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Rating action

Scope Ratings GmbH (Scope) has today affirmed the Republic of Italy’s long-term local- and foreign-currency issuer and senior unsecured debt ratings at BBB+ and affirmed the short-term issuer ratings at S-2 in local and foreign currency. All Outlooks are Stable.

Summary and Outlook

Italy’s BBB+/Stable rating benefits from i) supportive European monetary and fiscal policy frameworks under the EU and euro area institutional architecture; ii) the Italian economy’s size (EUR 1.8trn of GDP) and diversification, which, together with a high per-capita income of around EUR 30,000, strong external sector, moderate non-financial private sector debt and financial system buffers, supports economic resilience; and iii) a favourable public debt structure with an average cost of funding of around 2.5% and an average debt maturity of around seven years. Italy’s significant economic, financial market and political relevance as a founding member of the EU further underpins Scope’s expectation of exceptional support from European institutions under stressed scenarios. This includes the ECB’s flexible reinvestment of securities purchased via its asset purchase programmes and the Transmission Protection Instrument.

Rating challenges include i) weak public finances, given high government debt of around 145%-150% of GDP and elevated annual funding needs, including bills, of 25%-30% of GDP, expected to persist into the medium term; ii) structural bottlenecks, which hinder medium-term growth by limiting productivity growth and creating labour market rigidities that curb employment growth and labour force participation; iii) weak demographics, with an ageing and declining working population that will continue to weigh on government finances and growth; and iv) a fluid and fragmented political environment with snap elections scheduled for 25 September, risking a longer period of policy inertia.

The Stable Outlook reflects Scope’s opinion that risks to the credit ratings over the next 12 to 18 months are broadly balanced.

The ratings/Outlooks could be upgraded if there is, individually or collectively: i) a firm downward trajectory in the debt-to-GDP ratio; and/or ii) improved medium-term economic growth resulting from an effective implementation of public investments and structural reforms on which EU fund disbursements are conditioned.

Conversely, the ratings/Outlooks could be downgraded if, individually or collectively: i) support from European institutions weakened, increasing refinancing risk on Italy’s high public debt stock; ii) the medium-term growth outlook weakened due to delays in public investment and/or reforms under the country’s recovery and resilience programme; and/or iii) the fiscal outlook deteriorated, resulting in slower fiscal consolidation and an associated slower decline, or even reversal, in the debt-to-GDP ratio.

Rating rationale

The first driver underlying Scope’s affirmation of Italy’s BBB+/Stable rating is the extensive European institutional support the country benefits from via EU monetary and fiscal policies. This includes Scope’s expectation that Italy’s significant economic, financial market and political relevance as a founding member of the EU will result in exceptional support from European institutions under stressed scenarios. This provides a strong anchor for the country’s reform agenda and market access, supporting the sustainability of its public debt and its medium-term economic growth.

First, the ECB’s supportive monetary policy has been a primary anchor for favourable financing conditions for Italy during the pandemic shock, and will continue to provide support and stability as the normalisation of its monetary policy takes hold. The ECB will be reinvesting principal payments from maturing securities purchased under its Pandemic Emergency Purchase Programme (PEPP) and Public Sector Purchase Programme (PSPP), whose net asset purchases ended this year. Scope estimates that the Eurosystem will reinvest around EUR 100bn a year in Italian debt, which would cover about one-third of the country’s medium-to-long-term annual bond issuance going forward. Scope’s estimate is based on the Eurosystem’s holdings of Italian government debt of around EUR 727.3bn as of May 2022 (PEPP of EUR 279.3bn; PSPP of EUR 448.0bn), the bonds’ weighted average maturity of about seven years, and the flexibility in reinvestment. Reinvestment in the PEPP will occur until at least 2024 and is flexible across time, asset classes and jurisdictions. Reinvestment in the PSPP, while not as flexible, is also open-ended to date^1,2.

Second, the ECB approved on July 21 its Transmission Protection Instrument (TPI), a permanent tool that is unlimited in scope and unbound to the capital key. The TPI will in principle allow the ECB to purchase bonds of member states if it deems, at its own discretion, that yields and/or spreads reflect unwarranted, disorderly market dynamics that pose a serious threat to the ECB’s ability to transmit monetary policy across the euro area. Bonds with a maturity of 1-10 years may be purchased. The conditions for its activation relate to the compliance with the EU fiscal framework^a, an absence of severe macro-economic imbalances^b, fiscal sustainability^c, and compliance with the reform commitments submitted in the recovery and resilience plans. Scope expects that these conditions will increase the significance of the assessments and recommendations of the European Commission and the Eurogroup, giving Italian policymakers a strong incentive to ensure Italian bonds remain eligible under the TPI and thus reinforcing incentives to preserve the reform agenda and gradual fiscal consolidation beyond this year’s election³.

While the ECB’s criteria currently justify buying Italian bonds under the TPI, Italy still needs to fulfil 55 policy actions this year to comply with its National Recovery and Resilience Plan⁴. In addition, negotiations around EU fiscal rules, which are suspended and yet to be reformed, will determine whether Italy can comply with the rules once reinstated. Nonetheless, the TPI’s preventive nature – contrary to the corrective elements of the Outright Monetary Transactions programme – and the political incentives it provides reinforces Scope’s assessment of the institutional support Italy receives from the EU. This critically supports Scope’s BBB+/Stable rating assessment.

Moreover, European institutional support has been reinforced by the Next Generation EU (NGEU) recovery fund. Italy is the largest beneficiary of the programme in absolute terms, set to receive up to EUR 191.5bn (about 10% of average 2021-26 GDP), including EUR 68.9bn in grants under the Recovery and Resilience Facility, supplemented by EUR 13.9bn in React-EU initiative grants⁵.

Italy’s National Recovery and Resilience Plan comprises 132 investment programmes and 58 reforms. It revolves around three objectives: digitalisation and innovation, ecological transition, and social inclusion. Reform priorities include the public administration, the judiciary, competition and public procurement, education and research, and active labour market policies. So far, Italy has achieved targets according to plan, receiving tranches of EUR 21bn in April, following EUR 24.9bn in pre-financing in 2021, with another EUR 19bn expected in coming months, subject to the adoption of 55 agreed targets. The economic impact will depend on the timing and effectiveness of both the investments and the reforms. The government expects a 3.6pp aggregate boost to GDP by 2026, which assumes public investment is highly efficient. This compares with the Fiscal Council’s estimate of 2.3pp that assumes ‘average’ efficiency and 1.4pp in case of ‘low’ efficiency. The European Commission estimates an impact of 1.5-2.5pp. While the final impact is uncertain, complicated by implementation risks due in part to strained value chains and rising production prices, higher public investment and productivity-enhancing reforms support Scope’s BBB+/Stable rating⁶.

The second driver supporting Italy’s BBB+/Stable rating is the country’s large and diversified EUR 1.8trn economy, which, together with its high per-capita income of around EUR 30,000, strong external sector, moderate non-financial private sector debt and financial system buffers, supports economic resilience. Italy has kept its current account in surplus since 2013 thanks to its large manufacturing sector and became a net foreign creditor at the end of 2020. The country’s net international investment position is a positive 6.5% of GDP as of Q1 2022, a significant credit strength compared to peers Spain (A-/Stable; -67%) and Portugal (BBB+/Positive; -93%). While Scope expects a current account deficit this year given the costly energy imports, goods exports should result in sustained surpluses over the medium term. In addition, both corporate and household debt is moderate at around 71% and 43% of GDP respectively, compared to the euro area averages of 110% and 60%. Similarly, banking sector resilience remains robust, with a system-wide Tier 1 capital ratio of 15.8% of risk-weighted assets in Q1 2022 and the continued decline in non-performing loans, at below 3% in Q1 2022 from the 17% peak in 2015. This should support bank lending, corporate investment and household consumption and thus domestic demand over the medium term.

For 2022, Scope expects growth of around 3%, driven by a recovery in services, including tourism, construction, manufacturing and consumption (balancing pent-up savings with lower purchasing power given expected inflation of around 7% this year) and supported by a favourable carry-over from last year. Should energy shortages arise in Q4 2022, growth (inflation) could be lower (higher) by about 1.5-2.0pp. For 2023, Scope expects growth of around 1.5% and a recession in case energy shortages result in interruptions in industrial production, even steeper commodity prices and weaker foreign demand. However, in the absence of such an adverse scenario, Scope expects average growth of around 1.3% over 2023-27, a full percentage point above the average during the pre-Covid 2010-19 decade. This also reflects the expected positive economic impact from the NGEU recovery funds and associated reforms.

The third key credit strength supporting Italy’s BBB+/Stable rating is its favourable debt structure, which shields the sovereign from sudden changes in investor demand and reduces the immediate impact of higher rates on its funding costs. About 30% of Italian central government securities are held by the Eurosystem as of March 2022, up from 5% in 2014 before the start of the ECB’s purchase programmes. In addition, domestic banks and residents hold 40%, with non-residents only holding about 30%, down from around 50% in 2009 and 40% in 2014. Thus, when faced with higher yield volatility, Italy’s debt holders are less likely to divest and more likely to act as stabilising investors. Finally, the high cash buffer of about EUR 80bn, long debt maturity of 7.1 years, low but rising average cost of debt of around 2.5%-3.0% for 2022-23 (up from 2.4% in 2021 but still below the 4% in 2012) and the expected NGEU disbursements support the resilience of Italy’s debt financing.

Despite these credit strengths, Italy’s ratings are challenged by several credit weaknesses:

First, public debt will remain high at around 145%-150% of GDP over the coming years, about 15-20pp above pre-Covid levels, even with Scope’s expectation of continued economic growth, the favourable impact from inflation this year, and gradual fiscal consolidation. Scope’s baseline includes i) economic growth of around 3% in 2022 and 1.5% in 2023 before declining to about 1% over the medium-term; and ii) a reduced fiscal deficit of 5.5% of GDP in 2022 from 7.2% in 2021, followed by a gradual improvement towards 3.5% by 2027. Scope assumes no significant additional discretionary spending, a return of the primary balance to a surplus in 2026, and continued high gross financing needs at around 25%-30% of GDP. On this basis, Scope expects the debt-to-GDP ratio to decline only modestly to around 144% by 2027 from about 151% this year, and thus remain well above that of Spain (113%, expected by 2027) and Portugal (106%). The higher public debt will continue to structurally reduce Italy’s capacity to absorb future shocks, as the large debt amortisations will require more budgetary resources, particularly as interest payments rise. Italy’s high public debt thus constitutes a major rating constraint and underscores the need for a credible, multi-year fiscal consolidation strategy without curtailing investments.

Second, the Italian economy has weak total factor productivity, averaging just 0.3% annual growth during the pre-Covid decade compared to 0.7% for the euro area. Similarly, labour productivity increased by only 2.7% over 2000-21, compared with 18.9% in the euro area, 14.2% in Spain and 20.5% in Portugal. Italy’s real labour productivity growth averaged just 0.2% a year over the past 20 years, which is curbing medium-term growth. Reasons for the weak productivity dynamics include infrastructure gaps, an inefficient public administration, low investment in both R&D and human capital, a lower-skilled workforce as measured via PISA and DESI indices, large skill-mismatches, and longstanding labour market rigidities.

Third, medium-term economic growth is being hampered by labour market rigidities, reflected in the low employment rate of around 60% (against the euro area average of almost 70%) and the lowest labour force participation in the euro area, at 65% against 73.5% as of Q1 2022. Participation is particularly weak among women, with 3.8m inactive out of the 19.7m aged 25-54, and among older workers, with 3.7m inactive out of the 13.3m aged 55-64. In addition, still elevated structural unemployment of around 9.6% – the third highest in the euro area after Spain and Greece (both 12%) – and persistently high youth unemployment of around 33% further constrain Italy’s growth potential.

Fourth, Italy’s demographic developments are among the worst in Europe, with the rapidly ageing and declining working population having major economic and fiscal consequences. By 2050, the European Commission projects Italy’s working-age population (aged 20-64) to decrease by about 18% and those aged 80 and above to increase by 78%. This will cause the old-age dependency ratio, already the second highest in the euro area after Finland, to increase to around 67% by 2050 from around 40% in 2020, in line with that of Spain (65%) and Portugal (69%) but well above the euro area average of 58%. This trajectory, combined with net emigration of the younger segments of the population, will have a significant impact on the financing of Italy’s pension system and further limit growth potential, complicating the consolidation of public finances over the medium term.

Finally, Italy’s ratings are constrained by rising political uncertainty, exacerbated by the recent resignation of the national unity government led by Prime Minister Mario Draghi. This could result in an extended period of political vacuum that prevents the implementation of reforms that NGEU disbursements and TPI eligibility are conditioned on. Still, the formation of a political majority that would reverse current domestic economic policies is less likely given the high political fragmentation. In addition, the prospect of significant EU funds should also incentivise all parties to broadly continue with the reforms agreed with the European Commission. Finally, the ageing population, high home ownership and strong support for the euro (72% of citizens are in favour per the latest Eurobarometer) suggest a low risk of extreme policy outcomes. Instead, the key political risk is a weak government unwilling or unable to implement the reforms needed to raise Italy’s growth potential, ensure the consolidation of its finances and thus the sustainability of its public debt.

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) fiscal policy framework; iii) debt sustainability; iv) banking sector performance; v) social risks; and vi) governance risks.

Combined relative credit strengths and weaknesses generate a two-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 CVS, Italy scores average on a composite index of six World Bank Worldwide Governance Indicators. Furthermore, Scope’s QS evaluation on ‘institutional and political risks’ indicates Italy’s weakness relative to peers given its political volatility and parliamentary fragmentation. Italy’s record of political instability and paralysis – with 66 governments over roughly the past 75 years – represents a rating constraint.

For social-risk factors captured under the CVS, Italy scores the worst of the 19 euro area countries, in part due to its high old-age dependency ratio. Italy’s income inequality, while modest under an international comparison, is among the highest in the euro area. Its labour force participation is also the worst in the euro area. The complementary QS for ‘social risks’ is assessed as ‘weak’ given the high inactivity among younger workers (e.g. a ‘Not in Education, Employment, or Trainings’ ratio of above 23% in 2020), one of the highest gender employment gaps in the EU, the elevated risk of poverty, including of in-work poverty, and high undeclared work.

On the environmental risk sub-category, Italy scores well on the CVS against euro area peers for carbon emissions intensity, but worse for natural disaster vulnerability (e.g. earthquakes, floods, volcanic eruptions and forest fires) and the ecological footprint of its consumption relative to available biocapacity. Italy will need further policy progress and investment to achieve its ambitious goals by 2030 under the National Energy and Climate Plan to reduce emissions while improving renewable energy use and energy efficiency, as well as to mitigate the impacts of the climate crisis, which is exacerbating an already high vulnerability to natural disasters.

a. Not being subject to an excessive deficit procedure, or not being assessed as having failed to take effective action in response to an EU Council recommendation.
b. Not being subject to an excessive imbalance procedure, or not being assessed as having failed to take the recommended corrective action from the EU Council.
c. Based on the debt sustainability analyses by the European Commission, the European Stability Mechanism, the International Monetary Fund and its own assessment.

Rating committee
The main points discussed by the rating committee were: i) credit rating triggers; ii) EU monetary and fiscal policy support; iii) economic growth outlook; iv) fiscal outlook and debt sustainability; and v) sovereign peers considerations.

Rating driver references
1. ECB – PSPP Monetary Policy
2. ECB – PEPP Monetary Policy
3. ECB – TPI
4. Italian Government: Italia Domani, the National Recovery and Resilience Plan
5. European Commission – Recovery and Resilience Plans Italy
6. Fiscal Council 2022 Budgetary Planning Report

Methodology
The methodology used for these Credit Ratings and/or Outlooks, (Rating Methodology: Sovereign Ratings, 8 October 2021), is available on https://scoperatings.com/governance-and-policies/rating-governance/methodologies.
Information on the meaning of each Credit Rating category, including definitions of default, recoveries, Outlooks and Under Review, can be viewed in ‘Rating Definitions – Credit Ratings, Ancillary and Other Services’, published on https://www.scoperatings.com/governance-and-policies/rating-governance/definitions-and-scales. Historical default rates of the entities rated by Scope Ratings can be viewed in the Credit Rating performance report at https://scoperatings.com/governance-and-policies/regulatory/eu-regulation. 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 Ratings’ definitions of default and Credit Rating notations can be found at https://www.scoperatings.com/governance-and-policies/rating-governance/definitions-and-scales. Guidance and information on how environmental, social or governance factors (ESG factors) are incorporated into the Credit Rating can be found in the respective sections of the methodologies or guidance documents provided on https://scoperatings.com/governance-and-policies/rating-governance/methodologies.
The Outlook indicates the most likely direction of the Credit Ratings if the Credit Ratings were to change within the next 12 to 18 months.

Solicitation, key sources and quality of information
The Credit Ratings were not requested by the Rated Entity or its Related Third Parties. The Credit Rating process was conducted:
With Rated Entity or Related Third Party Participation    YES
With Access to Internal Documents                                  NO
With Access to Management                                            YES
The following substantially material sources of information were used to prepare the Credit Ratings: public domain and the Rated Entity.
Scope Ratings considers the quality of information available to Scope Ratings on the Rated Entity or instrument to be satisfactory. The information and data supporting these Credit Ratings originate from sources Scope Ratings considers to be reliable and accurate. Scope Ratings does not, however, independently verify the reliability and accuracy of the information and data. Prior to the issuance of the Credit Rating action, the Rated Entity was given the opportunity to review the Credit Ratings and/or Outlooks and the principal grounds on which the Credit Ratings and/or Outlooks are based. Following that review, the Credit Ratings were not amended before being issued.

Regulatory disclosures
These Credit Ratings and/or Outlooks are issued by Scope Ratings GmbH, Lennéstraße 5, D-10785 Berlin, Tel +49 30 27891-0. The Credit Ratings and/or Outlooks are UK-endorsed.
Lead analyst: Alvise Lennkh-Yunus, Executive Director
Person responsible for approval of the Credit Ratings: Dr Giacomo Barisone, Managing Director
The Credit Ratings/Outlooks were first released by Scope Ratings in January 2003. The Credit Ratings/Outlooks were last updated on 20 August 2020.

Potential conflicts
See www.scoperatings.com under Governance & Policies/EU Regulation/Disclosures for a list of potential conflicts of interest related to the issuance of Credit Ratings.

Conditions of use / exclusion of liability
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