Italy: relegation from Series A

The Canadian rating agency DBRS announced on Friday that it has downgraded Italy’s rating from A (low) to BBB (high), outlook stable. The initial market response this morning saw a slight softening of Italian bonds, but also of other peripheral securities, since the rating change by DBRS had not been expected by all market participants.

DBRS justifies the move on the one hand by growing doubts about Italy’s ability to continue implementing structural reforms following the failure to reform the senate. Although the new transitional government enjoys a certain degree of support from the coalition parties, the likelihood of a new election is nonetheless high. Following the constitutional court’s ruling on the electoral law expected for late January, the parties‘ primary focus could be on an election campaign. According to DBRS, the actual date of new elections may not be set until autumn this year.

On the other hand, DBRS mentions the weakness of the Italian banking sector owing to the high share of non-performing loans as a consequence of years of low economic growth. Although the EUR 20bn package of government aid for banks was a good start, the rating agency considers the programme insufficient to find a lasting solution to the vulnerability of the banking sector or the problem of non-performing loans.

Besides these main triggers, the agency also puts its decision down to Italy’s persistently slow growth and high national debt. Another negative rating trend could not be ruled out either if the government’s savings policy weakens any further or the country’s growth prospects deteriorate, thus jeopardising the downward consolidation of the national debt.

Italy’s downgrade by DBRS comes as no surprise. The agency placed the country on a negative credit watch back in summer 2016 and also expressed criticism after its failure to reform the senate. With this decision, Italy loses its last A rating, which amounts to a watershed. Not only is it the first time the credit rating of a large EMU country has slipped into mediocrity; the downgrade will also have consequences for Italian banks, because the discounts on Italian governments bonds used as collateral for ECB liquidity go up.

Italy’s future ratings performance will depend to a large extent on economic and political developments this year. Whereas expectations of root-and-branch reform have already diminished following the negative referendum result on Senate reform, the focus of attention for investors and rating agencies will now likely turn to the development of public-sector finances. The trend is not auspicious at the moment, since Renzi’s government pushed through tax reductions for 2017 and state aid for the banks will drive up the national debt. Meanwhile, there is no sign either of any lasting economic stimulus from the tax relief, which is due to rise again in 2018.

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