ARC Assigns BBB Rating to Italy

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1 ARC Assigns BBB Rating to Italy ISSUER RATINGS DATE Republic of Italy August 28, 2015 ISSUER RATINGS - FOREIGN CURRENCY Medium and Long Term BBB (BBB, Stable) ISSUER RATINGS - LOCAL CURRENCY Medium and Long Term BBB (BBB, Stable) A-2 Short Term (A-2) A-2 Short Term (A-2) COUNTRY CEILING - FOREIGN CURRENCY Foreign Currency AA (AA) COUNTRY CEILING - LOCAL CURRENCY Local Currency AA (AA) FIRST TIME RATING ACTION London, August 28, 2015, ARC Ratings S.A. (ARC), a global rating agency, has assigned a long-term foreign currency issuer rating to the Republic of Italy of BBB. The agency also assigned a long-term local currency issuer rating of BBB to Italy. The outlook on both ratings is stable. In addition, the agency assigned foreign currency and local currency country ceilings of AA to Italy, and short-term sovereign ratings of A-2. All ratings assigned are unsolicited. RATING RATIONALE The key rating drivers supporting Italy s BBB investment-grade foreign and local currency ratings are: 1. A new commitment to extensive reform of all sectors of the economy that, if realized and completed, should substantially improve the country s business environment, economic growth prospects, fiscal stability, and governance. 2. A policy environment in the Eurozone that is increasingly cognizant of deflation risks. The quantitative easing program by the European Central Bank is helping to counter growth-retarding deflationary pressures in Italy as well as in other Eurozone economies. 3. Eurozone membership that provides the institutional framework for economic management, and a proven source of emergency liquidity. 4. A manageable private sector debt. 5. A low to moderate external vulnerability given the diverse export base, low negative net IIP of around 30% of GDP, and moderate external indebtedness of around 120% of GDP. ARC Ratings, S.A. 1/5

2 6. Flexibility in debt servicing and debt management, partly thanks to Euro participation. The key constraints on Italy s credit ratings are: 1. An outsized government debt of over 130% of GDP. This high level of debt and sheer size of the borrowing program renders the country vulnerable to swings in market confidence, and constrains government financial flexibility. 2. Extensive inefficiencies in the economy that pervade all aspects of economic life, although which are being addressed under Prime Minister Matteo Renzi s reform agenda. Italy s economic growth is below the Eurozone average. 3. A high unemployment rate (12%), low labour force participation rate (65%), and high youth unemployment rate (40%). These features of the labor market underscore the inefficiencies in the economy. Weak institutional development indicators contribute to these efficiencies too. 4. Lingering contagion risks associated with a possible Greece exit from the Eurozone, or about the durability of the Eurozone project itself. 5. Banking sector risks with a high level of NPLs (17% of total) that stymies investment-led growth in addition to posing risks to the sector. SUMMARY OF KEY RATING CONSIDERATIONS (1) ARC s credit assessment is based on the expectation that Italy will grow by 1-2% on average over the near to medium term, with the lower end of the band being its present medium-term growth potential and the upper end what is credible if reforms are carried out robustly. ARC expects nominal GDP growth of 2-4%. This projection also considers that credit growth conditions will likely remain weak, and the longer-term nature of structural reforms (a time lag for gains to be realized in terms of growth). (2) Government debt is expected e to fall very moderately from its present level of 132% of GDP over the medium term, and remain high, a key constraint on the rating. Tax cuts may result in a falling revenue yield in the short-term, but faster growth would likely lead to greater revenue buoyancy. (3) The durability of investor confidence as underpinned by the generally improved financing environment in the Euro Area at large. (4) A strengthened external position with current account surpluses expected for the medium-term containing external debt accumulation. Italy posted its first current account surplus of 0.9% of GDP in a decade in 2013, thanks partly to difficult financial markets. (5) Structural improvements in the financial sector that mirror reforms economy-wide. A revamping of the insolvency system will be vital to the sector s longer-term health, but poses risks. More aggressive provisioning stimulated by a change in the tax treatment will help insulate the system against risks. NPLs are expected to stay high, presently around ARC Ratings, S.A. 2/5

3 17% of total, over the medium term, impeding credit growth in the near term. The deleveraging of the economy is a tailwind to economic growth and profitability of the banking sector. Critical to Italy s credit profile is the completion of the structural reform agenda aimed at boosting growth and improving fiscal health. Italy s sub par growth performance is a reflection of the many inefficiencies in the economy that have constrained productivity and exacerbated its loss of competitiveness since Euro adoption in It is also reflective of the extensive institutional weaknesses in governance that have led to inefficiencies in the allocation of capital, contributing to productivity challenges. These reforms are crucial to putting Italy on a path of falling debt ratios and improving the sustainability of the country s large government debt. Over the past year, many far-reaching reforms have been instituted, including the Jobs Act that was passed into law in December 2014, which addresses labour demand and supply side constraints. Judicial, education, political, and financial sector reforms are all part of the Renzi government s goal of boosting Italy s competitiveness. While plans are bold, execution risks are not nil. While Italy exited the EC s Excessive Deficit Procedure in 2013, weak economic growth and the threat of deflation exacerbate fiscal risks. Despite reduced fiscal deficits, Italy s debt load has continued to incrementally rise to 132.1% of GDP at present from 128.5% of GDP in Key fiscal reforms include a pension reform (2012) that helps safeguard public finances from its aging population and demographic pressures, public administration reform (in the works), ongoing reduction in public sector arrears, and personal and corporate tax cuts. Italy s headline general government deficit was -3% of GDP in 2014, down from a peak of -5.3% in 2009, and is expected to continue to fall only gradually so as not to imperil signs of growth. In 2015, the deficit is projected at -2.6% of GDP, while the structural balance is narrowing to -0.5%, underscoring the extent of fiscal restraint. Over the near term, the nominal deficit is expected to gradually fall, balancing the need to contain the growth of government debt with the equally urgent need to put the economy on a path of more robust recovery. Official projections are that a 0% deficit will be posted in 2018, and a 0.4% surplus will be posted in 2019, although this is based on the assumption of the reform program being realized in full. Should these goals be achieved, government debt is expected to register 120% of GDP in ARC s unified BBB sovereign issuer ratings for both foreign and local currency sovereign instruments reflects Italy s membership in the Eurozone and the fact that the Euro is a reserve currency. ARC s AA country ceiling for foreign and local currency transactions is based on our assessment of transfer and convertibility risk. While the use of capital controls in the Eurozone is prohibited by EU treaty, ARC believes the risk that they would be employed to stabilize economies in crisis is not zero for all countries in the bloc, especially those which have recently experienced crisis conditions. Companies whose operations are immunized at least to some extent from macro risks in Italy, and which have strong financial positions, could achieve higher ratings than the sovereign. ARC s sovereign ratings of Italy are determined using a methodology that looks at the entire economy s balance sheet and liquidity profile. Italy s weak institutional indicators are important considerations for its credit ratings, and are an important contributing factor for its lacklustre growth performance as well as high government indebtedness. ARC Ratings, S.A. 3/5

4 RATING OUTLOOK AND KEY TURNING POINTS Italy s ratings carry stable outlooks, and take into consideration our expectation that growth in the medium term will pick up and approach the upper end of the 2% band in the medium term should the reform agenda be implemented and executed comprehensively. The trigger for an upgrade would come from signs of sustainably improved competitiveness of the real economy, whereby much faster paced growth would be achieved, also contributing to the rapid reduction in the country s government debt burden through more robust government revenue inflows and nominal GDP growth. Triggers that could prompt a rating downgrade would include a deflationary environment, given the importance of economic dynamism for growing out of the country s large debt burden. Sharply increased political disarray that would interfere with the reform agenda and fiscal consolidation would also be rating negative. A rise in public sector arrears (they are being extinguished) would trigger rating pressures given the impact on the payments system economy-wide and also the negative signal provided about honoring commitments. Moreover, should Grexit (Greek exit) rise and/or should membership in the Eurozone for countries such as Italy come under pressure, ARC would revisit the rating. Notably, the Italian government bond market has weathered the recent events in Greece well. ABOUT ARC RATINGS ARC is a global ratings agency based in London and Lisbon that was formerly known as Companhia Portuguesa de Rating, SA. ARC has partnered with rating agencies in India (CARE Ratings), Malaysia (MARC), (SR Ratings), and South Africa (GCR). ARC is focused on carving out a niche based on the local knowledge and expertise of its partners across the globe. ARC is registered with European Securities and Markets Authority (ESMA). Please visit for further details. THIS DISCLOSURE IS FOR INFORMATION PURPOSES ONLY AND DOES NOT DISPENSE THE READING OF THE RESPECTIVE RATING REPORT. ARC Ratings, S.A. 4/5

5 ARC Ratings, S.A. 180 Piccadilly London W1J 9HF UNITED KINGDOM Phone: +44 (0) Site: Key Contacts: Joan Feldbaum-Vidra Head of Sovereigns Emma-Jane Fulcher Panel Chairperson / CRO +44 (0) Registered as a Credit Rating Agency with the European Securities and Markets Authority (ESMA), within the scope of the REGULATION (EC) Nº 1060/2009 OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL, of 16 September, and recognised as External Credit Assessment Institution (ECAI) for Corporates by the Bank of Portugal. Ratings do not constitute a recommendation to buy or sell, but only one of the factors to be weighted by investors. ARC s Ratings are assigned based on information collected from a wide group of sources. ARC Ratings uses and treats this information with due care and attention. Although all due care was taken in the collection, cross-checking and processing of the information for the purposes of the rating analysis, ARC Ratings cannot be held liable for its truthfulness. ARC Ratings must make sure that the information has a minimum level of quality prior to assigning a rating based on such information. ARC Ratings, S.A. 5/5

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