Fitch Ratings has affirmed Italy’s Long-term foreign and local currency Issuer Default Ratings (IDRs) at ‘A-‘ with a Negative Outlook.
The short-term foreign currency rating is affirmed at ‘F2’ and the country ceiling at ‘AAA’. In affirming Italy’s sovereign ratings Fitch has sought to look beyond current economic and financial conditions and take into account recent and prospective structural reforms that would enhance the growth potential of the economy as well as its assessment that debt stabilisation and reduction is within reach.
In addition, the affirmation reflects the demonstrated commitment of the government to reducing the budget deficit and public debt, as well as parliament’s adoption of a balanced budget amendment to the Constitution and ratification of the Fiscal Compact. The affirmation of Italy’s sovereign ratings’ is based on the following key factors and judgements.
Fitch recognises recent reform to the labour market and measures to render the economy more flexible. If effectively implemented and complemented by further structural reform, the medium-term growth and employment prospects of the Italian economy will be enhanced. – Pension reform has further strengthened the sustainability of the pension system and public finances over the medium to long-term.
The approval by parliament of a balanced budget amendment to the Constitution effective from 2014 and the ratification of the ‘Fiscal Compact’ underscore the broad political commitment to reducing the budget deficit and cutting public debt. – Four fiscal packages – the most recent announced in early July though not yet approved by parliament – over the last year and equivalent to 5% of GDP should be sufficient to reduce the budget deficit below 3% of GDP this year to place public debt on a downward path from 2013.
Economic and fiscal performance has been broadly in line with Fitch’s expectations at the time of the last formal review in January. Sensitivity and scenario analysis conducted by Fitch suggests that current budget plans are consistent with stabilising and reducing government indebtedness. Fitch’s current judgement is that in the absence of adverse shocks, the Italian Treasury will retain access to market funding, albeit at a relatively high cost.
The contingent liabilities to the sovereign from the financial sector are moderate and currently do not pose a significant risk to public finances. Actual and contingent liabilities from Italy’s contribution to support for other EAMS is however significant and rising.
The rating remains supported by the relatively wealthy, high value-added and diverse economy with moderate levels of private sector and foreign indebtedness. The Negative Outlook on Italy’s sovereign ratings reflects the following risk factors.
Potential for materially weaker near and medium-term economic outlook than currently forecast by Fitch. Deviation in fiscal performance from Fitch’s baseline projections that resulted in a failure to stabilise and place on a downward path the ratio of gross general government debt (GGGD) to GDP over the next two years. Policy uncertainty over the medium-term, especially with respect to the continuation and completion of the structural reforms necessary to enhance the competitiveness and growth potential of the Italian economy.
Worsening of fiscal funding conditions as a result of domestic or external shocks. The latter would include a failure at the European policy level to take timely measures to ensure the stability of European sovereign bond markets and to honour commitments reached at the June 28-29 and previous Summits as well as potential contagion from other EAMS, notably Greece (‘CCC’). KEY ASSUMPTIONS Fitch’s economic and fiscal projections imply that Italy is close to realising debt stabilisation and placing government debt to GDP ratio on a downward path and are premised on continued progress in reducing and sustaining the budget deficit below 1.5% from 2013 and bond spreads gradually declining from current levels. The current rating reflects Fitch’s judgement that Italy will retain market access and that external intervention would be forthcoming if bond yields were to rise significantly from current levels. Fitch judges that the systemic importance of Italy to the viability of EMU is such that in the unlikely event of loss of market access, financial support would be forthcoming from the EFSF/ESM and ECB to ensure that Italy continued to honour its sovereign debt obligations. It is also assumed by Fitch that commitments made by Euro Area policymakers at recent Summits, including the creation of the ESM and a single supervisory mechanism for European banks, will be implemented. It also assumes that the risk of fragmentation of the Eurozone remains low and is not incorporated into Fitch’s current rating of Italy, though Fitch’s ‘CCC’ rating of Greece does reflect a material risk of Greek exit from EMU over the next few years. The rating also incorporates Fitch’s assumption that the medium-term fiscal trajectory and commitments made by Italy under the Stability and Growth Pact and implied by the constitutional balanced budget amendment will be sustained by future as well as the current government. The rating also assumes that recent structural reforms will not be reversed by future governments and further measures to enhance the competitiveness and growth potential of the economy will be adopted.
ECONOMIC AND FISCAL OUTLOOK
Fitch forecasts a contraction of 1.9% in the Italian economy this year, followed by stagnation in 2013 and growth of 1% in 2014 supported by a boost from net exports and gradual pickup in private investment spending.
The severity of the current downturn is due to the combination of front-loaded fiscal consolidation and a de facto tightening of monetary and credit conditions reflecting the widening sovereign credit spread, a significant element of which reflects perceived systemic risks from the on-going crisis of confidence in the viability of European Economic and Monetary Union (EMU). The Italian government has adopted various measures aimed at increasing the flexibility and competitiveness of the economy that taken together mark the most significant structural reform effort since adopting the euro in 1999. If implemented effectively and complemented by further reforms, including by the next government, estimates by the IMF, EC and Ministry of Economy and Finance suggest that the growth potential of the Italian economy could be boosted by between 0.2% and 0.5% per annum over the medium-term. Fitch’s fiscal projections to 2021 assume that the economy will post average annual growth of 0.9% compared to 0.2% over the decade to 2011 and 1.4% over the period 1997-2007. The government is pursuing an ambitious and front-loaded fiscal consolidation effort aimed at achieving a structural budget balance by 2013. Fitch forecasts a headline budget deficit of 2.3% of GDP this year compared to the official target of 1.7% reflecting the severity of the recession and to a lesser extent higher fiscal funding costs. Nonetheless, this would still imply a primary (non-interest) budget surplus of close to 3% of GDP. Fitch forecasts the headline budget deficit to fall and stay below 1.5% of GDP from 2013 which would be consistent with a primary surplus of around 4.5% of GDP, sufficient to place GGGD/GDP ratio on a firm downward path and if sustained would imply GGGD/GDP falling below 110% of GDP compared to the peak next year of 125% (121% excluding the funding of Euro Area support). Public sector financial and real estate assets are large and there is potential to realise these assets to accelerate the pace of debt reduction, though this is not currently factored into Fitch’s medium-term debt projections. The principal risk to debt sustainability arises from further increases in Italian sovereign bond spreads that have the potential to deepen the recession and prevent economic stabilisation and recovery in latter part of next year and into 2014. The increase in sovereign credit spreads have resulted in a 200-250bps increase in Italian private sector borrowing costs relative to Germany over the last 6 months highlighting the breakdown of the common monetary policy and transmission mechanism across the Eurozone. Using the Oxford economic model, Fitch estimates that a 200bps interest rate shock implies a drag on annual real GDP growth of 0.3% in 2012 and 2013. The persistence of current elevated sovereign bond yields pose a material risk to the economic outlook and a further widening of sovereign spreads, if not addressed by European policy action, would likely de-rail prospects for economic stabilisation and recovery in 2013-2014. Under a negative scenario of higher interest rates and prolonged economic stagnation, Fitch projects that GGGD/GDP would continue to rise over the medium-term and reach 140% by 2021. Elevated sovereign credit spreads also pose a risk to the ability of the Treasury to sustain access to market funding. Over the next twelve months, gross fiscal financing requirement is around EUR370bn of which EUR340bn is maturing debt, including EUR160bn of Treasury bills. Non-resident private investor holdings have fallen sharply over the last year from 52% in 2010 to under 40% offset by increased purchases by the ECB, Italian banks and insurance companies as well as domestic retail investors. Sovereign debt currently accounts for around 8% of total Italian bank assets, its highest level since early 2005, though below the 12% level at the launch of the euro in 1999. However, it remains Fitch’s assessment that near-term risks to fiscal financing are low based on the judgement that there remains a core of non-resident investor holdings of Italian treasury securities as well as capacity for further absorption by domestic investors against the backdrop of a small and declining net borrowing requirement. The average maturity and duration of Italian Treasury debt at 6.7 and 4.6 years respectively helps to moderate the near-term budgetary impact of temporarily higher interest rates. Fitch estimates that for every 100bps increase in interest rates across all maturities, interest payments relative to GDP would increase by 0.2pps in the first year rising to 0.5% of GDP in year three and GGGD/GDP would be 3pps higher than otherwise by year six. Fitch continues to assess that the contingent liabilities from the banking sector for the Italian government remain limited. Nonetheless, if the recession is deeper and longer than currently anticipated, the risk that the government may be required to make further injections of capital into Italian banks cannot be wholly discounted. However, Italy’s support for other EAMS is significant and rising. Over the period 2010 to 2014, the cumulative contribution and increase in Italy’s GGGD from Euro Area support will be almost EUR63bn, equal to 3.8% of GDP.
A further EUR159bn (equivalent to 10% of 2011 GDP) of contingent liabilities arise from Italy’s contribution to the EFSF and ESM.
The affirmation of Italy’s sovereign ratings concludes a formal review initiated in June. Fitch will conduct a further formal review of Italy’s sovereign ratings before year-end that will incorporate an updated assessment of the medium-term economic and fiscal prospects; progress at the European level in addressing the Eurozone crisis; and the likelihood of policy continuity following general elections currently scheduled for April 2013.
Further significant and prolonged increases in the cost of market borrowing that did not prompt an effective European policy response would likely result in a downgrade because of the adverse consequences for public debt dynamics.