Update: sure enough, the Italian reaction didn’t take long and as Bloomberg cited an Italian Treasury official, the decision won’t impact the interest in Italian public debt. The “DBRS decision to downgrade Italy rating to BBB High from A Low could have impact on short-term debt, but that will be gauged only in coming months” and that the “rating change will not weigh significantly on cost of interests on Italy’s public debt.”
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When previewing the key events of the week, we noted that today Canadian DBRS rating agency is scheduled to review Italy’s credit rating after putting its credit worthiness on negative watch on 5 August. On 5 December, DBRS issued a press release declaring that they would wait for the impact of the Italian referendum result on the continuation of the reform push before making the final decision.
In case of a downgrade, the haircut for a 5y BTP used as collateral for ECB operations, as an example, would rise from 2% to 10%.
Moments ago DBRS did just that when it downgraded italy from A (low) to BBB (high), stripping the sovereign of its final A credit rating.
The rating agency cited “a deterioration in the “Monetary Policy and Financial Stability” and the “Political Environment” sections were the key factors in the downgrade. The Stable trend reflects DBRS’s view that Italy’s challenges are commensurate with the BBB (high) ratings and are balanced by the country’s strong commitment to fiscal consolidation and evidence of some, albeit very modest, economic recovery.”
It also warned that “if weaker political commitment to fiscal consolidation and the reform agenda or a significant downward revision to growth prospects were to materialize, further delaying a steady decline in the public debt-to-GDP ratio, this weakening could lead to a Negative trend.”
The new interim government, although supported to some extent by the same majority as the Renzi government, may have less room to make progress with growth-enhancing measures, as it was formed with the main aim of facilitating parliamentary discussion on the electoral law before political elections scheduled to be held in 2018. Furthermore, the risk of an early election remains, especially after a decision is made by the Constitutional Court on the electoral law, expected in late January 2017. This decision could affect the duration of Prime Minister Gentiloni’s cabinet. Political parties could immediately put more pressure for snap elections in the first half of 2017, using the electoral law produced by the decision of the Court. This pressure would be expected to capitalise on the result obtained in the referendum in December 2016.
However, there is also a lack of clarity over the timing of elections. DBRS considers that the next election is unlikely to be held before Autumn 2017, as the parliamentary discussions on the electoral law are likely to take time. DBRS also considers that the next electoral law is likely to have a higher proportional characteristic, increasing the chances of having a coalition government of mainstream parties and lowering the electoral chances of Euro-sceptic parties. Nevertheless, support for the opposition parties could increase if economic conditions were to not improve, especially for the young and the long-term unemployed.
According to a separate estimate from Rabobank, the haircut on Italian bonds imposed by the ECB would rise from 1.5% to 9%, and lenders would need to post €6.7 billion more in government debt to access the same levels of loans. Cited by the FT, Richard McGuire at Rabobanks said that this is not “a huge amount” but would be another unwanted headache for a banking system which lumbers under the biggest bad loan pile in the eurozone and which faces a key test under the EU’s bailout rules in the coming weeks.
Earlier today, S&P said it does not see any impact on its ratings on Italian banks, should credit rating agency DBRS downgrade Italy in its planned review, although should Italy’s borrowing costs jump as a result of the downgrade, it could lead to a feedback loop that ultimately does get the other rating agnecies involved.
We now look forward to the traditional Italian response, stating that all is well, and there is no reason to sell BTPs on the news.
Below is the full DBRS report.
DBRS Downgrades Italy to BBB (high), Stable Trend
DBRS Ratings Limited (DBRS) has today downgraded the Republic of Italy’s (Italy) Long-Term Foreign Currency – Issuer Rating and Long-Term Local Currency – Issuer Rating to BBB (high) with a Stable trend from A (low). At the same time, DBRS has confirmed the country’s Short-Term Foreign Currency – Issuer Rating and Short-Term Local Currency – Issuer Rating at R-1 (low) with a Stable Trend. This concludes the Under Review with Negative Implications for all ratings.
The rating action reflects a combination of factors including uncertainty over the political ability to sustain the structural reform effort and the continuing weakness in the banking system, amid a period of fragile growth. DBRS considers that, following the referendum rejecting constitutional changes that could have provided more government stability and the subsequent resignation of Prime Minister Renzi, the new interim government may have less room to pass additional measures, limiting the upside for economic prospects. Moreover, despite recent plans for banking support, the level of non-performing loans (NPLs) remains very high, affecting the banking sector’s ability to act as a financial intermediary to support the economy. In this context, low growth has resulted in lingering delays in the reduction of the very high public debt ratio, leaving the country more exposed to adverse shocks.
A deterioration in the “Monetary Policy and Financial Stability” and the “Political Environment” sections were the key factors in the downgrade. The Stable trend reflects DBRS’s view that Italy’s challenges are commensurate with the BBB (high) ratings and are balanced by the country’s strong commitment to fiscal consolidation and evidence of some, albeit very modest, economic recovery.
The new interim government, although supported to some extent by the same majority as the Renzi government, may have less room to make progress with growth-enhancing measures, as it was formed with the main aim of facilitating parliamentary discussion on the electoral law before political elections scheduled to be held in 2018. Furthermore, the risk of an early election remains, especially after a decision is made by the Constitutional Court on the electoral law, expected in late January 2017. This decision could affect the duration of Prime Minister Gentiloni’s cabinet. Political parties could immediately put more pressure for snap elections in the first half of 2017, using the electoral law produced by the decision of the Court. This pressure would be expected to capitalise on the result obtained in the referendum in December 2016.
However, there is also a lack of clarity over the timing of elections. DBRS considers that the next election is unlikely to be held before Autumn 2017, as the parliamentary discussions on the electoral law are likely to take time. DBRS also considers that the next electoral law is likely to have a higher proportional characteristic, increasing the chances of having a coalition government of mainstream parties and lowering the electoral chances of Euro-sceptic parties. Nevertheless, support for the opposition parties could increase if economic conditions were to not improve, especially for the young and the long-term unemployed.
Despite a slight decline in the stock of impaired assets since December 2015, uncertainty regarding the asset quality of the banking system continues to affect both investor appetite for bank capital and the ability of banks to act as a financial intermediary to support the economy via the credit channel. Although the Italian government has implemented several measures to facilitate the disposal of NPLs, these have so far had limited effectiveness and the weakness in the banking sector remains a factor in the rating. Moreover, while the decision to set up a Fund of EUR 20 billion (1.2% of GDP) to support ailing banks is a good start, it does not completely remove uncertainty about the vulnerability of the Italian banking system, nor does it clearly pave the way for a significant reduction in the high level of NPLs.
Over the last decade, Italy’s economic growth has been generally flat and lower than the euro area average. Growth potential remains weak. The need to improve growth performance is a fundamental challenge that affects the country’s ratings. Total factor productivity growth has been fragile and corporate profits have been weak. Feeble growth and weak competitiveness are likely the result of the low productivity of labour and capital, low employment rates and low investment in education and research & development.
The elevated level of public-debt-to-GDP continues to limit fiscal flexibility and hamper economic activity. Since 2008, government debt has continued to rise each year. In accordance with the Draft Budgetary Plan, the government projects a reduction of public debt in 2017, but following its decision to support banks, public debt could breach 133.0% of GDP instead of declining to 132.6%. This will likely further postpone the decline by one year to 2018. This high debt level makes the country more exposed to shocks.
Italy’s BBB (high) ratings are underpinned by the government’s commitment to fiscal consolidation, as reflected in a relatively good budgetary position compared with its euro area peers. Italy also benefits from demonstrated debt-servicing flexibility, relatively low private sector debt, a well-financed pension system and a large and diversified economy.
Italy’s credit profile is also supported by progress in fiscal consolidation achieved since 2009. According to the government, the budget deficit is expected to continue declining in 2017 to 2.3% of GDP, the lowest level in ten years.
Moreover, Italy continues to benefit from a significant improvement in funding conditions since the end of 2012, supported by measures taken by the ECB. Yields on ten-year Italian sovereign bonds, despite a slight increase in past weeks, continue to remain below 2%. Italy has also demonstrated debt-servicing flexibility during the crisis by maintaining a strong domestic investor base, which held 66.6% of government debt in September 2016 compared with 56.7% in 2010. At the same time, the average maturity of government debt has remained moderately high at 6.76 years.
Also underpinning the rating is Italy’s large and diversified economy. Importantly, this economy has generated a current account surplus since 2013, which amounted to 2.7% of GDP in October 2016. An important feature of the economy is that private debt (117% of GDP in 2015) is among the lowest in advanced countries and compares favourably with the European peer average (148% of GDP).
RATING DRIVERS
If weaker political commitment to fiscal consolidation and the reform agenda or a significant downward revision to growth prospects were to materialize, further delaying a steady decline in the public debt-to-GDP ratio, this weakening could lead to a Negative trend. On the other hand, progress on the fiscal side that was leading to a significant reduction in the debt-to-GDP ratio combined with the emergence of a strong structural reform effort and/or the occurrence of a meaningful improvement in banking sector credit quality, this would likely lead to a Positive trend.
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