OREANDA-NEWS. October 27, 2015. 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 creditworthiness is supported by a large, high value-added and diversified economy, with moderate levels of private sector indebtedness and a sustainable pension system. The rating balances these structural strengths against high public debt and weak growth performance and outlook.

Gross general government debt (GGGD) stood at 132% of GDP at end-2014, compared with the 'BBB' median of 40%. Although we forecast debt to peak this year around that level, it will likely remain above 120% until the end of the decade, leaving Italy highly exposed to potential adverse shocks. Reducing the debt ratio meaningfully is contingent on a continued recovery in nominal GDP and a large and sustained primary budget surplus.

Recent data underpin our forecast that Italy has exited its deep, protracted recession this year. The recovery is supported by the ECB's monetary easing, a weaker euro, strengthening confidence and lower oil prices. Nevertheless, our GDP growth forecasts of 0.7% in 2015 and 1.1% in 2016 are weak compared with those for other eurozone members, and Italy's real GDP is currently around its 2000 level and 9% below its 2008 peak. Nominal GDP growth will strengthen only gradually, having flat-lined between 2010 and 2014.

The government's Draft Budgetary Plan (DBP, or Stability Law) for 2016 was approved by the cabinet on 15 October. The expenditure reforms contained in the DBP are less ambitious than the government's original plans. The raising of the general government 2016 headline deficit target to 2.2% from 1.8%, while growth-friendly and potentially within the fiscal rules, damages the government's deficit-cutting credentials. We forecast a deficit of 2.4% next year, which nonetheless represents a small shrinkage on 2015 (Fitch: 2.7%).

Overall, this is a tax-cutting budget, scrapping the property tax on first homes, as well as the removal of the safeguard clauses that would have raised VAT and excise duties in 2016. Tax concessions to promote investment and employment are also a key feature.

The tax cuts are to be part-funded by savings from the expenditure review, amounting to EUR5.8bn for 2016. This is notably lower than the EUR10bn presented in the April 2015 Stability Programme (SP), or the EUR15bn in the April 2014 SP. Although nominal public expenditure is expected to remain broadly flat next year (up 0.5%) the incremental weakening of the spending review targets demonstrates the political constraints that the government is operating under.

The cyclical economic recovery and lower nominal interest expenditure will improve the headline fiscal deficit, while we do not expect the underlying fiscal stance to improve until 2017, one year later than our previous forecast. We have revised up our deficit/GDP forecast for 2016 to 2.4% from 2.2% despite the stronger cyclical recovery.

The large and medium-sized Italian banks have strengthened their capital ratios despite the prolonged recession in recent years. Higher capital buffers and the implementation of the Bank Recovery and Resolution Directive have lowered fiscal contingent risks for the sovereign over the medium term. Nevertheless, NPLs continue to rise, reaching EUR198.5bn (12.1% of GDP) in August 2015 and the large stock of impaired assets could constrain credit supply to support the recovery. The profitability of the sector, and therefore banks' ability to generate capital internally, is still low even though we expect some moderate improvements in 2016.

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, supports the gradual improvement of the external position. However, net external debt at 56% of GDP in 2014 is well above the 'BBB' median of 5%.

The constitutional reforms proposed by the government are close to the end of their long legislative journey. After a legislative "pause" and a final reading in both chambers, the reform will be put to a referendum in 2016. A new electoral law for the lower house was also approved on 4 May. Both of these reforms are central to the government's agenda and should lead to more stable governments, with less scope for legislative deadlock.

The ECB's monetary easing has supported benign financing conditions for Italy. The average yield at issuance in September 2015 was 0.74% The prolonged period of the low yield environment, combined with the 6.5 year average life of marketable central government debt, should lead to a steadily declining trend in interest expenditure over the coming years.

The near-term risk of political disruption to policy-making has been kept in check since Matteo Renzi became Prime Minister in February 2014. His high popularity ratings have enabled him to use the possibility of fresh elections to push such reforms through parliament. Nevertheless, political risk could rise if Renzi's popularity falls.

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:
- General government gross debt (GGGD) failing to decline from 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:
- A track record of falling GGGD/GDP.
- Sustained and broad-based economic recovery, including an acceleration in nominal GDP growth.

KEY ASSUMPTIONS
The ECB's asset purchase programme should help underpin inflation expectations. This supports our base case that in the context of an economic recovery, Italy and the eurozone will avoid prolonged deflation. Nevertheless deflation risks could re-intensify in case of adverse shocks.

Our long-run debt sustainability calculations are based on the unchanged assumption of 1% annual GDP growth, a GDP deflator of 2% and primary surplus of 2 % of GDP.