- We are affirming our ‘BBB/A-2’ long- and short-term sovereign credit ratings on the Republic of Italy.
- The affirmation reflects our view of Italy’s wealthy and diversified economy, as well as our expectation that the government will make some progress on important structural and fiscal reforms.
- The outlook on the long-term rating remains negative, reflecting our view of risks to the public sector balance sheet from weak real and nominal growth prospects.
On June 6, 2014, Standard & Poor’s Ratings Services affirmed its unsolicited ‘BBB’ long-term and ‘A-2’ short-term sovereign credit ratings on the Republic of Italy. The outlook on the long-term rating remains negative.
The ratings are supported by our view of Italy’s wealthy and diversified economy and the country’s relatively strong international investment position. We believe this reflects Italy’s traditionally elevated private-sector savings rate, buttressed by a gradually improving current account.
The ratings are constrained by our assessment that economic growth prospects remain weak in real and nominal terms. In our view, Italy’s modest growth prospects reflect only tentative progress by the past three governments in reforming Italy’s domestic labor and product markets, which we regard as less flexible than those of Italy’s key trading partners. The ratings on Italy are also constrained by the high net general government debt burden and what we consider to be an impaired monetary transmission mechanism, which has led to tighter credit conditions for Italy’s private sector.
The government of Prime Minister Matteo Renzi, of the Democratic Party (PD), assumed office in February 2014. It is pursuing fiscal, electoral, judicial, political, labor, and other economic reforms. Although the government’s policy intentions, as specified in the 2014 Stability Programme (Documento Di Economia e Finanza 2014), are encouraging, we consider it too early to assess how much of the program the government will be able to implement and over what time period.
We project that gross general government debt will peak at 132% of GDP this year (excluding European Financial Stability Facility guarantees) and then gradually decline to below 130% of GDP by 2017. This baseline projection
- Average government borrowing costs will remain close to 4%;
- The government will maintain a primary budgetary surplus of over 2% of GDP; and
- Receipts from the sale of minority stakes in public companies will approach 0.3% of GDP in both 2014 and 2015.
We expect that the recent decision to cut the personal income tax (PIT) burden on low wage earners, at a cost of 0.7% of GDP for 2014 and 1% of GDP (cumulative) for 2015, will lower the tax burden on labor in a progressive manner that will support demand. That said, our understanding is that more than half of the sources of financing for this measure during 2014 are nonrecurring.
We consider Italy’s weak nominal and real GDP prospects to be the main source of risk to our fiscal projections for Italy. In particular, we see the rigidities and cost pressures weighing on the profitability of Italy’s private sector as a weakness. These include:
- A wage bargaining process organized at the national, rather than the firm level, which contributes to wage rigidity, regardless of underlying productivity trends;
- High nonwage employment costs, including elevated judicial, legal, and other administrative fees, and high severance costs;
- A wholesale cost of energy substantially higher than that of peers, partly due to Italy’s dependence on imported oil and natural gas for power generation, but also reflecting market dominance by incumbent utility monopolies and the absence of sufficient electricity interconnections with its neighbors;
- Incentives created by tax and labor laws for companies to remain small; and
- Low internal labor mobility, partly because the property rental market is underdeveloped, but also because incumbent professions such as notaries and lawyers levy high transaction and business fees for buyers and sellers of residential property.
Although Italy’s corporate sector appears to have preserved considerable pricing power, as demonstrated by consistently high value-added deflators, it has done so to a considerable extent by increasing manufacturing abroad, and by substituting capital for labor, via layoffs of temporary employees and cuts to worker hours. The resulting rise in underemployment and unemployment has, in turn, depressed consumer spending and corporate investment. Ultimately, these pressures on the profitability of the private sector weigh on GDP, which is the sum of value added (profit margins) in the economy.
At the end of 2013, the volume of economic activity in Italy remained 8% below the previous peak levels in 2007 and unemployment was higher than its previous peak, which it reached in the late 1980s. Although employment increased slightly during the first few months of 2014, we anticipate that unemployment will continue to rise toward 13% during 2014 as discouraged workers re-enter the jobs market, before starting to decline next year.
In light of only modest structural reforms implemented since the onset of the turmoil in the eurozone and our expectations of subdued growth in employment this year and next, we are projecting that real and nominal GDP growth between 2014-2016 will average 0.9% and 1.9%, respectively. By contrast, the government expects real and nominal GDP growth of 1.2% and 2.4%, respectively. Given our lower growth projections for 2014 and 2015, we are forecasting higher general government deficits (2.9% of GDP for 2014, and 2.7% of GDP for 2015) compared to the Italian government’s targets (2.6% of GDP for 2014 and 1.8% of GDP for 2015).
The government’s steps to keep the deficit from rising this year include extending the freeze on public sector wages announced last year. At the same time, we estimate a slight increase in primary expenditure (government spending excluding interest payments) for 2014. We understand that the government plans to make permanent primary expenditure cuts worth almost 1% of GDP in 2015, in order to meet its fiscal objective, but these have yet to be fully articulated.
As a consequence, in our view, most of the projected improvement in the budgetary position relies on the government’s higher nominal GDP projections and on lower expected interest payments as a percentage of GDP. The rest of the consolidation projected for this year and next appears to be based on the government’s expectation that domestic demand, and thus indirect tax receipts, will recover.
Most metrics of cost competitiveness indicate that an internal devaluation, comparable to what has occurred in eurozone trading partners Ireland and Spain, has yet to take place in Italy. Although, in our view, Italy did not experience an inflationary construction boom before 2008, wages consistently increased above underlying productivity both before and after 2008. As a result, according to Eurostat data, as of the fourth quarter of 2013, economywide nominal unit labor costs in Italy were still 16.6% above 2005 levels. Combined with weak external demand and a large capital goods and consumer durables component in Italy’s export basket, this may partly explain why Italian volume export growth during 2012 and 2013 averaged only 1.1%. It may also explain weak growth performance in the nontradeables sector, which makes up the bulk of the Italian economy. That said, an external adjustment has been occurring. In 2013, Italy posted a current account surplus of 1.0% of GDP, the first current account surplus since Italy joined the eurozone in 1999. Since the end of 2011, much of the improvement in Italy’s current account has stemmed from declining merchandise imports.
European Central Bank (ECB) actions have helped reduce financing tensions for many eurozone members, including Italy. Partly as a consequence, nonresidents have started to buy Italian government debt again. We view this positively, and our economic projections are based on the assumption that ECB monetary policy will remain supportive. The domestic financial sector (including state-owned Cassa Depositi e Prestiti), moreover, has a considerable exposure to the sovereign.
In March 2014, credit to the nonfinancial sector was contracting by an estimated rate of just under 3% a year, according to data released by the Banca d’Italia. However, in an important development, quarterly credit to the nonfinancial corporate sector rose for the first time this year. Nonperforming loans (NPLs) remain high at an average 15.9% in December 2013, according to Banca d’Italia data, but performance varies materially among banks.
Significantly, the increase in bad debts has slowed during 2014. Over the past two years, the supervisory authority has pressed Italian banks to book more than €60 billion of specific and generic loan-loss provisions. This has improved the system’s specific NPL coverage ratio to 42% from 40% at the end of 2011. We estimate that generic provisions also improved, representing 0.7% of net customer loans at the end of 2013, up from 0.6% in 2011. We also note that midsize and larger Italian commercial banks have successfully raised capital on the international markets, indicating to us that the sovereign’s contingent liabilities are diminishing.
The negative outlook reflects our belief that there is at least a one-in-three chance that we could lower the ratings, either this year or in 2015. According to our criteria, we could lower the ratings if we conclude that the government cannot implement policies that would help to restore growth and keep debt indicators from deteriorating beyond our current expectations.
Sustained delays in addressing some of the rigidities in Italy’s labor, services, and product markets–which have been holding back growth–could also cause us to lower the ratings. Under our criteria, a downward revision of our assessment of Italy’s institutional and governance effectiveness, for example, could lead us to lower the rating by one notch or more, depending on the severity of the circumstances.
On the other hand, we could revise the outlook to stable if the government implemented reforms to the labor, product, and service markets that we considered sufficient to trigger a sustainable increase in Italy’s economic growth.