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DBRS: “Privatizations are not enough to reduce Italy's high debt burden, more real estate sales needed”

by Isabella Bufacchi

The rating agency DBRS changed Italy's “trend” or outlook from negative to stable last Friday and confirmed Italy's rating at the “A-low” level, higher that S&P's, Moody's and Fitch's ratings. Italy “ is not out of the woods yet” but there is room to be optimistic. In this exclusive interview to Italy24-IlSole24Ore, the analyst who follows Italy at DBRS, Giacomo Barisone (Senior Vice President at Global Sovereign Ratings) says that reforms “remain fundamental” to address Italy's structural weaknesses and that DBRS “remains moderately optimistic on the reform front” as “several structural, constitutional and electoral reforms are underway”. Italy has a good track record on primary surpluses and the debt to GDP ratio will start to fall from next year. Barisone sees signs of stabilization in the political front and in the credit conditions. The reform of the country's slow-moving judicial system is another key priority to make Italy's economic system more efficient and “so far the reform is making some headway”. More must be done on the spending review and privatizations but DBRS underlines some progress has been made so far.

BUFACCHI: Italy's economic recovery is very fragile, as the loss of competitiveness and productivity has been severe: is Italy out of the woods? What will happen when the ECB Public Sector Purchase Programme, the expanded quantitative easing, will be over? Many foreign non-Italian investors are still not convinced that Italy's public debt is sustainable.

BARISONE: The Italian economy is not out of the woods. We expect cyclical factors such as QE and the oil price decline to boost growth in the short term. But reforms remain fundamental to address Italy's structural weaknesses and lift the too low potential growth in the medium to long term. Our view is that QE is an unconventional monetary policy operation that has no long-lasting or direct impact on the sovereign's debt levels, even though higher GDP growth could provide an indirect effect. We expect the ECB to eventually wind down its asset purchases as the economic outlook normalizes. However, exiting from QE will likely be gradual and could take place over a long time horizon.

BUFACCHI: DBRS upgraded Italy changing its trend from negative to stable. Italy's debt to GDP has gone up during the crisis, it will peak this year and fall very slowly afterwards. Italy's GDP in the meantime is improving but the recovery is fragile, it is vulnerable to external shocks: is this enough to strengthen a stable trend?

BARISONE: Prospects for debt stabilization will continue to weigh on Italy's sovereign rating. We expect government debt to peak in 2015 at close to 133% of GDP, and to decline gradually in 2016 driven by a structurally high primary surplus and stronger nominal GDP growth. Nevertheless, we believe the trajectory is subject to several risks, including less positive fiscal outturns, lower output growth, lower inflation and higher financing costs. If these risks were to materialize, the prospect that public debt will be put on a firmly downward path over the medium term would be lower, adding pressure on the ratings.

BUFACCHI: DBRS changed the trend in Italy's rating from negative to stable mentioning Italy's progress in fiscal consolidation and a “healthy” primary surplus at 1.7% of GDP. Don't you think that Italy needs a higher primary surplus to lower significantly its debt to GDP ratio and to put it on a sustainable downward path?

BARISONE: Italy has a track record of having achieved sizeable primary fiscal surpluses, despite the low growth environment. Consolidation efforts conducted between 2011-2014 have, in our view, created the conditions for the debt to GDP ratio to start gradually declining from 2016. Italy has among the highest structural primary surplus (adjusted for the cycle) in the EU estimated around 3.8% in 2014. After easing moderately in 2015, we expect fiscal consolidation to resume from 2016, with primary surpluses averaging approximately 3% in 2016-18.

BUFACCHI: In your report on Italy, you highlighted privatizations in the pipeline as a good way to reduce Italy's debt: but up to now, past government targets have not been met. Do you think that more public companies will be sold in 2015 compared to the past?

BARISONE: Privatization proceeds so far have been limited amounting to 0.3% of GDP. Increased volatility of financial markets and the need to prepare state-owned companies for listing has delayed implementation of some of the biggest disposals. We do expect the government's privatization effort to resume more forcefully this year supported by better market conditions as seen recently with the sale of quotas of Enel. Expected privatization proceeds of 0.7% of GDP per year are, however, not large enough to materially reduce Italy's high debt burden. Additional real estate sales should also be implemented in order to generate a stronger debt reduction over the medium term.

BUFACCHI: According to your estimates, if the interest bill on public debt servicing were to be reduced from 4.5% of GDP to 2.6% of GDP, Treasury would save €43 billion a year. It is huge savings: the Treasury is very cautious as it takes more than 6 years to roll over Italy's public debt and interest rates might rise fast when QE ends.

BARISONE: We expect QE to provide some support to Italy's fiscal consolidation over the near term, by steadily lowering interest payments. While interest payments amounted to 4.7% of GDP in 2014, it is reasonable to expect an annual 0.4 percentage point potential savings on interest rate expenses for the next 2-3 years, on the back of the roll-over of the debt into lower-yielding government bonds.

BUFACCHI: DBRS also mentions in its report on Italy the progress of structural reforms, pointing out the execution risk for implementing these reforms. Implementation in Italy has been historically slow. Does Italy risk missing the unique opportunity given by the ECB Public Sector Purchases Programme (QE with extremely low funding costs)? Does Italy risk missing its last train?

BARISONE: We remain moderately optimistic on the reform front. Several structural, constitutional and electoral reforms are underway. But there is still a long way to go. In order to maximize the opportunity that QE creates, the government will have to proceed at a sustained pace on the full implementation of its reform plan. We believe that the effective success of reforms goes beyond the Parliamentary approval, and also needs to follow through at the public administration and local government level before having an impact on the broader economy.

BUFACCHI: One of the positive factors which seems to have contributed to Italy's upgrade from a negative to a stable trend is the capability of cutting public spending to finance tax reductions: yet, Matteo Renzi's government is criticized for not being bold enough on the spending review. DBRS underlines that a deterioration of economic activity would make adjustments more difficult: how severe is the risk that cuts on unproductive public spending will not be enough?

BARISONE: Our main concern is that the cuts of unproductive public spending identified by the spending review may be insufficient and prove quite difficult to implement. Additional savings will be difficult to be achieved without addressing the large pension and healthcare spending, which account for over 40% of total expenditure. It is necessary, in our view, that the government demonstrates greater determination to implement these cuts and to improve the efficiency and quality of public spending making it more conducive to growth.

BUFACCHI: If I remember correctly, DBRS negative trend on Italy was due to political instability. Are you confident that Renzi's government is more stable than previous ones? In other words, do you think that the risk of a hung Parliament is reduced with Renzi's premiership?

BARISONE: There have been some signs of stabilization on the political front, yet some risks of instability have also re-emerged following the election of the President of the Republic with the interruption of the alliance between Matteo Renzi and Silvio Berlusconi. As public support currently stands, we believe that Renzi would be the favorite to obtain an absolute majority in Parliament under the recently approved electoral system, which will apply from mid-2016. Under the existing electoral law, the risk of another hung Parliament would however be high. We do not expect early elections as long as the constitutional reforms are not fully implemented and the government should maintain a working majority at least until 2016.

BUFACCHI: You mention that the banking system is less of a problem after AQR assessments and stress tests, however non performing loans are rising: Italy's economic growth is held back by SMEs, too small and too many, furthermore Italy lacks a proper capital market. Is Italy's financial market structure a fundamental structural weakness? Do you think the Juncker Plan will help Italy's economic recovery? If yes,how?

BARISONE: The recovery is indeed exposed to risks inherent in Italy's fragile financial and corporate sectors. Bank credit to corporates has continued to contract in 2014, driven by weak demand and tight supply to SMEs. Recent indicators are however showing some signs of stabilization in credit conditions. Lower interest rates and the government's recent measures to reform the banking sector and improve SMEs' access to capital markets should start to support the recovery more meaningfully this year. We would expect that stronger credit growth could also be facilitated by the Juncker Investment Plan, by raising public and private investment in Italy. Given the Plan's complex guarantee structure, we expect however it will take some time to be implemented and to start having an impact only in 2016-2017.

BUFACCHI: One of Italy's major weaknesses is corruption: the latest scandals on Italy's major infrastructure projects show that not much has changed since Tangentopoli (Bribesville) in the 1980's. This lowers Italy's potential growth. Is the reform of the judicial system fast and deep enough to attract more FDI in the future?

BARISONE: The reform of the country's slow-moving judicial system is another key priority to make Italy's economic system more efficient. So far the reform is making some headway but more needs to be done to improve the efficiency of the system before starting to see a material increase in attracting FDI's. Sustained action against corruption should also remain a priority. The anti-corruption agency ANAC has been given some additional powers and has used them in recent cases of corruption, with some success.