Fitch Affirms Italy at 'BBB'; Outlook Negative
Fitch Ratings - Frankfurt am Main - 09 August 2019:
Fitch Ratings has affirmed Italy's Long-Term Foreign-Currency Issuer Default Rating (IDR) at 'BBB' with a Negative Outlook.
KEY RATING DRIVERS
Italy's 'BBB' rating and Negative Outlook reflect the extremely high level of general government debt, very low trend GDP growth, policy risk and uncertainty arising from the current political dynamic and associated downside risks to our public debt projections. The relatively high net external debt and still-weak banking sector asset quality also weighs on the rating.
The rating is supported by a diversified, high value-added economy, with GNI per capita, governance and human development indicators much stronger than the peer group medians. Italy also has moderate private sector indebtedness, a sustainable public pension system, relatively favourable average maturity of public debt (6.8 years), a negligible share of foreign currency debt, a current account surplus and a net international investment position close to balance.
The general government deficit was 2.1% of GDP in 2018, the lowest for a decade. Fitch forecasts an unchanged deficit of 2.1% of GDP in 2019, 0.2pp lower than our forecast at the previous review and below the 2.4% expected in the April Stability programme. The better performance reflects higher-than-forecast tax revenues despite the economic weakness. Specifically, an additional EUR2.9 billion stemmed mostly from better-than-expected personal income tax and value added tax revenues, higher receipts from lottery and gambling operations, and the settlement of one large company's past tax liabilities. Social security contributions of EUR0.6 billion and other revenues, including higher dividends from Bank of Italy and Cassa Depositi e Prestiti (EUR 2.7 billion), are also notable. Lower take-up of citizenship income and the "Quota 100" early retirement scheme is expected to yield EUR1.5 billion in expenditure savings.
A decree-law approved by parliament provides for a spending freeze mechanism worth EUR 1.5 billion if the projected savings fail to materialise. This should help ensure that fiscal gains are not spent on other measures for the rest of 2019.
In light of these measures the European Commission concluded in July 2019 that an excessive deficit procedure (EDP) was not warranted. The government also pledged a structural fiscal adjustment in 2020 consistent with the EU's Stability and Growth Pact. In our view the avoidance of the EDP shows that the Italian government remains engaged with the EU's fiscal processes. However, the nature of any fiscal adjustment in 2020 remains unclear, and tensions with the European Commission are likely to resurface, but we believe a future government will be wary of fully disengaging from EU processes, which could risk financial market instability.
Fitch continues to expect moderate fiscal loosening in 2020 and we have kept unchanged our deficit projection at 2.7% of GDP. We assume there will not be an activation of the VAT safeguard hikes (which would account for 1.3% of GDP) and that there is a partial implementation of Lega's flagship 15% 'flat tax' rate, which could be restricted to annual incomes below EUR50,000 at a cost of around 0.6%-0.7% of GDP. We expect this will only partly be offset by savings from the government's "integrated strategy" of a spending review and revision of tax allowances, which will be politically difficult. Our 2020 deficit forecast will likely equate to a small worsening of the structural deficit, compared with the current Stability and Growth Pact target for a 0.6% of GDP improvement, resulting in renewed tensions with the European Commission.
Bond market sentiment has improved towards Italy over the past months. Yields on 10-year Italian government bonds had dropped to 1.4% at end-July from 2.4% at end-May 2019. This also reflects market expectations that policy interest rates will remain low for longer and the possibility that the ECB will resume sovereign bond purchases. Low interest rates and additional quantitative easing by the ECB will support debt burdens in highly indebted sovereigns like Italy, but could also ease pressure on the government to reduce public debt and implement structural reforms.
Fitch forecasts an increase in general government debt to 134.7% of GDP in 2021 from 132.2% in 2018, driven by lower nominal GDP growth, and a 0.7pp weakening in the primary balance from 2018-2021. This compares with the current 'BBB' median of 36% of GDP and would leave Italy as one of the most highly indebted sovereigns we rate, exposed to downside risks and with reduced scope for counter-cyclical fiscal policy. Public debt/GDP increased by 0.8pp in 2018 due to a positive stock flow adjustment of 0.9pp, partly related to debt management operations and a marked rise in Treasury cash reserves; we do not incorporate any further stock-flow adjustments in our forecast. Under our longer-term debt sensitivity analysis, which assumes average GDP growth of 0.5% in 2019-2028 and an average primary surplus of 1.0% of GDP, public debt increases to 138% of GDP in 2028.
Our long-held view is that policy tensions in the coalition government and the potential for early elections add to uncertainty over fiscal and economic policy. At the time of writing, the leader of Lega, Matteo Salvini, has triggered a no-confidence vote in the government and expressed his willingness to hold snap elections. The government is likely to lose the confidence vote, and it would then be for the President of the Republic, Sergio Mattarella, to decide the next steps. Alternative outcomes to a snap election are also possible, and include a caretaker government or a different coalition under the current Parliament.
This week's political developments reinforce our assessment at the previous review that the government was unlikely to see out a full term and there is an increasing risk of an early election from the second half of this year. Should there be an election, we see some moderate upside potential to medium-term debt sustainability in the event that a new government is more stable and a longer planning horizon facilitates some fiscal adjustment, as well as a more predictable and growth-supportive policy mix. In contrast, there are downside risks to the fiscal outlook should a future government opt to disengage from EU fiscal rules and be more willing to risk financial market instability. We continue to believe that the risk of market instability will ultimately act as the main constraint on greater fiscal loosening.
Fitch forecasts GDP growth of 0.1% in 2019, down from 0.9% in 2018, with investment growth slowing to 1.3% from 3.4% last year, and some softening of private consumption (as weaker consumer confidence and moderation in employment and wage growth is only partly offset by implementation of citizenship income). Net trade contributes 0.5pp to our 2019 forecast, partly due to weakening imports (which declined to 1.5% in 1Q19).
We forecast GDP growth of 0.5% in 2020 and 0.4% in 2021, driven by moderate private consumption growth (0.5% on average in 2020-21) and a normalisation of global trade. This would take the five-year average to 0.7%, compared with the 'BBB' historical median of 3.6%, and leave the level of Italy's real GDP still 3.3% below that in 2007. We assess Italy's trend rate of growth at around 0.5%, unchanged since the last review.
The external competitiveness of the Italian economy has so far remained resilient to recent external shocks. The current account surplus was 2.6% of GDP in 2018 and we forecast the surplus to remain above 2% of GDP in 2019-2020, compared with a current 'BBB' median of deficit of 1.9% of GDP. The current account surplus is driven by subdued imports, contained unit labour costs, and a lower oil price. Nevertheless, export volume growth slowed over the last quarters as the Italian manufacturing sector is closely linked to German developments.
The strong export performance and recurrent surpluses in the income account have led to a marked improvement in Italy's net international investment position (NIIP) which was close to balance (- 3.9% of GDP) at end-2018 from a peak of -22.7% of GDP at end-2013. Net external debt (which excludes equity and investment fund shares) declined to 48.7% of GDP from 51.7% in 2017. We forecast some moderation in the size of net portfolio outflows which totalled 5.3% of GDP in 2017 and 6.3% in 2018, and for net external debt/GDP to remain at close to 49% of GDP in 2020-21, high relative to the peer group median of 7% of GDP.
The steady improvement in the banking sector's underlying credit fundamentals and market access for funding has continued in recent months. NPL securitisations and portfolio sales have continued, supporting a fall in the NPL ratio to close to 9% at end-March 2019 from 16% at end-2016, albeit still high compared with similarly rated peers. Profitability has been resilient, helped by lower impairment charges and improved cost efficiency, but in our view remains a weakness, given the lack of pricing discipline and modest credit growth, alongside low interest rates. Banking sector consolidation progressed in 2019 with the integration of over 200 mutual banks into two domestically significant banking groups directly supervised by the ECB, resulting in improved cohesion of, and supervision over, a particularly fragmented segment of the domestic banking sector.
Italy has an ESG Relevance Score of 5 for Political Stability and Rights as World Bank Governance Indicators have the highest weight in Fitch's Sovereign Rating Model (SRM) and is therefore highly relevant to the rating and a key rating driver with a high weight.
Italy has an ESG Relevance Score of 5 for Rule of Law, Institutional and Regulatory Quality and Control of Corruption as World Bank Governance Indicators have the highest weight in the SRM and are therefore highly relevant to the rating and a key rating driver with a high weight.
Italy has an ESG Relevance Score of 4 for Human Rights and Political Freedoms as World Bank Governance Indicators have the highest weight in the SRM and are relevant to the rating and are a rating driver.
Italy has an ESG Relevance Score of 4 for Creditor rights as willingness to service and repay debt is relevant to the rating and is a rating driver.
SOVEREIGN RATING MODEL (SRM) AND QUALITATIVE OVERLAY (QO)
Fitch's proprietary SRM assigns Italy a score equivalent to a rating of 'A' on the Long-Term Foreign-Currency IDR scale.
Fitch's sovereign rating committee adjusted the output from the SRM to arrive at the final LT FC IDR by applying its QO, relative to peers, as follows:
- Macroeconomic policy and performance: -1 notch, to reflect Italy's very low GDP growth potential.
- Public finances: -1 notch, to reflect very high government debt levels. The SRM is estimated on the basis of a linear approach to government debt/GDP and does not fully capture the risk at high debt levels.
- External finances: -1 notch, to reflect relatively high net external debt, which is not captured in the SRM. The NIIP is close to balance but the large stock of net external debt makes the country vulnerable to shocks, in light of the high degree of political volatility and policy risk.
Fitch's SRM is the agency's proprietary multiple regression rating model that employs 18 variables based on three-year centred averages, including one year of forecasts, to produce a score equivalent to a Long-Term Foreign-Currency IDR. Fitch's QO is a forward-looking qualitative framework designed to allow for adjustment to the SRM output to assign the final rating, reflecting factors within our criteria that are not fully quantifiable and/or not fully reflected in the SRM.
The following factors may, individually or collectively, result in negative rating action:
- Weaker government debt dynamics, for example due to additional fiscal policy loosening and/or weaker GDP growth prospects;
- Political developments negatively affecting economic and fiscal policies and/or outturns; and
- Adverse developments in the banking sector increasing risks to the real economy or public finances.
As the Outlook is Negative, Fitch does not currently anticipate developments with a high likelihood of triggering an upgrade. However, the following factors could, individually or collectively, result in a stabilisation of the Outlook:
- A track record of fiscal policy that supports an improvement in Italy's government debt dynamics;
- A stronger economic recovery and greater confidence in medium-term growth prospects, particularly if supported by the implementation of effective structural reforms and reduction in banking sector risks.
Fitch's long-run debt sustainability calculations assume average GDP growth of 0.5% in 2019-2028, GDP deflator inflation rising to 1.5%. The primary surplus is assumed to be stable at 1% of GDP from 2020 onwards. In light of the persistence of the very low risk-free yields in the Eurozone, we assume the 10-year Italian yield will increase only to 4% by 2025, compared with our previous assumption of 4.75% by end-2025.