Fitch Downgrades Italy To BBB From BBB+

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Having largely disappeared from the market’s scope for the past 6 months, ever since Europe “bent” its rule allowing the bailout of Monte Paschi and several smaller banks despite Italy having the greatest amount of disclosed NPLs of any European nation, moments ago Fitch decided to drag Italy right back in the spotlight when it downgraded Italy to BBB from BBB+, citing “Italy’s persistent track record of fiscal slippage, back-loading of consolidation, weak economic growth, and resulting failure to bring down the very high level of general government debt has left it more exposed to potential adverse shocks. This is compounded by an increase in political risk, and ongoing weakness in the banking sector which has required planned public intervention in three banks since December.

And some more:

Italy has missed successive targets for general government debt/GDP, which increased by 0.5pp in 2016 to 132.6%. This is 11.2% of GDP higher than the target in the Stability Programme of 2013, the year Fitch downgraded Italy’s Long-Term IDRs to ‘BBB+’, and compares with the current ‘BBB’ range median of 41.5% of GDP. Fitch forecasts general government debt to peak at 132.7% of GDP in 2017, falling only gradually to 129.3% in 2020 in our debt sensitivity projections.

 

Fitch’s rating Outlook for the Italian banking sector is Negative, primarily reflecting the challenge of reducing the high level of un-provisioned non-performing loans (NPLs), alongside weak profitability and capital generation. The rate of new NPLs edged down to 2.3% in 4Q16, and there is some greater impetus for disposals and write-downs, which has slightly reduced total NPLs. However, sofferenze, the worst category of loans, increased to EUR203 billion in February, from EUR199 billion in October. Total NPLs amount to close to 17.5% of loans and 20% of GDP, and just over half are provided against.

 

In our view, political risks have increased since Fitch’s previous rating review. Current polls point to a further hollowing out of support for more centrist parties and to a fragmented political landscape that could result in minority government. Risks of weak or unstable government have increased, as has the possibility of populist and eurosceptic parties influencing policy. Greater populism may dampen political appetite for reform, increase the pressure for fiscal loosening, and weigh on investor sentiment.

With France – and much of Europe – already on edge due to populist tensions, is Italian sovereign – and bank – risk about to make a grand reapparance? For the answer, check in when Europe opens on Monday.

Meanwhile, Italian CDS trades at 190bps, wider than Russia, Croatia and almost as wide as South Africa.

Full report:

Fitch Downgrades Italy to ‘BBB’; Outlook Stable

Fitch Ratings-London-21 April 2017: Fitch Ratings has downgraded Italy’s Long-Term Foreign- and Local-Currency Issuer Default Ratings (IDRs) to ‘BBB’ from ‘BBB+’. The Outlooks are Stable. The issue ratings on Italy’s senior unsecured foreign- and local-currency bonds have also been downgraded to ‘BBB’ from ‘BBB+’. The Country Ceiling has been revised down to ‘AA’ from ‘AA+’. The Short-Term Foreign- and Local-Currency IDRs have been affirmed at ‘F2’. The issue ratings on Italy’s short-term local-currency bonds have also been affirmed at ‘F2’.

KEY RATING DRIVERS

The downgrade of Italy’s Long-Term IDRs reflects the following key rating drivers and their relative weights:

MEDIUM

Italy’s persistent track record of fiscal slippage, back-loading of consolidation, weak economic growth, and resulting failure to bring down the very high level of general government debt has left it more exposed to potential adverse shocks. This is compounded by an increase in political risk, and ongoing weakness in the banking sector which has required planned public intervention in three banks since December.

Italy has missed successive targets for general government debt/GDP, which increased by 0.5pp in 2016 to 132.6%. This is 11.2% of GDP higher than the target in the Stability Programme of 2013, the year Fitch downgraded Italy’s Long-Term IDRs to ‘BBB+’, and compares with the current ‘BBB’ range median of 41.5% of GDP. Fitch forecasts general government debt to peak at 132.7% of GDP in 2017, falling only gradually to 129.3% in 2020 in our debt sensitivity projections.

The general government deficit fell to 2.4% of GDP in 2016 from 2.7% in 2015, with reductions in capital expenditure of 0.7pp and interest costs of 0.17pp more than offsetting lower revenues/GDP due to indirect labour tax cuts. The 2016 structural deficit widened by 0.6% of GDP, based on European Commission methodology. The current Stability Programme targets a 2017 fiscal deficit of 2.1% of GDP, 0.3pp higher than was targeted a year ago, and 1.3pp higher than two years ago. Fitch forecasts a 2017 deficit of 2.3% of GDP, which incorporates the 0.2% of GDP structural measures required to avoid the opening of EU excessive deficit procedures.

The government has maintained its 2018 fiscal deficit target of 1.2% of GDP, and is expected to announce by September new measures to avoid the activation of VAT safeguard clause hikes. Fitch expects a smaller reduction in the deficit next year, to 1.7% of GDP, as the government seeks to limit fiscal tightening ahead of the elections.

Banking sector weakness adds to downside risks to the economy and public finances, and plans are being put in place for sovereign recapitalisations in three banks. Recourse to the EUR20 billion (1.2% of GDP) Precautionary Recapitalisation Fund established in December would negatively impact public finances in 2017. Monte Paschi di Siena is expected to draw EUR6.6 billion (factoring in EUR2.2 billion of burden sharing), higher than the EUR5 billion it unsuccessfully sought to raise privately. The mid-sized banks Banca Popolare di Vicenza and Veneto Banca, are expected to call on a further EUR5 billion. We consider additional public support for the sector may be needed in the absence of greater bank restructuring efforts.

Fitch’s rating Outlook for the Italian banking sector is Negative, primarily reflecting the challenge of reducing the high level of un-provisioned non-performing loans (NPLs), alongside weak profitability and capital generation. The rate of new NPLs edged down to 2.3% in 4Q16, and there is some greater impetus for disposals and write-downs, which has slightly reduced total NPLs. However, sofferenze, the worst category of loans, increased to EUR203 billion in February, from EUR199 billion in October. Total NPLs amount to close to 17.5% of loans and 20% of GDP, and just over half are provided against.

In our view, political risks have increased since Fitch’s previous rating review. Current polls point to a further hollowing out of support for more centrist parties and to a fragmented political landscape that could result in minority government. Risks of weak or unstable government have increased, as has the possibility of populist and eurosceptic parties influencing policy. Greater populism may dampen political appetite for reform, increase the pressure for fiscal loosening, and weigh on investor sentiment.

The 59% ‘No’ vote in December’s constitutional reform referendum has left a weakened interim government less able to implement new policy this side of elections. In failing to streamline the legislative process, there will also be a less conducive environment for economic reform in the medium term.

Italy’s ‘BBB’ IDRs also reflect the following key rating drivers:

Fitch forecasts GDP will grow by 0.9% in 2017, the same rate as last year, and by 1.0% in 2018, which would leave real GDP still more than 5% below the 2007 level. Consumer spending growth is expected to moderate from 1.3% in 2016 to 0.9% in both 2017 and 2018 in light of continued nominal wage restraint and higher inflation. Italy’s GDP growth has averaged -0.6% over the last five years, compared with the ‘BBB’ median rate of 3.2%.

Italy’s creditworthiness is supported by a large, diversified, and high value-added economy, with GNI per capita almost twice the median of the ‘BBB’ range. Governance indicators remain stronger than the ‘BBB’ median, and private sector debt moderate. Ultra-loose ECB monetary policy is supporting very low sovereign financing costs, with an average yield for new issuances of 0.55% in 2016 and 0.76% in 1Q17.

Italy’s current account surplus rose to 2.6% of GDP in 2016, from 1.4% in 2015, which compares with a ‘BBB’ median of -1.8%. A EUR12 billion increase in the primary income balance and EUR10 billion increase in goods exports accounted for the higher surplus in 2016. Depreciation of the euro, resource reallocation during Italy’s downturn, and some unit labour cost adjustment, have led to a moderate recovery in Italy’s competitiveness, despite investment falling by more than 25% since 2007. However, net external debt, at above 55% of GDP, compares unfavourably with the ‘BBB’ median of 1%.

RATING SENSITIVITIES

The following factors may, individually or collectively, result in negative rating action:

  • Political developments negatively affecting economic and fiscal policies.
  • A rise in general government gross debt/GDP.
  • Adverse developments in the banking sector increasing risks to the real economy or public finances.

The following factors may, individually or collectively, result in positive rating action:

  • A track record of falling general government gross debt/GDP.
  • A stronger economic recovery and greater confidence in medium-term growth prospects, particularly if supported by the implementation of effective structural reforms.
  • Reduction in banking sector risks.

KEY ASSUMPTIONS

  • Our 2017 general government debt forecast incorporates only a 0.1% of GDP positive stock-flow adjustment for bank recapitalisations as we assume they are largely financed through the Treasury cash reserve (which increased EUR7.5 billion in 2016). Our forecast does not incorporate any further public recapitalisation of banks.
  • Fitch’s long-run debt sustainability calculations are based on average annual GDP growth of 1.0% from 2017-2026, GDP deflator inflation rising to 1.8%, an average primary surplus of 2.0% of GDP, no stock-flow adjustments for privatisations, and a steady increase in marginal interest rates from 2017.
  • Italy remains a member of the EU and the eurozone.