S&P Lowers Italy Outlook To Negative

Tyler Durden's picture

First Credit Agricole, now Italy....Maestro: the EUR take down orchestra is reaching the fortissimo cadenza. Next up: the glissando.

Overview

  • In our view Italy's current growth prospects are weak, and the political commitment for productivity-enhancing reforms appears to be faltering.
  • Potential political gridlock could contribute to fiscal slippage.
  • As a result, we believe Italy's prospects for reducing its general government debt have diminished.
  • We have therefore revised the rating outlook on Italy to negative, implying a one-in-three chance that the ratings could be lowered within the next 24 months.
  • We have also affirmed the 'A+/A-1+' sovereign credit ratings on Italy.

Rating Action

On May 20, 2011, Standard & Poor's Ratings Services revised its outlook on the ratings on the Republic of Italy to negative from stable to reflect its views of the heightened downside risks in the government's debt reduction plan. At the same time, Standard & Poor's affirmed its 'A+' long-term and 'A-1+' short-term sovereign credit ratings on Italy. The transfer and convertibility assessment remains at 'AAA'.

Rationale

The negative ratings outlook on Italy (unsolicited rating A+/Negative/A-1+) reflects Standard & Poor's view of the increased downside risks to the Italian government's debt-reduction plan because of potentially weaker-than-expected economic growth and possible political gridlock that could contribute to fiscal slippage. The diminished growth prospects stem from what we consider to be a lack of political commitment to deregulating the labor market and introducing reforms to boost productivity. We believe measures to reduce the bottlenecks and rigidities in Italy's economy are especially important in light of Italy's limited monetary flexibility, which stems from its membership in the European Monetary Union and its limited fiscal room to maneuver because of Italy's high government debt burden.

We expect that Italy's government debt burden will remain the key rating constraint over the foreseeable future. We forecast net general government debt at 116% of GDP in 2011, up from 100% of GDP in 2007 and on par with the 1997 level. Under our analysis, the economic contraction between 2008 and 2009 has negated all of Italy's fiscal-consolidation efforts over the last decade. In our view, there is greater than a one-in-three chance that Italy will not reduce general government net debt to 113% of GDP by 2014, which is envisaged in our baseline projection.

Italy's economic recovery since the 2008-2009 contraction has been lackluster, constrained mainly by net exports. Italy's traditionally near-balanced trade deficit has widened in the past 15 months. In our view, the Italian economy's limited ability to benefit from strengthening external demand reflects low productivity growth, limited labor mobility, and a steady erosion of international competitiveness over the past decade. Although these factors have affected the Italian economy for more than a decade, their impact on growth and, consequently, debt dynamics is greater now because of intensifying competition in Italy's key export sectors, further appreciation of Italy's wage-deflated real effective exchange rate, and the risk of rising funding costs for Italy's private and public sectors.

We believe that the structural measures implemented in 2010 and those in the recently updated National Reform Plan are insufficient to boost economic growth in the medium term. In addition, we believe the increasing fragility of the current governing coalition makes the timely implementation of more significant growth-enhancing structural reforms politically more challenging. If low economic growth persists, the fiscal outcome will, in our view, likely significantly miss the government's targets and therefore may derail the debt-reduction plan laid out in its most recent Stability and Growth Program. In the longer term, we believe that growth prospects could dim further as a result of Italy's unfavorable demographic profile.

Italy's interest burden is more than 10% of government revenues in 2011, is  higher than the 'A' median of 7.5%, and is forecast to rise. Interest expense  reflects the impact of Italy's high debt burden on its public finances. On the other hand, strong household and corporate balance sheets have enabled  the government to fund itself at historically low rates, and we expect that  these low rates could facilitate a more gradual fiscal adjustment in Italy  relative to many of its southern European neighbors. Italy's corporate sector  is in a net external asset position (including outbound foreign direct  investment and equity) equal to 42% of GDP, equivalent to twice the net  external liability position of the financial sector. However, the public  sector's net external liability is high at €782 billion (50% of GDP). We also believe the Italian banking sector has recently been strengthened by  additional capital issuance and is in a stronger financial position than it  was six months ago. We do not expect the government will provide direct assistance to the Italian banking system in the near term; on the contrary, we expect most of the Tremonti Bonds, which provided four banks' Tier I capital during the 2008-2009 recession, will be repaid this year.

Outlook

The negative outlook on Italy reflects Standard & Poor's view of the mainly downside risks to the government's debt-reduction plan over the 2011-2014 period, and implies a one-in-three chance that the ratings could be lowered within the next 24 months. In our view, these downside risks will primarily stem from weaker growth than our current assumption of average GDP growth of 1.3% over the 2011-2014 period. In addition, extended political gridlock could contribute to fiscal slippage.

If one or a combination of these risks materializes, Italy's general  government debt could stagnate at the current high level. In this case, we may lower the long- and short-term ratings on Italy. On the other hand, if the government manages to gather political support for the implementation of competitiveness-enhancing structural reforms, paving the way for higher economic growth and faster reduction of its debt burden, the ratings could remain at the current level.