Country risk: Italy is the volcano waiting to erupt

Heat is on: Mount Etna’s most recent activity in March reflects the ground-shaking political and economic situation in Italy

Euromoney’s survey still shows Italy to be the riskiest G10 member state, lying 51st in the global rankings, within the third of the five risk categories equivalent to a BB+ to A- credit rating:

The sovereign borrower is now rated a BBB (stable) investment grade by Fitch after it was downgraded this month from BBB+.

Standard & Poor’s rating is a notch lower on BBB-, and also stable, while Moody’s assigns a negative Baa2 rating.

Portugal, which is only rated BB+/Ba1, is one place higher in Euromoney’s global rankings, and is therefore a safer credit according to the survey.

Italy’s risk score is 21 points below the level prevailing in 2010. Only Greece is rated lower in western Europe, and only Greece has experienced a larger score decline.

Italy’s problems are multi-fold, its growth outlook being at least one major consideration, despite being propped up by the European Central Bank’s quantitative easing (asset purchase) programme.

Whereas the IMF’s latest World Economic Outlook shows 1.7% real GDP growth for the euro area this year – the same as in 2016 – Italy is expected to remain weak, managing just 0.8%, and down a fraction from last year’s 0.9% pace.

Independent forecasts corroborate this. Euro Zone Barometer, a monthly survey, shows 1.7% growth for the euro area this year, with Italy on 0.9%, and one forecaster predicting just 0.6%.

The banking sector is overwhelmed by non-performing loans, poor returns on core non-credit assets, and deterioration in future demand for credit giving rise to a bank-stability indicator score of just 5.3 out of 10. This compares with 6.2 for France, 6.8 for Germany and 7.3 for the Netherlands.

The fiscal deficit has been gradually reduced in successive years, but still stood at 2.4% of GDP at the end of 2016 on an EU basis, with the gross debt burden climbing to 132.6% of GDP.

This is the largest in Europe besides Greece, in the region’s fourth largest economy.

Italy’s risk score is still being held down by downgrades to the government finances and a range of political indicators. They include the regulatory and policy environment, and government stability.

There is uncertainty as to the precise timing of the elections, which must be held by the spring of 2018, and could take place against the backdrop of escalating risks elsewhere, compounding market fears.

The outcome is extremely uncertain, which is further weighing on the investor outlook.

With Greece in intensive care, Norbert Gaillard, an independent eurozone sovereign risk expert, believes Italy is the biggest risk to the eurozone.

“It is the country where an anti-system party [the Five Star Movement] is most likely to come to power,” he says.

The polls are showing Five Star Movement in the lead on around 30% to 32%, ahead of the Democratic Party on 25% to 26%.

As Gaillard explains: “The proportionality electoral system reduces the risk that this party might be able to govern alone.”

A coalition with the Democratic Party would be more acceptable than a populist-nationalist one with the Northern League, which could jeopardize solvency and increase the risk of Italexit.

However, this would also create tensions and policymaking uncertainty, with no guarantee of stability.

Constantin Gurdgiev, a professor at the Middlebury Institute of International Studies, and an expert on European country risk, pinpoints huge structural problems caused by the “lack of deep fiscal reforms and declining demographics, coupled with anaemic growth in external demand for Italian exports”.

The country is suffering from chronic long-term unemployment and under-employment, especially among the younger demographic cohorts.

Gurdgiev says this is “acting as a key transmission mechanism from economic pressure to social and political uncertainty, supporting the rise in political populism and undermining Italy’s position within the euro area.

“In simple terms, Italy is the sickest patient in the already weakened ward of the European common currency zone.”

This article was originally published by ECR. To find out more, register for a free trial at Euromoney Country Risk.