Dagong Global Credit Rating Co., Ltd.
May 16, 2018
Dagong Global Credit Rating Co., Ltd. (hereafter referred to as “Dagong”) has decided today to downgrade the local and foreign currency sovereign credit ratings of the Italian Republic (hereafter referred to as “Italy”) from BBB- to BB+, each with a negative outlook. Italy’s politics display a stronger right-wing tendency while it remains increasingly difficult to solve its long-standing structural problems. The debt-based economy stagnates and thereby keeps undermining the foundation of the country’s repayment sources, rendering it challenging to clear off the debt, and ultimately jeopardizing government solvency.
The key reasons for downgrading the sovereign credit ratings of Italy are below:
First, Italy’s highly vulnerable political ecology prevents the country from rebuilding its wealth creation ability. Following the parliamentary election in March 2018, it becomes more obvious that traditional parties wane while anti-establishment parties continue to expand. The highly divided voters and reduced representation of parties underscore the fragmentation of Italy’s political pattern, which leaves government formation hanging in the air. Given the changes to Italy’s current political spectrum, Dagong judges that it remains impossible to quickly settle the partisan disagreements while any ruling coalition out of the current political pattern can hardly reach a broad consensus, which might reverse any initial progress in structural reform and impede the fundamental improvements in economic growth.
Second, systemic banking crises remain, putting Italy’s credit ecology under pressure. Economic recovery has resumed banks’ profitability, although there still exists an eroding effect on the margins exerted by the low-rate environment. The slow pace of writing off bad debt hampers improvements in asset quality; meanwhile the non-performing loan ratio stands as high as 16.4%. Bad asset quality and a relatively wide capital gap cause some fragile banks to continue relying on government bailout funds in 2018, thus systemic risks within the banking sector are significant and threaten the stability of the financial system as the credit ecology comes under pressure.
Third, that Italy cannot throw off its dependence upon debt leads the country’s growth to extensively hover at a low level. In the near term, the recovery in domestic demand will be constrained by several factors including limited improvements in labor market reform, slower credit expansion, residents’ stronger saving tendencies, as well as uncertainties over the business environment. It is expected that in 2018 and 2019, Italy’s growth will drop to 1.2% and 1.0%. As a debt economy, in the long run Italy will be plagued by skill mismatch, weakened industrial international competitiveness, development quagmires facing small and medium-sized enterprises, as well as serious population aging, leading its growth potential to be consistently undermined. As a result, the country’s growth rate will average as low as 0.9% in the medium and long term.
Fourth, the tapering of fiscal consolidation worsens government repayment sources, thus government solvency continues declining. In the near term, the government’s strengthening of spending regulation alongside recent decline in interest expenses can somewhat reduce the dependence of the fiscal spending gap on debt financing. It is projected that in 2018 and 2019, the Italian general government’s fiscal deficit will be 1.7% and 1.3%, while financing needs over the same period will be as high as 40.2% and 37.9% of fiscal revenues, respectively. Hence, repayment sources are highly vulnerable while the structure of government repayment sources, as shored up by debt financing and heavily reliant on money issuance, is extremely insecure. Given the ongoing fiscal consolidation and the very low financing costs, it is forecasted that in 2018 and 2019, the ratio of Italian general government debt burden to fiscal revenues will decline down to 277.2% and 269.9% from a high level. However, government solvency diminishes due to its weak wealth creation ability, the continued accumulation of banks’ contingent liabilities, bleak political prospects obstructing the reform process, as well as the fact that it remains challenging to clear off heavy debt materially.
The short term will see an adverse impact on economic base, as exerted by uncertainty about the political ecology and weakness of the credit ecology. Meanwhile, the national economy cannot depart from the path of debt, which will continue hampering fiscal consolidation and weakening fragile repayment sources, thus placing government solvency under pressure. Therefore, Dagong assigns a negative local and foreign currency sovereign credit rating outlook for Italy in the following one to two years.