Fitch Ratings is providing further comment on the rating actions it took earlier today on the Italian Republic (Italy), where its long-term issuer default rating (IDR) was downgraded to 'A-' from 'A+'; Negative Outlook; and its short-term IDR was downgraded to 'F2' from 'F1'.
The downgrade follows the Rating Watch Negative (RWN) placed on the sovereign ratings of Italy and five other Euro Area Member States (EAMS) on 16 December 2011. The RWN was initiated in response to concern over the lack of clarity on the ultimate structure of a fundamentally reformed Economic and Monetary Union; the risk of self-fulfilling liquidity and even solvency crises in the absence of a fully-credible financial 'firewall' against contagion; and the significant negative external shock to the region's economy from the prolonged nature of the Eurozone systemic crisis.
The two-notch downgrade of Italy's sovereign ratings primarily reflects two factors:
- a re-assessment by Fitch of the potential financing and monetary shocks that members of the Eurozone face in light of the increasing divergence in economic, monetary and credit conditions and prospects across the region, which is also a factor in the downgrades of some other Eurozone sovereign governments;
- a permanent upward shift in Italy's relative cost of fiscal funding and consequently an increase in the interest rate growth differential with adverse implications for long-run public debt dynamics.
The factors that have prompted the downgrade reflect the systemic nature of the Eurozone crisis that Italy's high public debt and low potential growth rate have rendered it especially vulnerable to. A more severe rating action was forestalled by the strong commitment of the Italian government to reducing the budget deficit and to implementing structural reform as well as the significant easing of near-term financing risks as a result of the ECB's 3-year Longer-term Refinancing Operation (LTRO).
The intensification of the Eurozone crisis in the latter part of last year and the funding stress faced by the Italian government and financial sector, albeit since eased by the LTRO, highlight the continuing risks posed by the absence of a fully credible framework for providing financial support to solvent but potentially illiquid sovereigns. Moreover, the divergence in monetary and credit conditions across the Eurozone and near-term economic outlook highlight the greater vulnerability to monetary as well as financing shocks faced by Euro Area sovereign governments. One notch of the two-notch downgrade of Italy reflects this systemic weakness that only more fundamental reform of Economic and Monetary Union can address.
The additional fiscal measures announced in the latter half of 2011, including the supplementary budget adopted in December, are equivalent to around 4.83% of GDP over the period 2012-2014. This, as well as the proposed constitutional 'balance budget' amendment effective from 2014, underscore the government's commitment to eliminating the structural budget deficit. The pension reforms also strengthen the long-run sustainability of public finances in Italy and account for most of the projected reduction in primary (non-interest) public spending. However, as previously noted by Fitch, the greater reliance on raising revenues (which account for around two-thirds of the planned deficit-reduction) implies that the tax burden and public spending will remain high by international standards. More fundamental fiscal reform would strengthen confidence that a large primary surplus can be sustained over several years as well as enhance the productivity and growth potential of the economy.
The marked deterioration in the near-term economic outlook - Fitch forecasts the Italian economy to contract by 1.7% in 2012 and grow by only 0.2% in 2013 - heighten the risks to the government realising its fiscal targets and to continuing political support and public acceptance for further fiscal austerity and structural reform. Nonetheless, under Fitch's baseline assumptions regarding medium-term economic growth (1% pa) and gradual reduction in spreads over German bunds to below 200bps, the fiscal consolidation effort - if effective and sustained - would support a stabilisation of the public debt to GDP ratio this year and a gradual decline over the remainder of the decade towards the 100% of GDP level. Fitch's medium-term projections imply an interest-rate growth differential (IRGD) of between 2%-3% compared to just over 1% between 1999 and 2007. The primary (non-interest) budget surplus that must be sustained to reduce the public debt to GDP ratio over the medium-term is correspondingly higher. Consequently, Fitch has made an adjustment to Italy's sovereign rating equivalent to one-notch to reflect this worsening in public debt dynamics as well as the risks associated with the recession and uncertainty over the medium-term economic outlook.
Fitch's medium-term projections and assessment of relative creditworthiness of the Italian government is premised on the assumption that reforms to EMU will be adopted and be successful in ultimately resolving the systemic weaknesses revealed by the crisis. The 'A' category rating is also underpinned by the relatively high level of private savings and wealth, absence of severe macro-financial imbalances within the economy and moderate private and foreign indebtedness, including limited contingent liabilities from the financial sector.
The Negative Outlook primarily reflects the risks associated with a further intensification of the Eurozone financial crisis, though today's action incorporates Fitch's expectation that the crisis will be prolonged and punctuated by further episodes of market volatility. Moreover, the rating also incorporates some slippage in realisation of the balanced budget target in 2013 reflecting a weaker economic outlook than that assumed by the government. However, policy reversals, including to planned reforms that would enhance the business environment and improve the flexibility and job creation potential of the labour market, would place downward pressure on the rating.
