OREANDA-NEWS. Fitch Ratings has affirmed Italy's Long-term foreign and local currency Issuer Default Ratings (IDR) at 'BBB+' with Stable Outlooks. The issue ratings on Italy's senior unsecured foreign and local currency bonds have also been affirmed at 'BBB+'. The Country Ceiling has been affirmed at 'AA+' and the Short-term foreign currency IDR at 'F2'.

KEY RATING DRIVERS
Italy's economic growth performance is weak. Nevertheless, recent data underpins Fitch's unchanged forecast since the last rating review in October 2014 that Italy will finally exit its deep and protracted recession in 2015. The recovery is supported by the combination of the ECB's monetary easing, the weaker euro, strengthening confidence and lower oil prices. However, the GDP growth forecast of 0.6% in 2015 and 1% in 2016 is weak compared with other eurozone members and GDP is currently close to its 2000 value, 9% below its peak in 2008. Nominal GDP growth will strengthen only gradually after being flat between 2010 and 2014.

General government gross debt (GGGD) is exceptionally high at 132% of GDP in 2014, compared with the 'BBB' median of 40%. Fitch forecasts it will peak at 133% of GDP this year and remain above 120% until 2020, leaving Italy highly exposed to potential adverse shocks. Reducing the debt ratio will require a continued recovery and maintaining large primary budget surpluses.

The cyclical economic recovery and lower nominal interest expenditure will improve the headline fiscal deficit, while Fitch does not expect the underlying fiscal stance to improve until 2016. In the recently published 2015 stability programme, the government forecast that the headline deficit will decline to 2.6% of GDP in 2015 and 1.8% in 2016 from 3% in 2014, a cumulative improvement of 1.2pp of GDP. At the same time, the government forecast that the structural balance will improve by only 0.3pp of GDP.

Inflation has declined further since the last rating review until January (-0.5%) due to the sharp fall in oil prices, and rebounded to 0% by March. Core inflation (HICP excluding energy and unprocessed food) remained broadly stable around 0.5%, close to its historical low.

Italy's creditworthiness is supported by a large, fairly wealthy, high value-added and diversified economy, with moderate levels of private sector indebtedness and a sustainable pension system.

The ECB's monetary easing has led to a further improvement in financing conditions. Yields of 10-year sovereign bonds declined below 1.5% in 1Q15 and the short end of the curve is close to 0%. The prolonged period of low yield environment combined with the 6.4 year average life of GGGD will lead to a steadily declining trend in interest expenditure over the next years.

The ECB's comprehensive assessment in October 2014 confirmed that large and medium-sized Italian banks were able to strengthen their capital positions despite the prolonged recession. Higher capital buffers and the progress in the implementation of the Bank Recovery and Resolution Directive lowers fiscal contingent risks for the sovereign over the medium term.

Nevertheless, NPLs reached EUR187bn (11.6% of GDP) by February 2015 and the large stock of impaired assets could constrain credit supply to support the recovery. Cleaning up the NPL portfolio could boost credit flows and support the economic recovery. The Italian authorities have announced they are examining ways to accelerate this process. In our view, the sovereign is unlikely to commit significant fiscal resources towards this, but the use of additional guarantees is a possibility (public guarantees of bank liabilities have fallen from 5.1% of GDP in 2013 to 1.4% in 2014). Reform of the insolvency regime would also facilitate NPL clean-up, but this is unlikely in the near term, given the busy legislative agenda.

The current account surplus increased close to 2% of GDP in 2014 after recording its first surplus in 2013 since the introduction of the euro. The favourable external environment, in particular the weaker euro, low oil prices and strengthening external demand in advanced economies support the gradual improvement of the external position. However, net external debt remains close to 50% of GDP, well above the 'BBB' median of 5%.

The rapid election of Sergio Mattarella as the new Italian president in February suggests Prime Minister Renzi has strengthened his position and the prospects of political stability have improved. This provides an opportunity for the government to continue focusing on institutional and structural reforms. The adoption of the Jobs Act is an important step in the government's structural reform agenda, which, if implemented successfully, could have a positive impact on the growth rate over the medium term.

RATING SENSITIVITIES
The Stable Outlook reflects Fitch's assessment that upside and downside risks to the rating are currently balanced.

Factors that may, individually or collectively, result in negative rating action are:
- GGGD/GDP not declining from its 2015 estimated peak of 133% of GDP.
- Disruption to the recovery of real and nominal GDP growth.
- Political turmoil disrupting economic and fiscal policies.

Factors that may, individually or collectively, lead to positive rating action are:
- GGGD/GDP being placed on a sustainable downward path after its 2015 peak.
- Sustained and broad-based economic recovery, including an acceleration in nominal GDP growth.

KEY ASSUMPTIONS
Fitch assumes that a GDP contraction of 0.4% in 2014 will be followed by 0.6% growth in 2015 and 1% in 2016. Fitch remains cautious regarding the potential benefits of structural reforms and maintains its view that the growth potential of the Italian economy will not exceed 1% over the medium term.

The debt sustainability calculations are based on the unchanged assumption of 1% annual GDP growth, a GDP deflator converging to 2% and primary surplus to 2.5% of GDP over the medium term. However, we have revised our interest rate path assumption down given the further fall in yields since the October rating review.

The European Central Bank's asset purchase programme should help underpin inflation expectations, and supports our base case that, in the context of a modest economic recovery, the eurozone will avoid prolonged deflation. Fitch also assumes gradual progress in deepening financial integration at the eurozone level and that eurozone governments will tighten fiscal policy over the medium term.