Scope revises the Outlook on Italy’s BBB+ long-term ratings to Negative
|Deteriorating public finances and weakness in Italy’s medium-run growth prospects drive the Outlook change. European institutional support, including from the ECB, the economy’s systemic importance and a strong external sector support the ratings.|
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Scope Ratings GmbH has today affirmed the Republic of Italy’s long-term local- and foreign-currency issuer and senior unsecured debt ratings at BBB+, with the Outlook revised to Negative. The agency has also affirmed the short-term issuer ratings at S-2 with Outlook Stable in local and foreign currency.
Summary and Outlook
The revision of the Outlook on Italy’s long-term sovereign ratings to Negative, from Stable, reflects the following two drivers:
The Outlook change to Negative reflects changes under Scope’s assessments in the ‘public finance risk’ and ‘domestic economic risk’ categories in its sovereign methodology.
The affirmation of Italy’s BBB+ long-term ratings considers Italy’s multiple credit strengths including EU and euro area memberships and access to the programmes and facilities of European institutions including to ECB asset purchases and refinancing operations that have maintained financing rates at sustainable levels to date and eased liquidity risks for the public and private sectors. The BBB+ rating also recognises Italy’s systemic relevance for the euro area and the associated high likelihood of additional enhanced contingent support from European institutions under more severe market scenarios. In addition, a pre-crisis record of primary fiscal surpluses, a strong external sector, moderate levels of non-financial private sector debt and enhanced financial system cushions are credit strengths.
The ratings could be downgraded within the next 12-18 months if, individually or collectively: i) a material weakening in the outlook for debt sustainability and/or significant structural increase in annual gross financing needs is likely; ii) expectations regarding the economic growth outlook observe significant downside risk; and/or iii) support from European institutions is weakened, exposing Italy’s elevated debt stock to greater refinancing risk and/or questioning the contingent timely support from European facilities under stressed scenarios.
Conversely, the Outlook could be revised to Stable if, individually or collectively: i) there is convergence around a sustainable post-crisis reform programme that balances raising growth potential with a deeper reflection of Italy’s limited fiscal space – enhancing the debt sustainability outlook by placing the debt ratio on a durable downward trajectory; and/or ii) structural long-term transfer of Italian sovereign debt to European institutions is seen and/or some form of a mutualisation of public debt is more extensively contemplated to a macro-economically relevant degree.
The first driver underlying Scope’s decision to revise the Outlook on Italy’s long-term ratings to Negative is the sharp deterioration of the country’s public finances after this year’s large increase in the general government debt stock. This increase will likely result in a structural, that is, a material and lasting, rise in average annual gross government financing needs after the crisis, further limiting Italy’s fiscal space and adding pressure regarding the country’s medium-run debt sustainability.
Italy’s public debt was elevated already entering this year (134.8% of GDP at end-2019). In 2020, Scope expects a severe economic decline, with output to contract by around 7.5% under Scope’s baseline scenario, before a recovery of +4.5% in 2021. In addition, under more adverse scenarios, Italy faces the prospect of a double-digit 2020 contraction. The government has appropriately responded to the economic and public health crisis with significant budget and liquidity support, in line with responses of other major European governments.
Aggregate fiscal support amounts to date to around 4.5% of GDP for 2020 (and 1.4% for 2021) alongside 40% of GDP in public guarantees on bank loans. Spending actions to address the economic and health consequences of the crisis alongside the significant impact of the recession on Italy’s budget mean, however, the 2020 headline deficit is expected to rise to over 10% of GDP (from 1.6% in 2019), followed by over 5% of GDP in 2021. The general government debt ratio during 2020 is expected to rise to in excess of 155% of GDP – remaining the highest such ratio of any euro area sovereign issuer in terms of public debt owed to the private sector – the segment of sovereign debt rated by Scope. Risks to Scope’s baseline debt projections remain skewed to the upside with, for example, the 2020 increase in debt being much greater under a scenario of a more severe economic contraction and/or in the case additional fiscal resources are activated to address the crisis beyond those announced to date.
In addition, a structural rise in the government’s gross annual financing needs is anticipated in the aftermath of the crisis – even if interest payments stay within moderate bounds of about or below 4% of GDP, presenting risks to the sustainability of Italy’s debt burden. Scope expects GFNs in 2020 to increase to over 30% of GDP (from 23% of GDP in 2019) and then to fall somewhat with reductions in the deficit but remain above 25% of GDP each year through 2024. As such, financing needs will remain above an IMF GFN threshold of 20% of GDP, above which an advanced economy is defined to have limited fiscal space.
The second driver of the Outlook change relates to weak nominal growth potential and structural bottlenecks to long-term fiscal consolidation expectations, raising doubt on Italy’s ability to place its high public debt burden on a firm downward trajectory. Due to structural bottlenecks, Scope expects a significant share of the fiscal burden from this crisis to the public sector balance sheet to be of permanent nature. Absent structural reforms to raise Italy’s low potential growth, Scope expects the country’s public debt ratio to remain on an upward structural trajectory (i.e. when viewed through the cycle).
The structural nature of public balance sheet impairment experienced over past crises in Italy’s case is linked in significant part to low nominal growth. Over 2010 to 2019, nominal growth averaged 1.3% (with average real growth of 0.2% per year) – the weakest in the euro area after Greece. Scope estimates Italy’s medium-run real economic growth potential at 0.7% (the second weakest in Scope’s rated sovereign universe after that of Japan), reflecting in part assumptions of medium-run working-age population decline of 0.4% per year. Moreover, a track record of pro-cyclical loosening of fiscal policy during good economic times questions the likelihood of significant fiscal consolidation after the crisis. After the 2014 start of economic recovery after the last crisis, Italy observed steady deterioration in the structural balance in all except one year (2019). In addition, observed high turnover in governments and a lack of long-run uniformity around a reform agenda to address high public debt and raise economic growth potential are constraints to debt reduction.
Despite these structural weaknesses, Italy retains considerable credit strengths.
The affirmation of Italy’s ratings at BBB+ is supported by the economy’s memberships of the European Union and euro area with a strong reserve currency and the ECB and European Stability Mechanism acting as lenders of last resort. The EU’s response to the 2020 crisis has demonstrated, moreover, its determination and resolve to support member states through phases of crisis and prevent exceptional market stress. The ECB’s open-ended guidance and commitment to public sector bond purchases have been critical in the anchoring of accommodative financing conditions for sovereign issuers experiencing economic distress in 2020. The interventions of the ECB have been the prime anchor for the preservation of Italy’s market access, and facilitation of sustainable funding rates to cover elevated GFNs. Italy’s 10-year yield level is below 2% at the time of writing, comparatively benign compared with the above 7% level reached at 2011-12 sovereign debt crisis peaks.
ECB policies have not only held financing costs low but will also indirectly finance a significant share of Italy’s additional GFNs for 2020. We estimate the ECB could indirectly cover in full Italy’s additional GFNs in 2020 beyond those funding needs for 2019. The ECB, moreover, now holds over 20% of Italian medium- to long-term government securities – with this share increasing presently, representing the ongoing transfer of Italy’s marketable debts from the private sector to the ECB balance sheet. Scope considers this ongoing liability transfer to be credit positive, easing to a significant extent the increase in Italian debt owed back to the private sector (the segment of debt rated by Scope).
In addition, Scope recognises Italy’s systemic importance in the European Union (as the third largest economy with nominal GDP of EUR 1.8trn in 2019 and as the borrower with Europe’s largest debt stock – of EUR 2.4trn in March). This systemic role in the European economy and financial system stability, in Scope’s view, links to a high likelihood of additional contingent support from European institutions for Italy under more severe market scenarios. However, outside of the ECB’s unlimited capacity, Scope does not consider alternative official sector financing vehicles – for example the European Stability Mechanism’s EUR 410bn lending capacity – to currently have the adequate scale to stem a broader liquidity crisis were one to take place in a member state of Italy’s size. Thus, any sign that the ECB’s monetary policy support were to be curtailed in a significant manner without a compensating European policy instrument to offset negative effects of such a reduced ECB role would be credit negative.
Italy’s BBB+ ratings are further supported by the government’s record of primary fiscal surpluses before the crisis over an extended 2010-19 period, despite tepid economic growth during most years. Although frequently in non-compliance with European fiscal rules with relation to annual structural fiscal adjustments, Italy’s headline budget balance nonetheless observed gradual improvement since 2009, with the headline deficit reaching only 1.6% of GDP in 2019 – the lowest level since 2007. In addition, a seven-year average life of government debt – close to the weighted average of G-20 advanced economies – and nearly all Italian general government debt being denominated in euros are credit strengths. Italy’s well financed pension system, with limited unfunded pension liabilities, has traditionally been a credit strength. However, the ageing population and the ‘Quota 100’ pension reform of recent years are weighing upon fiscal expenditure, with pension expenditures expected to rise to 17% of GDP in 2020 (and more significantly over time) from 15.4% in 2019.
Finally, Italy’s ratings are anchored by a strong external sector, with the second largest manufacturing sector of the euro area. A track record of current account surpluses since 2013 has brought the economy to a nearly balanced external position (net international investment position of -1.7% of GDP in 2019, compared with -23.3% in 2013). In addition, the financial situations of families and businesses entered the 2020 crisis on a more solid footing than they were a decade before, with lowered non-financial private sector indebtedness (110% of GDP in 2019 versus 126% in 2010, well under a euro area average of 165% at end-2019). Banking sector resilience had been enhanced pre-crisis, with improved capitalisation (system-wide tier 1 capital ratio of 14.9% at end-2019, compared with 9.5% in Q2 2011). Italian banks’ stock of non-performing loans (NPLs) had, moreover, been trimmed to 6.7% of total loans in Q4 2019, from 18.2% in 2015. However, the severely weakened operating environment in Europe has lowered visibility on bank earnings and asset quality, with an increase in NPLs expected in 2020 – even if the scale of this increase might be mitigated by public guarantees issued on loans by government authorities.
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 ‘BBB’ (‘bbb’) 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) economic policy framework; ii) market access and funding sources; iii) current account vulnerability; iv) external debt sustainability; v) vulnerability to short-term external shocks; and vi) recent events and policy decisions. Relative credit weaknesses are signalled for: i) growth potential of the economy; and ii) debt sustainability.
The combined relative credit strengths and weaknesses generate a one-notch upside 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 its ‘Institutional and Political Risk’ pillar under the sovereign methodology, on which Italy has an average score on a composite index of six World Bank Worldwide Governance Indicators in the Core Variable Scorecard (quantitative model). Qualitative governance-related assessments include Scope’s Qualitative Scorecard evaluation on ‘recent events and policy decisions’ of ‘strong’ for Italy compared with ‘bbb’ sovereign peers – this evaluation represents an upside revision on ‘poor’ in the QS governance assessment during the last Italy sovereign rating announcement of December 2018, relating to a more moderate policy-setting framework under the Five Star Movement-Democratic Party government since September 2019, an improved Italian government relationship with European institutions since then and the government’s rapid and balanced response to the Covid-19 crisis – supporting Italy’s credit ratings at the BBB+ level. The next general elections in Italy are not due until 2023. Scope’s assessment on the ‘geopolitical risk’ QS category is judged, moreover, at ‘neutral’ compared with peers.
Socially-related factors are captured in Scope’s CVS in Italy’s high GDP per capita (of an estimated USD 32,947 in 2019) compared with that of ‘bbb’ sovereign peers, but a high level of unemployment and weak old-age dependency ratios are comparative weaknesses. Italy’s unemployment rate had declined pre-crisis to 9.3% as of February 2020 (from a 2014 peak of 13.1%), however is now forecasted by the European Commission to rise significantly to 11.8% on average over 2020, before easing to 10.7% in 2021. In 2020, the Italian government has implemented measures to protect employment, including by expanding available social safety nets, such as the Cassa Integrazione Guadagni to provide extraordinary wage supplementation to companies, as well as subsidies for the self-employed and a nine-month mortgage relief plan for self-employed and other non-salaried workers. The government’s support for social inclusivity and employment are considered in Scope’s QS evaluations of ‘weak’ on ‘growth potential of the economy’, but ‘strong’ on the ‘economic policy framework’ and ‘neutral’ on ‘macro-economic stability and sustainability’.
Italy has been among the hardest hit countries by the coronavirus crisis in Europe, with over 223,000 confirmed cases and the death toll over 31,000 (the fifth highest of countries around the world in total cases and third highest in mortalities, and amongst the highest in the EU per capita). After a national lockdown with strict limitations on non-essential economic activity and on freedom of movement, transmission of the SARS-CoV-2 pathogen has in recent weeks slowed, with new daily cases on a downward trajectory since late March. However, with around 75,000 persons presently infected, mitigation measures are expected to be relaxed only slowly after some reopening started in April and May. Italy’s measured response to the 2020 Covid-19 crisis is considered in the stated improved ‘recent events and policy decisions’ QS mark.
On environment, Italy recorded the sixteenth highest score (out of 180 countries) on the 2018 Environmental Performance Index – an index developed by Yale University. In addition, Italy has compared solidly on several environmental sustainability parameters: i) the government has made progress on Sustainable Development Goal 13 (climate action); ii) Italy scores above an EU average on resource productivity and investments in the circular economy; and iii) Italy scores at or near the top of the list on “energy efficiency regulation” and “renewable energy regulation” in the World Economic Forum’s 2019 Global Competitiveness Report. The government is advancing environmental sustainability in budgeting (green budgeting); however, Italy is also heavily impacted by environmental risks such as earthquakes and floods. Environmental factors are considered during the rating process; however, they did not play a direct role in this rating action.
Rating driver references
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