Paris, August 05, 2022 -- Moody's Investors Service ("Moody's") has today changed the outlook on the Government of Italy to negative from stable and affirmed the local- and foreign-currency long-term issuer and senior unsecured ratings at Baa3. The senior unsecured foreign currency MTN program rating and foreign currency senior unsecured shelf ratings were affirmed at (P)Baa3, while the local currency Commercial Paper rating was affirmed at Prime-3 and the foreign currency Other Short-Term rating was affirmed at (P)Prime-3.
While growth and fiscal developments delivered positive surprises in 2021 and early 2022, risks to Italy's credit profile have been accumulating more recently because of the economic impact of Russia's invasion of Ukraine (Caa3 negative) and domestic political developments, both of which could have material credit implications:
1. Heightened risks that the political environment will impede the implementation of structural reforms, including those contained in Italy's National Recovery and Resilience Plan (NRRP);
2. Increased risk that energy supply challenges will weaken economic prospects;
3. Risks that Italy's fiscal strength will be further weakened by sluggish growth, higher funding costs, and potentially weaker fiscal discipline.
That said, the Baa3 ratings reflect Italy's significant economic strengths, including its robust manufacturing sector, high household wealth, and the low indebtedness of the private sector. It also balances the strengths and challenges of Italian institutions. Finally, the rating reflects Moody's assumption that core euro area countries will support Italy in case of need, a view that has been confirmed by the European Central Bank's (ECB) recent announcement of the Transmission Protection Instrument (TPI).
Italy's local- and foreign-currency ceilings remain unchanged at Aa3. For euro-area countries, a six-notch gap between the local currency ceiling and the local currency rating as well as a zero-notch gap between the local-currency ceiling and foreign-currency ceiling is typical, reflecting benefits from the euro area's strong common institutional, legal and regulatory framework, as well as liquidity support and other crisis management mechanisms. It is also in line with Moody's view of de minimis exit risk from the euro area.
Please click on this link https://www.moodys.com/viewresearchdoc.aspx?docid=PBC_ARFTL468478 for the List of Affected Credit Ratings. This list is an integral part of this Press Release and identifies each affected issuer.
RATIONALE FOR THE NEGATIVE OUTLOOK
FIRST DRIVER: HEIGHTENED RISKS THAT THE POLITICAL ENVIRONMENT WILL IMPEDE THE IMPLEMENTATION OF STRUCTURAL REFORMS
The end of the Draghi government on 21 July and early elections on 25 September 2022 (brought forward from spring 2023) increase political and policy uncertainty against the backdrop of a challenging economic and market environment.
The outgoing government had made significant progress in meeting in full and on time the milestones and targets contained in Italy's NRRP, requesting two installments for a total of €42 billion or 2.4% of GDP (on top of the pre-financing disbursed in August 2021 worth €25 billion or 1.4% of GDP ). However, the early elections are likely to delay the achievement of some milestones and targets that were due by the end of 2022; these achievements are needed to unlock access to the next installment of NGEU funding, which totals €19 billion (1.0% of GDP). There is also a material risk that the milestones and targets that are due in 2023 could also be delayed.
Partial disbursements of NGEU funding are possible, but lower-than-expected disbursements would put downward pressure on investment spending at a time when high inflation and risks to energy supplies are already weighing on business and consumer confidence, as well as economic activity.
Italy has strong incentives to comply with the terms of the NRRP because it only receives investment funds in exchange for reforms. Moreover, compliance with NRRP is also one of the preconditions for access to the ECB's TPI. While these incentives are clear, a future government may try to test the willingness of the European Commission and ECB to strictly enforce this conditionality. Given the incentive structures that are in place, though, failure to eventually follow through with reform commitments could be an indication of weakening legislative and executive institutions or weaker effectiveness of macroeconomic policymaking.
SECOND DRIVER: INCREASED RISK THAT ENERGY SUPPLY CHALLENGES WILL WEAKEN ECONOMIC PROSPECTS
Significant reliance on gas for its energy exposes Italy to further cuts in supply from Russia as well as higher energy prices. Gas is mostly used for electricity generation and by households, with industry representing a smaller share than is the case in some other gas-dependent European sovereigns. The outgoing government had taken a number of measures to reduce gas consumption and diversify supplies, having stated that Italy's reliance on Russia had been cut to around 25% from 40% of total imports.
Having said this, Italy is better positioned than other vulnerable European countries such as Germany (Aaa stable), thanks to its LNG terminals and pipeline linkages to North Africa, Northern Europe and Central Asia, which allow Italy to use alternative gas supply sources without new infrastructure, though capacity of existing infrastructure does not allow a total replacement of Russian gas supplies. The government has made significant efforts to diversify gas supplies through deals with African and Middle Eastern countries, though some of this additional supply will take time to become available. Italy also has domestic gas production and renewable energy potential that could be increased in the coming years.
Although the lower reliance of Italy's industry on gas reduces the economic risks of the disruption, the use for electricity generation and by households will result in higher domestic energy prices, fueling inflation and causing a significant confidence shock. Efforts to mitigate the economic impact on households could also have a fiscal impact, though to-date support measures have not caused a deviation from fiscal targets because of higher-than-expected government revenues. There could also be second-round effects from Italy's reliance on gas for electricity generation. While some measures have been taken such as a cap on heating and air conditioning as well as a restart of coal-fired power plants, gas accounts for almost 50% of electricity supply and the impact would be felt through the wider economy.
THIRD DRIVER: RISKS THAT ITALY'S FISCAL STRENGTH WILL BE FURTHER WEAKENED BY SLUGGISH GROWTH, HIGHER FUNDING COSTS AND WEAKER FISCAL DISCIPLINE
Under Moody's current baseline scenario, debt will continue to decline in 2022 owing to strong nominal growth and a reduction in the deficit. Moody's forecasts debt-to-GDP to stand at 145% down from 151% in 2021 but about 11 percentage points higher than before the pandemic. Debt will decline further in 2023 and stabilise below 143% of GDP thereafter, due to slowing nominal growth and higher interest payments.
A positive differential between nominal growth and interest rates is key to Moody's baseline and the debt trajectory is vulnerable to shocks. Significantly weaker economic growth or a more rapid increase in Italy's borrowing costs would likely challenge debt sustainability if, as Moody's expects, Italy continues to run primary deficits until at least 2024.
As outlined above, there are material risks to growth prospects due to uncertainties regarding the execution of Italy's NRRP and risks to energy supplies. Moreover, funding costs have been rising since the start of 2022 after the ECB signaled it would end the pandemic asset purchase programme in July 2022 and hike rates; funding costs rose further following recent political developments.
The increase in funding costs will start to reverse the improvements in debt affordability recorded over the last decade although interest costs will remain lower than a decade ago. Higher interest rates will be relatively slow to feed through to higher interest payments given Italy's reasonably long debt maturity of 7.1 years as at end-July 2022. So far, Italy continues to issue below the average cost of its debt, which means it continues to refinance maturing debt at lower rates: as of June 2022, the average cost of debt at issuance was 140-150 basis points lower than the average cost of debt although the difference has been falling.
That said, debt affordability metrics will start deteriorating as soon as this year because Italy has just over 11% of the central government debt that is inflation-linked and a further 11% that is floating rate. According to the Italian fiscal council, every 1 percentage point increase in inflation adds €1.8 billion (0.1% of GDP) in interest costs while a 100-bps upward shift in the yield curve adds €2.5 billion in the first year (0.1% of GDP). In Moody's base case, debt affordability will deteriorate gradually through the forecast period, with interest costs reaching a still-manageable 8.1% of revenue by 2025.
The return of political uncertainty and a failure to meet NRRP targets would leave Italy more exposed to investor confidence at a time when the government needs investors to play an increased role in the Italian debt market amid ECB monetary policy normalisation. Moody's does not expect the recently announced TPI will be a panacea against rising yields in all circumstances. While the ECB's Governing Council has a lot of discretion over the activation of the tool, its aim is to counter a deterioration in financing conditions that is not warranted by country-specific fundamentals. In other words, the ECB will be less likely to activate the tool quickly if the rise in yields is triggered by domestic policy choices.
Signs that the next government was implementing policies that resulted in structurally higher fiscal deficits would also put debt on an upward trajectory. Some parties are advocating for tax cuts and social benefit hikes that would be politically difficult to reverse. A more expansionary fiscal policy than outlined in the previous government's medium-term fiscal plan would likely result in higher debt.
RATIONALE FOR THE Baa3 RATING
The Baa3 ratings reflect Italy's large, very diversified and competitive manufacturing sector, which has shown its capacity to rebound swiftly. High household wealth levels and the low indebtedness of the private sector provide a cushion in the current inflationary shock. Institutions are strong compared to rating peers although there are lingering weaknesses in the country's administrative capacity and the control of corruption.
Italy is the third-largest economy in the euro area and its bond market is the largest in the monetary union. The significant exposure of systemic institutions to Italy makes core European economies susceptible to the potential emergence of stress in the Italian government debt market. Italy's systemic importance to the euro area therefore represents a strong case for support by core European countries if needed, a view that has been confirmed by the ECB's recent announcements of TPI.
ENVIRONMENTAL, SOCIAL AND GOVERNANCE CONSIDERATIONS
Italy's ESG Credit Impact Score is moderately negative (CIS-3), reflecting a combination of moderate exposure to environmental risks, high exposure to social risks and, like many other advanced economies, very strong governance and in general strong capacity to respond to shocks.
Italy's E issuer profile score is moderately negative (E-3). Italy has low exposure to environmental risks across most categories, though the country has a moderate exposure to physical climate risk, in particular water and heat stress as well as wildfires. Italy is among the most exposed to heat stress in Southern Europe according to Moody's climate risk data. Agriculture, though a relatively small share of GDP and employment, is located in regions that are at higher risk of drought around the Po River and in the South. Although it generates a relatively small share of electricity supply (20%), hydropower is the second largest source of energy generation and is affected by recurring droughts.
Moody's assesses Italy's S issuer profile score as highly negative (S-4), mainly due to high demographic risks as well as risks related to labour and income. Italy has one of the oldest populations already now and public social spending is heavily geared towards pensions. Labour force participation rates are low for an advanced economy, in particular for women, and regional divergences in unemployment are profound, reflecting at least in part ineffective labour market institutions. Successive governments have implemented pension reforms over the past, which provides an important mitigating factor for the rapid ageing of the population, though health care spending and long-term care spending are still set to rise in the coming decades. Exposure to other social risks such as housing, health and safety issues and access to basic services is low.
Italy's very high institutions and governance strength is reflected in a positive G issuer profile score (G-1). In a global comparison, Italy scores well on global surveys assessing voice & accountability, regulatory quality and government effectiveness. Italy scores somewhat weaker on control of corruption and rule of law than other European countries, but in line with other similarly rated sovereigns. Fiscal transparency and planning is good, with Italy benefitting from European fiscal rules and the credibility of the European Central Bank.
The publication of this rating action deviates from the previously scheduled release dates in the EU sovereign calendar published on www.moodys.com. This action was prompted by heightened policy uncertainty following the government's collapse in July, which comes against the backdrop of a much more challenging economic and market environment.
GDP per capita (PPP basis, US$): 46,161 (2021) (also known as Per Capita Income)
Real GDP growth (% change): 6.6% (2021) (also known as GDP Growth)
Inflation Rate (CPI, % change Dec/Dec): 4.2% (2021)
Gen. Gov. Financial Balance/GDP: -7.2% (2021) (also known as Fiscal Balance)
Current Account Balance/GDP: 2.5% (2021) (also known as External Balance)
External debt/GDP: 131.7% (2021)
Economic resiliency: a2
Default history: No default events (on bonds or loans) have been recorded since 1983.
On 02 August 2022, a rating committee was called to discuss the rating of the Italy, Government of. The main points raised during the discussion were: The issuer's economic fundamentals, including its economic strength, have not materially changed. The issuer's institutions and governance strength, have not materially changed. The issuer's fiscal or financial strength, including its debt profile, has not materially changed. The issuer's susceptibility to event risks has not materially changed.
FACTORS THAT COULD LEAD TO AN UPGRADE OR DOWNGRADE OF THE RATINGS
WHAT COULD MOVE THE RATINGS UP
Although a rating upgrade is unlikely in the near future, Moody's would consider changing the outlook to stable if Italian institutions, growth prospects and the debt trajectory proved resilient to downside risks stemming from political uncertainty, risks to energy security and rising borrowing costs. Evidence that the next government is committed to the implementation of growth-enhancing structural reforms, including those outlined in the country's NRRP, would likely lead to a stabilisation of the outlook if this was accompanied by a credible medium-term fiscal consolidation plan that would prevent debt from significantly rising.
WHAT COULD MOVE THE RATINGS DOWN
Moody's would likely downgrade Italy's ratings if it were to anticipate a significant weakening of the country's medium-term growth prospects, possibly due to failure to implement growth-enhancing reforms, including those outlined in the country's NRRP. Signs that the debt was likely to start significantly trending upwards, either as a result of materially weaker growth prospects, a spike in interest costs or material fiscal loosening, would be negative for the ratings. Fiscal and/or economic policies that weakened market sentiment and caused debt levels to rise over the medium term would also lead to downward rating pressure.
The principal methodology used in these ratings was Sovereign Ratings Methodology published in November 2019 and available at https://ratings.moodys.com/api/rmc-documents/63168. Alternatively, please see the Rating Methodologies page on https://ratings.moodys.com for a copy of this methodology.
The weighting of all rating factors is described in the methodology used in this credit rating action, if applicable.
The List of Affected Credit Ratings announced here are a mix of solicited and unsolicited credit ratings. For additional information, please refer to Moody's Policy for Designating and Assigning Unsolicited Credit Ratings available on its website https://ratings.moodys.com. Additionally, the List of Affected Credit Ratings includes additional disclosures that vary with regard to some of the ratings. Please click on this link https://www.moodys.com/viewresearchdoc.aspx?docid=PBC_ARFTL468478 for the List of Affected Credit Ratings. This list is an integral part of this Press Release and provides, for each of the credit ratings covered, Moody's disclosures on the following items:
• EU Endorsement Status
• UK Endorsement Status
• Rating Solicitation
• Issuer Participation
• Participation: Access to Management
• Participation: Access to Internal Documents
• Lead Analyst
• Releasing Office
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For ratings issued on a program, series, category/class of debt or security this announcement provides certain regulatory disclosures in relation to each rating of a subsequently issued bond or note of the same series, category/class of debt, security or pursuant to a program for which the ratings are derived exclusively from existing ratings in accordance with Moody's rating practices. For ratings issued on a support provider, this announcement provides certain regulatory disclosures in relation to the credit rating action on the support provider and in relation to each particular credit rating action for securities that derive their credit ratings from the support provider's credit rating. For provisional ratings, this announcement provides certain regulatory disclosures in relation to the provisional rating assigned, and in relation to a definitive rating that may be assigned subsequent to the final issuance of the debt, in each case where the transaction structure and terms have not changed prior to the assignment of the definitive rating in a manner that would have affected the rating. For further information please see the issuer/deal page for the respective issuer on https://ratings.moodys.com.
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Regulatory disclosures contained in this press release apply to the credit rating and, if applicable, the related rating outlook or rating review.
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Please see the issuer/deal page on https://ratings.moodys.com for additional regulatory disclosures for each credit rating.
Sarah Carlson, CFA
Senior Vice President
Sovereign Risk Group
Moody's France SAS
96 Boulevard Haussmann
JOURNALISTS: 44 20 7772 5456
Client Service: 44 20 7772 5454
Sovereign Risk Group
JOURNALISTS: 44 20 7772 5456
Client Service: 44 20 7772 5454
Moody's France SAS
96 Boulevard Haussmann
JOURNALISTS: 44 20 7772 5456
Client Service: 44 20 7772 5454