Scope Ratings AG today confirms the Republic of Italy’s long-term local-currency issuer rating at A-, following the release of its revised sovereign rating methodology, and converts its status from subscription to public. The agency also assigns a long-term foreign-currency issuer rating of A-, along with a short-term issuer rating of S-1 in both local and foreign currency. The sovereign’s senior unsecured debt in both local and foreign currency was also rated at A-. All Outlooks are Stable.

Rating drivers

The A- rating is underpinned by Italy’s euro area membership with a large common market; a strong reserve currency; an independent European Central Bank (ECB), which effectively acts as a lender of last resort; and an economic governance and macro-prudential framework that supports credible macroeconomic policies and provides access to financial facilities from European institutions. Scope believes that institutional developments and adjustments of past years have increased euro area member states’ protection from adverse shocks, underpinning their sovereign creditworthiness.

Italy’s A- ratings are underpinned by its large and diversified economy. The economy has a competitive manufacturing sector – the second-largest in the euro area after Germany – that has helped to generate current-account surpluses since 2013. Unlike many advanced economies Italy has not experienced a credit-driven boom-bust cycle in the past 15 years. As a consequence, economic growth in Italy remained below euro area averages during the pre-crisis period. Private debt in relation to nominal GDP remains among the lowest in advanced countries and, at 125% of GDP in 2016, compares favourably with those of European peers.

The country lost production capacity in the aftermath of the global financial crisis in 2008-2009. At the beginning of 2017 industrial production volumes stood at around 93.7% of 2010 levels. Scope expects moderate economic expansion of around 1% to continue in both 2017 and 2018, driven by stronger external demand and the recovery of investment. Limited fiscal room, coupled with new political uncertainties, is likely to hinder the dynamics of the recovery.

Overall, Italy has made some progress, by implementing a number of reforms to address deeply rooted structural weaknesses and increase growth potential. These include labour market reform focused on increasing flexibility and reducing segmentation of the workforce. Others include the shift in taxation away from productive factors, reforms of civil justice, as well as new measures in the banking sector aimed at improving corporate governance and the insolvency and debt collection framework. However, the full impact of these reforms is expected to materialise only over the medium term, but early signs are positive. Despite this progress, momentum has slowed in this regard since mid-2016 and, in some key areas, reforms are still pending.

The Italian government is committed to fiscal consolidation, as reflected in its relatively sound budgetary positions compared to those of euro area peers. Excluding 2009, Italy has generated primary surpluses for more than 20 years, even during recessions. In Scope’s view, this is credit-positive as it signals Italy’s ability to service costs related to its high public-debt stock using its own revenues. Italy’s fiscal consolidation effort, after easing moderately in 2015 and 2016, is expected to resume from 2017, with primary surpluses set to average approximately 3% in 2018-20.

Italy has continued to benefit from favourable funding conditions since the second half of 2012, supported by the ECB’s quantitative easing measures to alleviate market liquidity constraints. Market fears have faltered quickly, and yields on Italian Buoni del Tesoro Poliennali (10 year BTPs) fell to historical lows of nearly 1% in Q3 2016, before trending towards 2% with new political uncertainties that have developed since Q4 of that year. Throughout the euro debt crisis, Italian debt management has benefited from a relatively strong domestic investor base (which held 67% of government debt in December 2016 versus 56.7% in 2010) as well as from a robust government debt structure with an average maturity of nearly seven years, which has prevented prohibitive refinancing costs.

The government’s plans point to further gradual reductions in the deficit ratio, to slightly above 2% until 2017 and 1.2% in 2018. In this scenario, Italy’s debt-to-GDP ratio will start a slight downward trajectory in 2017 and 2018, following the peak of nearly 132.6% in 2016. The high stock of public debt remains a key vulnerability, despite Italy’s proven ability to service debt. It is also a drag on economic growth due to high tax pressure and the trade-off between fiscal consolidation and government expenditure.

However, despite the immediate challenges that accompany a high stock of public debt, Italian public finances are relatively sound in terms of long-term sustainability. This is mainly due to a well-financed pension system that has not generated unfunded pension liabilities. As a consequence, there is no implicit public debt in Italy. This is in sharp contrast to most euro area countries, which currently face age-related liabilities that are a multiple of the explicit general government debt.

The ratings also take into account the challenges for the Italian banking system. Banks’ non-performing loans remain at high levels despite being largely a legacy of the past, and are unlikely, in Scope’s view, to lead to widespread bank failures or to weigh heavily on public finances. The government has set aside funds, and its recent involvement in the liquidation of two small banks Venento Banca and Banca Popolare di Vicenza in the Veneto region will not alter Italy’s debt credit metrics. However, NPLs continue to dampen the banking sector’s lending activities, even as credit supply conditions improve. Although NPLs remain a justified concern, asset quality trends have improved over the last several years, together with the economy. Banks have continued to work out their recapitalization plans.

There is uncertainty surrounding the potential makeup of the government that may emerge following the general elections in the spring of 2018. Increasing political fragmentation is also likely to hinder the formation of stable majorities. In Scope’s view, ongoing political uncertainties may slow down the implementation of further reforms.

In the meantime, the interim government led by Paolo Gentiloni aims at preparing a new electoral law for the upcoming general elections. Anti-establishment political forces strengthened during the economic crisis and have benefited from divisions in the ruling PD party as well as in centre-right parties. Support for euro-sceptic parties will depend on the sustainability of the economic recovery and its ability to substantially reverse the high level of youth unemployment.

As in many eurozone countries, Italy’s unemployment rose significantly during the crisis to over 10% of the workforce, with youth unemployment peaking at over 40% in 2013. The government’s Jobs Act, a labour market reform implemented in the spring of 2015, has boosted the numbers of those in permanent jobs despite unemployment and labour costs remaining high. Scope believes that further enhancement of labour market efficiency will remain decisive for improving Italy’s growth prospects.

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” rating range for the Italian sovereign. 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 analysts’ qualitative analysis.

For Italy the QS signals relative credit strengths for the following analytical categories: 1) current account vulnerabilities; and 2) external debt sustainability. Relative credit weaknesses are signalled for 1) growth potential of the economy; 2) macroeconomic stability and imbalances; 3) fiscal flexibility; 4) political risk; 5) financial sector performance; and 6) macro-financial vulnerabilities and fragility.

Combined relative credit strengths and weaknesses generate a downward adjustment and signal an A- sovereign rating for Italy.

The results have been discussed and confirmed by a rating committee.

For further details, please see the Appendix 2 of the rating report.

Outlook and rating-change drivers

The Stable Outlook reflects Scope’s assessment that even though the risks faced by Italy remain significant, options are available for authorities for a timely adjustment.

The ratings could be upgraded if continued progress on the fiscal consolidation side were to lead to a significant reduction in the debt-to-GDP ratio together with the resumption of economic policies that enhance GDP growth potential. Conversely, downward pressure on the ratings could be exerted if: 1) a rising debt ratio were to materialise, due to substantially weaker-than-projected primary surpluses that cannot sufficiently reduce the snowball effect of interest costs on the public-debt stock; 2) weaker political commitment to fiscal consolidation and structural reforms, or 3) GDP growth turned out substantially weaker than projected, either due to adverse external shocks or lack of productivity growth.

For the detailed research report please click HERE.

Rating committee

The main points discussed during the rating committee were: (1) impact of GDP growth on debt sustainability, (2) macroeconomic imbalances (banking fragilities), (3) fiscal consolidation outlook, (4) short-term vs. long-term debt sustainability and scenario analysis, (5) latest political developments, (6) peers consideration.

Methodology

The methodology applicable for this rating and/or rating outlook “Public Finance Sovereign Ratings” is available on www.scoperatings.com.

Historical default rates of Scope Ratings can be viewed in the rating performance report on https://www.scoperatings.com/governance-and-policies/regulatory/esma-registration. 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, definitions of rating notations can be found in Scope’s public Credit Rating methodologies on www.scoperatings.com.

The rating outlook indicates the most likely direction of the rating if the rating were to change within the next 12 to 18 months. A rating change is, however, not automatically ensured.

Regulatory disclosures

This credit rating and/or rating outlook is issued by Scope Ratings AG.
Rating prepared by Dr Giacomo Barisone, Lead Analyst
Person responsible for approval of the rating Dr Stefan Bund, Chief Analytical Officer
The ratings /outlook was first assigned by Scope as subscription rating on January 2003. The subscription ratings/outlooks were last updated on 05.05.2017.
The senior unsecured debt ratings as well as the short term issuer ratings were assigned by Scope for the first time.
As a "sovereign rating" (as defined in EU CRA Regulation 1060/2009 "EU CRA Regulation"), the ratings on Republic of Italy are subject to certain publication restrictions set out in Art 8a of the EU CRA Regulation, including publication in accordance with a pre-established calendar (see "Sovereign Ratings Calendar of 2017" published on 30.06.2017 on www.scoperatings .com). Under the EU CRA Regulation, deviations from the announced calendar are allowed only in limited circumstances and must be accompanied by a detailed explanation of the reasons for the deviation. In this case the deviation was due to the recent revision of Scope’s Sovereign Rating Methodology and the subsequent putting the ratings under review, in order to conclude the review and disclose these ratings in a timely manner, as required by the Article 10(1) of the CRA Regulation¹.

¹Editor's note: The above paragraph was corrected on 17 July 2017 following the publication of the credit rating action on 30 June 2017. The original wording was: Deviation of the publication of sovereign ratings or related rating outlooks from the calendar shall only be possible where necessary for the credit rating agency to comply with its obligations under Article 8(2), Article 10(1) and Article 11(1) and shall be accompanied by a detailed explanation of the reasons for the deviation from the announced calendar. It was replaced with the following: As a "sovereign rating" (as defined in EU CRA Regulation 1060/2009 "EU CRA Regulation"), the ratings on Republic of Italy are subject to certain publication restrictions set out in Art 8a of the EU CRA Regulation, including publication in accordance with a pre-established calendar (see "Sovereign Ratings Calendar of 2017" published on 30.06.2017 on www.scoperatings .com). Under the EU CRA Regulation, deviations from the announced calendar are allowed only in limited circumstances and must be accompanied by a detailed explanation of the reasons for the deviation. In this case the deviation was due to the recent revision of Scope’s Sovereign Rating Methodology and the subsequent putting the ratings under review, in order to conclude the review and disclose these ratings in a timely manner, as required by the Article 10(1) of the CRA Regulation.

Solicitation, key sources and quality of information
The rating was initiated by Scope and 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 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 publication, 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.

Conditions of use / exclusion of liability
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