market conditions. In the process, over 25% of Italian general government debt will have been shifted to the joint Eurosystem balance sheet by end-2021, from 17% before the crisis. As sovereign ratings are assigned on the debt due to be paid to the private sector, the shifting of debt to the official sector balance sheet is credit positive, curtailing the outstanding segment of rated Italian sovereign debt held by the private sector whilst increasing the share of debt the government effectively owes to itself – through holdings via the Bank of Italy. In addition, loosening of ECB collateral framework credit rating regulations in this crisis mitigated market concerns during spring of 2020 surrounding possibility of Italy becoming a “fallen angel” and associated systemic implications for the Italian financial system.
The ECB facilities have given an extended window of opportunity for Italy and other euro-area sovereign borrowers to improve their debt profiles. In addition to outlined transitions in the ownership structure of Italian sovereign debt in favour of BTPs being held by the Eurosystem – supporting in step market stability, the weighted average interest cost of Italy’s outstanding debt has declined to 2% this year from 4% as of 2012. Scope anticipates further drop in weighted average interest costs with Italy issuing at high volume with 10-year borrowing rates of under 0.6% at time of writing – near historic lows – which has helped reduced the average cost of issuance to under 0.2% from 0.9% as of 2019. In addition, the average life of Italian debt has increased slightly to 7.02 years in July 2021, from 6.73 years in August 2020, due to actions of the Italian Treasury, taking advantage of issuance longer term in view of the flatter yield curve.2 A stronger debt profile supports resilience in view of outstanding risk from the more elevated stock of debt.
European institutional support has, moreover, been reinforced by steps in direction of greater fiscal union by the EU over the crisis, exemplified by agreement surrounding the Next Generation EU (NGEU) recovery fund. Italy is the largest beneficiary of the programme under absolute terms, expected to receive up to EUR 191.5bn (10.1% of average 2021-26 GDP), including EUR 68.9bn in grant money, under the Recovery and Resilience Facility (RRF) over the next five years, complemented by further grant financing of EUR 13bn via the React-EU initiative.3 EU financial support for public investment creates critical fiscal space for the Italian government to use in further bolstering economic recovery and sustainable growth.
Italy’s National Recovery and Resilience Plan (NRRP)4 was approved in July by the European Council. The programme, combining EU financing with EUR 31bn in nationally funded assignments, comprises of 135 aggregate investments and 51 reforms, around three strategic objectives (digitalisation and innovation, ecological transition, and social inclusion). The economic impact will hinge upon the timing and effectiveness of implementation given historically poor absorption rates of Italy of EU funding. The Italian government expects from NRRP a cumulative 3.6pp aggregate boost to GDP by 2026, compared with a European Commission estimate of 1.5-2.5pps excluding the impact of nationally-fund projects. NGEU funding of Italy exceeds Italy’s cumulative public investment of the past five years (2016-20).
As investment stimulus from the Next Generation EU recovery programme begins flowing in (the European Commission disbursed an inaugural “pre-financing” tranche of EUR 24.9bn on 13 August5), continued growth over the second half of this year is further supported if Italian households continue spending some of the forced savings accrued during successive lockdowns, further progress is achieved with vaccination of residents plus growth dividend via raised consumer confidence after Euro 2020 and Olympics successes. After a GDP contraction of 8.9% in 2020, Scope expects the economy to recover this year, with a 2021 growth estimate of 6.1% (revised up modestly from 5.6% under Scope’s December 2020 forecasts), followed by 3.8% growth in 2022, before gentle convergence in direction of an upward-revised estimate of medium-run potential growth of 0.8% per annum (revised up from an estimate of 0.7% from previous to the Covid-19 crisis). The outlook for medium-run growth potential has been edged up on basis of growth-enhancing effects of public investment plus gradual economic adaptation to coexisting with the SARS-CoV-2 virus, curtailing some associated longer-term economic scarring effects.6,7,8
The second driver for the Outlook revision to Stable is a current phase of enhanced credibility and stability of the national government, under Mario Draghi’s leadership, strengthening reform momentum centring upon addressing key structural economic bottlenecks. Reform conditionality for access to additional EU funding strengthens commitment to reform. In addition, a markedly pro-EU stance of the government supports expectation for strengthened cooperation with European institutions over the coming period and a closer alignment of future European institutional reforms with Italian government priorities.
Since the Draghi government’s inauguration in February 2021 with an absolute parliamentary majority, the government has accomplished some core objectives over the short space of time, including acceleration of a flagging vaccination campaign to now exceeding an EU average in percentage of the population vaccinated, drafting the economic recovery programme and approval of first elements of judicial reform, aimed at curtailing the length of civil and criminal trials. Over past months, the cohesion of the government has proven critical to advancement of reform, contrasting with past years characterised by a succession of short-lived governments and a degree of reform backsliding. Scope expects a stable policy environment until the end of the current legislature under Draghi’s stewardship, giving the government the requisite space of time to oversee near-term reform priorities.
In addition, the pro-EU stance and strong regional standing of the Draghi government mitigates risk of any near-term re-emergence of a more contentious relationship of Italy with European institutions and associated adverse implications for contingent support from Europe. Instead, an enhanced leadership of the Italian government and Italian policy makers in key European institutional posts favour a continued reshaping of the European architecture over the coming period in a direction more supportive of Italy.
This aside, outstanding credit strengths that anchor BBB+ sovereign ratings include a systemic economic and financial-system relevance of Italy within the euro area and associated elevated likelihood of contingent support from European institutions under stressed scenarios. In addition, a robust external sector is credit positive, reflecting Italy as home to the second largest euro-area manufacturing sector. A track record of current account surpluses since 2013 brought last year the economy to a net external creditor position for the first time in 30 years, standing at a modest 2.1% of GDP as of March 2021. In addition, the financial situations of families and businesses entered the Covid crisis on a more solid footing than a decade before, with non-financial private sector indebtedness (of 123% of GDP as of Q1 2021) remaining well under a euro area average of 178%. Banking sector resilience has stayed robust amid crisis, with bolstered capitalisation (system-wide tier 1 capital ratio of 16.7% of risk-weighted assets in Q1 2021, against 14.9% pre-crisis as of end-2019). Italian banks’ official stock of non-performing loans (NPLs), moreover, continued to be drawn down, to 4% of total loans by Q1 2021, from 17% as of 2014. However, an increase in NPL recognition may crystallise as loan payment moratoria are slowly withdrawn.9
Despite these credit strengths, Italy’s ratings are challenged by crucial credit weaknesses.
Italy’s government debt is very elevated – third highest of Scope’s publicly-rated sovereign universe of 36 nations, after Japan (rated A/Stable) and Greece (rated BB/Positive). Spending actions to address economic and public health consequences of the crisis and raise medium-run growth have nonetheless elevated the 2021 headline deficit to an estimate of 11.7% of GDP, after an already wide 9.5% of GDP deficit in 2020. A general government debt ratio of 157.7% of GDP is expected by end-2021, higher than the 155.8% in 2020 despite strong 2021 economic recovery and versus an elevated pre-crisis ratio of 134.6% of GDP as of 2019. Scope expects the government to maintain a pro-growth fiscal policy orientation over the coming period with significant budget deficits decreasing gradually with time, and the primary balance to average a deficit of 2.3% of GDP over a 2022-2026 horizon. Even with assumption of robust real growth of an average of 1.8% over 2022-26 plus higher structural rates of inflation post-crisis under a baseline scenario, debt-to-GDP nonetheless edges slightly higher, ending a forecast horizon at 160.9% by 2026. This is consistent with Scope’s long-standing opinion that Italy’s debt ratio remains on an upward structural trajectory, recognising expected much more significant discrete jumps in the debt ratio upon future downturns. A high and rising (through the cycle) stock of government debt remains a core credit rating constraint.
Besides elevated explicit public debt, an increased stock of contingent liabilities might crystallise and affect the sovereign balance sheet, especially under adverse scenarios. The higher stock of debt and continued excess deficits over an immediate post-crisis phase result in higher annual gross government financing requirements despite declining interest payments. Scope expects annual GFNs to stay above 25% of GDP yearly through 2026, after exceeding 30% over 2020-21 (highest of the EU-27), remaining above an IMF 20% threshold, above which advanced economies are considered by the IMF to display more restricted fiscal space. High government debt and gross financing requirements mean Italy’s sovereign credit profile remains vulnerable to sudden risk reappraisals in capital markets, with any significant rise in credit spreads presenting risk for debt sustainability.10,11,12
Further ratings challenges include economic bottlenecks such as comparatively weak economic growth potential (Scope foresees medium-run nominal growth remaining modest at around 2%), even after accounting for higher productivity and employment growth and a somewhat higher rate of inflation after the crisis due to the scale of policy support. This recognises a rapidly ageing population, with Italy holding the second highest old-age dependency ratio of the euro area-19, which, combined with net emigration of youth segments of the population, curtails growth in the working-age population to around -0.5% annually over the next five years. The Italian economy has historically seen poor real labour productivity growth, with the level of productivity having increased only a cumulative 4% over 2000-20, compared with 18% as regards the euro area aggregate. Italy holds, moreover, comparatively low employment and labour force participation rates, of 58% and 64% in June 2021. There is risk, furthermore, that sizeable EU funds to raise growth potential are absorbed only incompletely or ineffectively. Moreover, moratoria since the crisis affecting NPL recognition and zombification of many unproductive entities may undermine growth longer term. By constraining growth potential, restricting the tax base and increasing spending pressure, these challenges impact the health of public finances.
Finally, there is risk around the longer-term political and policy outlook. While there is momentum presently behind a concerted reform agenda, optimism around recovery and policy alignment with European institutions, such favourable developments remain contingent upon continuity of the policy framework. There is uncertainty concerning this policy agenda especially after the 2023 elections.
Core Variable Scorecard (CVS) and Qualitative Scorecard (QS)
In line with Scope’s methodology, movements between indicative ratings are not immediate but rather executed after analyst review of CVS results. The rating committee approved an implied indicative rating of ‘a-’, after accounting for a one-notch positive adjustment for the euro’s reserve currency status. This indicative rating can be adjusted by the Qualitative Scorecard (QS) by up to three notches depending on the size of relative credit strengths or weaknesses versus the indicative sovereign peer group based on qualitative analysis.
For Italy, the QS signals relative credit strengths against indicative sovereign peers for the following qualitative analytical category: i) monetary policy framework. Relative QS credit weaknesses are signalled for: i) growth potential of the economy; ii) debt sustainability; and iii) social risks.
Combined relative credit strengths and weaknesses generate a one-notch downside adjustment via the QS 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 explicitly factors in ESG sustainability issues during the ratings process via the sovereign methodology’s stand-alone ESG sovereign risk pillar, with 20% weights under the methodology’s quantitative model (CVS) and qualitative scorecard (QS).
Under governance-related factors captured in Scope’s Core Variable Scorecard (quantitative model), Italy has an average score on a composite index of six World Bank Worldwide Governance Indicators. Furthermore, Scope’s Qualitative Scorecard evaluation on ‘institutional and political risks’ indicates Italy as being roughly in line with the risk level associated with its ‘a-’ indicative sovereign peers, as a fragmented Parliament and medium-term risks of government change and renewed confrontation with the EU are presently mitigated by the government of national unity and current strong partnership with European institutions. Nevertheless, Italy’s record of political instability and paralysis – with 66 governments over roughly the past 75 years – represents a ratings constraint.
Social-risk factors captured under the CVS display the lowest score for Italy of the euro area-19, partially driven by the economy’s elevated old-age dependency ratio. In addition, Italy’s income inequality, while modest under an international comparison, is nonetheless among the highest of the euro area. In addition, labour force participation, of around 64% of the active labour force, is the lowest of the euro area. The complementary QS assessment of ‘social risks’ is appraised as ‘weak’, corresponding with high labour force inactivity rates among youth segments (e.g., a “Not in Education, Employment, or Trainings” ratio of above 23% in 2020), among the highest gender employment gaps in the EU, elevated risk of poverty, including of in-work poverty, and high undeclared work. The share of the nation’s population with tertiary education is the lowest of the euro area, of below 18% in 2020. Expenditure on pensions, of around 17% of GDP in 2020, is, moreover, above a euro area average, although Italy’s pension system remains well-funded. The government’s support for social inclusivity and employment may, however, improve CVS and QS social risk assessments over the medium run.
On the sovereign ESG pillar’s environmental risk sub-category, Italy scores comparatively well on the CVS vis-à-vis euro area peers on the economy’s carbon emissions intensity, but worse than indicative peers on natural disasters vulnerabilities and the ecological footprint of consumption relative to available biocapacity. Further policy progress and investment is needed to achieve ambitious greenhouse gas emissions reduction, renewable energy and energy efficiency 2030 objectives under the National Energy and Climate Plan, as well as climate change mitigation goals, with Italy being especially vulnerable to climate change-related and other environmental hazards such as earthquakes, floods, volcanic eruptions and forest fire. Progress in the ecological transition of the economy is, importantly, however, a priority of the government, which has allocated a dedicated Ministry to the objective. The government is advancing environmental sustainability in budgeting (green budgeting) and issued earlier in 2021 its first BTP Green, while 37% of the recovery plan’s financial allocation is dedicated to the green transition. Italy’s green programme is considered under the QS with an evaluation of ‘neutral’ against ‘a-’ indicative sovereign peers.
The main points discussed by the rating committee were: i) credit rating triggers; ii) EU monetary policy support for indebted borrowers; iii) EU Recovery Fund and long-run fiscal union; iv) debt sustainability outlook; v) fiscal space; vi) medium-to-long run growth potential; and vii) sovereign peers considerations.
Rating driver references
1. ECB – Monetary Policy
2. Ministry of Economy and Finance: Treasury – Public Debt
3. European Commission – Recovery and Resilience Plans’ assessments
4. Italian Government: Italia Domani, the National Recovery and Resilience Plan
5. NextGenerationEU: European Commission disburses €24.9 billion in pre-financing to Italy
6. European Commission Summer Economic Forecast 2021
7. Bank of Italy Economic Bulletin – July 2021
8. Ufficio Parlamentare di Bilancio (upB)
9. Bank of Italy Financial Stability Report – April 2021
10. Ministry of Economy and Finance: Economic and Financial Document (DEF) 2021
11. Ministry of Economy and Finance: Relevant factors influencing public debt developments in Italy – April 2021
12. IMF Fiscal Monitor – April 2021
The methodology used for these Credit Ratings and/or Outlooks, (Rating Methodology: Sovereign Ratings, 9 October 2020), is available on https://www.scoperatings.com/#!methodology/list.
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