Frankfurt am Main, April 26, 2013
Moody’s Investors Service has today affirmed Italy’s Baa2 long-term government bond ratings, and is maintaining the negative outlook. In addition, Moody’s has also affirmed Italy’s Prime-2 short-term debt rating.
The key factors for maintaining the negative outlook are:
- Italy’s subdued economic outlook as a result of weak domestic and external demand (especially from its EU trading partners) and a slow pace of improvement in unit labour costs relative to other peripheral countries.
- The negative outlook on Italy’s banking system, which is characterised by weak profitability, a deterioration of asset quality and restricted access to market funding, and which indirectly raises the cost of funding for small and medium-sized enterprises (SMEs).
- The elevated risk that the Italian sovereign might lose investor confidence and, ultimately, access to private debt markets as a result of the political stalemate and the resulting uncertainty over future policy direction, as well as contagion risk from events in other peripheral countries.
The key factors behind the affirmation of Italy’s Baa2 rating are:
- Low funding costs, which, if sustained, buy time for the government to implement reforms and for growth to resume.
- The government’s primary surplus, which increases the likelihood that Italy’s debt burden will be sustainable, despite the expectation of low medium-term growth in nominal GDP.
- Economic resiliency, which is supported by the country’s large diversified economy, the relatively low indebtedness of its private sector and the likely availability of financial support, if needed, from euro area members given Italy’s fiscal consolidation progress in recent years and Italy’s systemic importance for the euro area.
RATIONALE FOR MAINTAINING THE NEGATIVE OUTLOOK
The first factor underpinning the negative outlook is Moody’s view that Italy’s medium-term growth rate will continue to be anaemic as a result of the growing risk that the current recession will extend beyond the first half of 2013. Moody’s has now lowered its forecast for Italy’s 2013 GDP growth to -1.8% from its previous forecast of -1.0%, and predicts growth of only 0.2% for 2014. Italy’s economic outlook remains weak due to a number of factors. Firstly, low consumer and investor confidence, in part reflecting the inconclusive election outcome and uncertain political prospects, together with rising unemployment, are weakening domestic demand. Moreover, credit remains constrained and expensive, particularly for SMEs which are Italy’s engine of growth. Indeed, close to one third of Italian firms cannot meet their operational expenses as they are short of liquidity, according to Confindustria, the Italian business federation. Lastly, external demand remains weak as a result of the combination of weak growth in Italy’s euro area trading partners and its weak competitiveness, with unit-labour costs continuing to fall more slowly than in other euro area peripheral economies.
The prospects for an improvement in the medium-term growth outlook are limited given that further progress on structural reforms has been undermined by the political paralysis induced by the elections of 24-25 February. The elections resulted in no single party winning either the lower or upper house, thereby prolonging political uncertainty and raising the possibility of new elections. Despite the ongoing efforts to form a government, without firm consensus and a clear mandate, the prospects of further economic reform look poor. In its absence, the growth of the Italian economy will remain constrained by its impaired competitiveness.
The second factor that supports the negative outlook is the country’s weak banking system. Many domestic banks have weak core profitability, high and growing levels of non-performing loans, and are largely reliant on central bank funding to replace maturing debt. The exposure to the Italian corporate sector is high, especially to the SME sector, which is facing increasingly severe pressures from weak domestic demand and constrained credit. While the system has continued to build capital levels (with a system-wide Tier-1 ratio of 10.3%), doubtful and non-performing loans are also increasing across the system, and a further economic shock would likely cause a material rise in bank impairments and a reduction in capital.
In time, Moody’s expects that the banking sector will have selected and limited needs for recapitalisation or restructuring, which may include injections of capital from the government or the imposition of losses on creditors. Given that second-tier banks are at greater risk of needing such re-capitalisation than the first-tier banks, Moody’s estimates that the total size of bank re-capitalisation expenses is not likely to be material to Italy’s sovereign credit profile. Weakness in the banking system is additionally compounding to the weak economic outlook as the banking sector’s high cost of funds and capital is being passed on to its borrowers, particularly SMEs, in the form of higher lending rates.
The third factor underlying the negative outlook relates to Italy’s elevated susceptibility to loss of investor confidence, as a result of the political stalemate in the wake of the inconclusive parliamentary elections, as well as the continuing risk of contagion from potential credit events in other euro area peripheral countries. The political paralysis stemming from the inconclusive elections, and the resulting uncertainty over the future commitment to reform increase the probability that investors will conclude that Italy’s high debt burden is no longer sustainable, resulting in rising yields. In such a scenario, the government would be likely to seek support from euro area peers via the European Stability Mechanism (ESM) and, potentially, the European Central Bank (ECB) — although this option would be considerably complicated by the domestic political stalemate, since any external support would inevitably require a credible commitment by the Italian government to further reforms.
Moody’s notes that a shock to investor confidence could also be triggered by events elsewhere in the euro area. While the impact of events in Cyprus on yields of other peripheral countries has been surprisingly benign to date, those events have served as a timely reminder that the euro area authorities’ ‘muddle-through’ strategy, based on reactive policy-making with forward progress largely induced by shocks, tends to heighten the potential for financial market volatility. In Moody’s view, contagion risk among euro area countries remains elevated, given policymakers’ apparent willingness to countenance Cyprus’s potential exit from the euro area, and the signalled intention to move further in the direction of routinely bailing-in private creditors. Wider progress on institutional reforms remains slow and halting, with little clarity on what further agreement will be forthcoming on the planned banking union, and further fiscal integration no longer being discussed. In such an environment, Moody’s continues to believe that despite Italy’s recent successful tapping of the market overall appetite to invest in peripheral banks and sovereigns will remain fragile.
RATIONALE FOR AFFIRMING THE Baa2 RATING
The first two factors underlying Moody’s affirmation of Italy’s Baa2 rating are represented by the strong fundamentals that support the sovereign’s debt sustainability; i.e., the government’s reasonably low current cost of funding, which buys time for further economic reform to take effect and for growth to start to materialise, and the government’s primary surplus. Both are currently supporting factors for Italy’s debt sustainability, despite the weak outlook for nominal GDP growth over the medium term. Italy’s debt remains affordable in light of its relatively low funding costs: the yield on its 10-year government bonds is currently at around 4%, significantly below its five-year historical average yield of 4.8%; and the government’s interest -to-revenue ratio was around 11.5% in 2012, which is not particularly high compared to other sovereigns in the Baa rating category.
Moreover, Italy has over the years implemented significant fiscal consolidation, which led to a decrease of the headline general government budget deficit to 3.0% of GDP in 2012. The primary surplus increased to 2.5% of GDP in 2012, which is one of the highest among all Baa-rated sovereigns. This primary surplus offers the prospect of an eventual reversal in the government’s debt trajectory — if sustainable and large enough to compensate for Italy’s subdued economic growth, the government’s high debt stock with its associated interest burden, and a potential risk in its borrowing costs. We expect that Italy’s debt-to-GDP ratio would likely peak within the next two years at a level below 133% in a scenario in which modest economic growth resumes, fiscal consolidation is implemented according to the authorities’ plans, funding costs do not increase and no contingent liabilities crystallize.
The third factor underpinning Italy’s Baa2 rating is the country’s economic resiliency, supported by the relatively low indebtedness of the private sector, the economy’s large size and its significant diversification. Italy is the third-largest economy in the euro area, its bond market is the largest in the monetary union. Europe’s core banks, insurers and retail investors have significant exposures to Italy, making core European economies susceptible to the potential emergence of stress in Italy’s government debt market. If needed, Italy’s systemic importance to the euro area therefore represents a strong case for support by core European countries.
WHAT COULD MOVE THE RATING UP/DOWN
Moody’s would consider downgrading Italy’s government debt rating in the event of additional deterioration in the country’s economic prospects, a decrease in its primary surplus and/or a need for a significant recapitalisation of banks by the government. A deterioration in the sovereign’s funding conditions would also put downward pressure on Italy’s rating. More specifically, should Italy’s ability to access to public debt markets become constrained and the country were to require external assistance, Moody’s would likely downgrade Italy’s sovereign rating, possibly by more than one rating notch.
Given the negative outlook on the Baa2 rating, an upgrade is currently unlikely over the medium term. However, the rating agency would consider moving the outlook on Italy’s sovereign rating to stable in the event that further economic and labour market reforms were successfully implemented and led to an effective strengthening of the growth prospects of the Italian economy. Moreover, a sustained reversal of the upward trajectory of Italy’s general government debt-to-GDP ratio against the backdrop of a resumption of growth, which would make public-sector finances less vulnerable to volatile funding conditions, would be credit positive.