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Fitch on Friday downgrades Italy's 'BBB-' rating from 'BBB'and outlook stable. Reflects impact of global COVID-19 pandemic on Italy's economy and on sovereign's fiscal position

Italy Parliment House

KEY RATING DRIVERS

The impact of the global COVID-19 pandemic on Italy's economy and on the sovereign's fiscal position was a key driver of the downgrade of the IDR to 'BBB-'on 28 April 2020 from 'BBB'.

  • Fitch's latest forecast is a 9.5% economic contraction in 2020, followed by a recovery of 4.4% growth in 2021 and 2.1% in 2022.
  • Very high government debt and structurally weak economic growth will continue to weigh on the rating.

The rating is supported by a diversified, high value-added economy, eurozone membership, and gross national income per capita, governance and human development indicators much stronger than the peer group medians. Italy benefits from the ECB's large scale quantitative easing (QE) programmes and also has moderate private sector indebtedness, a favourable average maturity of public debt (6.9 years), a current account surplus and a net international investment position close to balance.

  • Expect the budget deficit to exceed 10% of GDP in 2020 and to remain above 6% in 2021.
  • These projections are consistent with the gross general government debt (GGGD) to GDP ratio increasing by 25pp this year.
  • Fitch baseline is for GGGD to reach 160% of GDP at the end of 2020 (revised up from our forecast of 156% at the April review) and to stay broadly stable until 2024.
  • Recent EU-wide initiatives, including the proposed Recovery Plan (Next Generation EU) for Europe by the European Commission may limit the expected deterioration in public finances from 2021.

The final extent, design and timing of these initiatives are uncertain, and we have not yet taken them into account in our public finance projections.

The COVID-19 pandemic has taken a heavy toll on the Italian economy.

The containment measures triggered by the pandemic led to a 5.3% qoq GDP contraction in 1Q20, the most severe in the eurozone, and it was already the second quarter of recession as GDP declined by 0.2% in 4Q19. 2Q20 will see an even sharper GDP contraction than 1Q20, but qoq growth is expected to turn positive in 2H20.

The government started easing lockdown restrictions in May 2020 and moved gradually with consecutive steps to help economic normalisation. Business and consumer confidence has also increased markedly from its trough in April. Retail sales grew by 24% month-on-month in May, following a 32% decline in the previous two months, while the unemployment rate stood at 7.8%, below the 1Q20 average of 8.9%.

The adjustment in the labour market is being delayed by the government wage subsidy scheme and will lead to a peak unemployment rate of 11.6% in 2021, following 11.2% in 2020.

The macroeconomic forecast implies that the level of GDP at the end of 2021 will be around 4pp below the pre-crisis (4Q19) level, compared with a 3pp gap in the eurozone. In the event of a second wave of infections and the widespread resumption of lockdown measures, economic outturns would be even weaker for 2020 and 2021. The five-year (2016-2020) average real GDP growth rate is -1.1%, one of the weakest among Fitch rated sovereigns, compared with 0% in the eurozone.

The deep recession and the fiscal policy response to the pandemic will result in a surge of the budget deficit in 2020. Based on the support packages and the automatic stabilisers, we expect the budget deficit to reach 10.7% of the GDP in 2020.

Following the initial boost to health expenditures and liquidity support in March and April, the 'Revival' decree was the main fiscal easing package announced in May. The total cost of measures is EUR55 billion (3.3% of GDP) in 2020, predominantly due to higher expenditure (EUR49.8 billion), for example to provide support to employees and firms, while the revenue impact is only EUR5.6 billion this year.

The borrowing requirement of the central government budget was EUR95.5 billion in 1H20, according to preliminary cash-flow data. This is almost three times higher than the EUR33.4 billion deficit in 1H19 and would imply mechanically a full year budget deficit of around 12% of GDP in 2020. Credit guarantee schemes to the private sector could reach EUR475 billion (approximately 28% of GDP), representing a contingent liability for the sovereign, although take-up of the schemes has been relatively slow so far and eventual utilisation is expected to be modest.

  • The revised 2020 budget contains only EUR30 billion (2% of GDP) of provisions for the guarantee schemes. The fiscal outlook beyond 2020 is highly uncertain.
  • The government plans to cut the budget deficit to 5.4% of GDP in 2021, mainly on the back of the strong expected economic rebound, but our forecast is for a deficit of 6.1%.
  • At the same time the Revival decree includes the abrogation of the 'safeguard' VAT hikes, which will result in substantial revenue reduction over the next years relative to prior plans:
  • EUR19.8 billion in 2021 and EUR26.7 billion in 2022 (although these were never likely to be implemented).

The European Commission estimates that the total fiscal easing measures are equal to 4.5% of GDP in 2020 and 1.5% in 2021. Italy's poor growth track record and gradual easing in the fiscal stance since 2015 mean that official debt reduction targets have consistently been missed. The GGGD at end-2019 stood at 134.8%, only 0.5pp below its 2015 level. The fiscal space created by lower interest service costs since 2015 has not been used to reduce the stock of debt and finance growth-enhancing reforms.

The government held a comprehensive national debate on economic policy post-pandemic, Stati Generali, in June 2020. The aim was to create consensus among key stakeholders (trade unions, business groups, etc) on structural reforms to boost medium-term growth. The key areas identified were the public administration, including the tax system, innovation, investment in human and physical capital.

In addition to the Stati Generali, Mr. Vittorio Colao, a leading private sector businessman, has presented a potential reform package at the request of prime minister Giuseppe Conte. The extent to which this debate will translate into actual economic policy is unclear at this stage. Divisions between PD and M5S on reform and spending priorities have the potential to delay the implementation of credible medium-term economic strategy. Fitch is not factoring any specific new reforms into its assessment.

The extended size (EUR1.3 trillion) and flexibility of the ECB's Pandemic Emergency Purchase Programme (PEPP) reduces refinancing risks in the short to medium term and helps facilitate the fiscal response to the crisis through lower bond yields. Up to May 2020 the PEPP purchases of Italian sovereign bonds were EUR37.4 billion from a total of EUR186.6 billion, taking the share of Italian assets to 20%, compared with Italy's 14% capital key at the ECB.

The ECB's asset purchases directly lower yields, and thus interest burden for the sovereign, across the entire yield curve and indirectly also have a substantial effect through the Bank of Italy's increased profits. Fitch estimates that the Bank of Italy will earn around EUR10 billion (0.6% of GDP) annually 'QE extra profit' and the increased profit will likely prevail for the next couple of years, as long as the ECB reinvestments continue and the spreads remain around the current level. The average maturity of the GGGD is 6.9 years, providing a buffer to absorb market shocks in the short term.

The average cost of debt fell to 2.5% in 1H20 from a peak of 4.4% in 2012.

Long yields have declined in recent months after a surge in mid-March before the ECB's PEPP was announced on 18 March. The current account surplus was 3.0% of GDP in 2019 and we forecast surpluses around 1%-2% of GDP until 2022, compared with a current 'BBB' median deficit of 1.8% of GDP. Italy's net international investment position (NIIP) is close to balance (-1.7% of GDP at end-2019), down from a peak of -23.3% of GDP at end-2013. Net external debt, which excludes equity and investment fund shares, was 48.3% of GDP in 2019 compared with the 'BBB' median of 6.6%.

The banking sector outlook has deteriorated after the COVID-19 shock, as the deep recession amplifies credit quality risks and puts pressure on earnings and profitability. Fitch downgraded the largest and strongest Italian banks following the sovereign downgrade on 28 April. The Outlooks are Stable on the Long-Term IDRs of the largest banks to reflect the relative strength of their capitalisation, and that under various possible downside scenarios, the banks are expected to maintain sufficient capital, irrespective of a likely reduction in profitability.

Furthermore, government support measures for the corporate and household sectors, including government guarantees on loans to SMEs, should partly support asset quality and to some extent mitigate the adverse impact on banks. ESG - Governance: Italy has an ESG Relevance Score (RS) of 5 for both Political Stability and Rights and for the Rule of Law, Institutional and Regulatory Quality and Control of Corruption, as is the case for all sovereigns.

These scores reflect the high weight that the World Bank Governance Indicators (WBGI) have in our proprietary Sovereign Rating Model. Italy has a WBGI ranking at the 67.5 percentile, reflecting relatively strong institutional capacity, effective rule of law and lower political stability score.

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, a one notch downward revision compared to score at the previous rating review. 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: -2 notches, to reflect very high government debt levels and debt sustainability risks exacerbated by the lack of a medium-term fiscal strategy and high degree of policy risk.
  • 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.
  • The removal of the -1 notch under the external finances reflects the steady improvement in the NIIP position on the back of consistent current account surpluses since 2013. In addition, the ECB's PEPP further reduces external financing risks.
  • While the large stock of net external debt makes the country susceptible to shocks reflecting relatively high political volatility, Fitch judges that a negative notch adjustment for external finance risks is no longer warranted.

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.

RATING SENSITIVITIES

Factors that could, individually or collectively, lead to positive rating action/upgrade:

  • Public finances: Implementation of a medium-term fiscal consolidation strategy that supports a decline in Italy's government debt/GDP; Macroeconomic policy and performance:
  • A stronger economic recovery and greater confidence in medium-term growth prospects, particularly if supported by the implementation of growth-enhancing structural reforms.

Factors that could, individually or collectively, lead to negative rating action/downgrade:

  • Public finances: Failure to stabilise the GGGD to GDP ratio following the expected 25pp increase this year due to the COVID-19 shock;
  •  Macroeconomic policy and performance: Failure to implement a credible economic growth strategy that enhances confidence that general government debt/GDP will be placed on a downward path over time; 
  • Structural: Severe deterioration in the relationship between Italy and the EU raising concerns around Italy's commitment to the eurozone. 
  • Structural: Adverse developments in the banking sector increasing risks to the real economy or public finances.

Source: Fitch

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