FITCH DOWNGRADES SPAIN TO 'AA-'; OUTLOOK NEGATIVE
FITCH DOWNGRADES ITALY TO 'A+'; OUTLOOK NEGATIVE
Fitch is busy today....France next?
Fitch Ratings-London-07 October 2011: Fitch Ratings has downgraded Spain's Long-term foreign and local currency Issuer Default Ratings (IDRs) to 'AA-' from 'AA+'. The rating Outlook is Negative. Fitch has simultaneously affirmed Spain's Short-term rating at 'F1+' and the Country Ceiling at 'AAA'.
The downgrade primarily reflects two factors: the intensification of the euro area crisis and secondly, risks to the fiscal consolidation effort arising from the budgetary performance of some regions and downward revision by Fitch of Spain's medium-term growth prospects.
As Fitch has previously cautioned, a credible and comprehensive solution to the crisis is politically and technically complex and will take time to put in place and to earn the trust of investors. In the meantime, the crisis has adversely impacted financial stability and growth prospects across the region. However, the still sizeable structural budget deficit, high level of net (although not
gross) external debt and the fragility of the economic recovery as the process of deleveraging and rebalancing continues render Spain especially vulnerable to such an external shock.
While gross external debt (169% of GDP in 2010) is not high by euro area comparison, the net external debt of the economy (91% of GDP in 2010) is one of the highest in the world, reflecting a relative lack of Spanish foreign financial assets. This leaves the Spanish external finances sensitive to interest rate increases. While the current account adjustment has been significant, falling from 10% of GDP in 2007 to 4.5% of GDP in 2010 and a forecast 3.2% in 2011, further adjustment over the medium is necessary to improve the external balance sheet.
The intensification of the euro area crisis was identified as a negative rating trigger on 4 March 2011 when Spain's rating Outlook was revised to Negative.
With large fiscal and external financing needs, heightened volatility has adversely impacted market financing conditions for Spain as illustrated by the Eurosystem's intervention in the secondary market. However, Spain's 'AA-' rating incorporates Fitch's judgement that as a solvent and systemically important sovereign, in extremis, the ECB and/or EFSF/IMF will provide support to prevent a self-fulfilling liquidity crisis.
The second principal driver of the downgrade of Spain's sovereign ratings is the budgetary performance of some regional governments, which in Fitch's opinion, poses a risk to fiscal consolidation. In September 2011, the agency downgraded five autonomous communities and maintains a Negative Outlook on the sector reflecting the still difficult fiscal and economic environment and the execution risks in implementing some of the cost cutting measures announced. While the sub-national sector's debt was only 11.1% of GDP in 2010, it accounts for roughly one-third of total expenditure, making it a vital part of the necessary correction in the public finances to restore confidence and public debt sustainability.
The process of rebalancing the Spanish economy is well underway but is not yet complete and Fitch expects it to weigh more heavily on economic growth over the medium term. The agency projects annual economic growth to remain below 2% through to 2015 and unemployment to remain high. Despite the important measures already adopted by the government, further structural reform will be necessary to further enhance the competitiveness and productivity of the economy. The fundamental weakness of the labour market, as underscored by an unemployment rate in excess of 20%, is a material rating weakness relative to European and high-grade peers. Nonetheless, while the recovery over the medium term will be lacklustre, Fitch expects the long-term (ie, post-2015) potential growth rate to exceed the average for the euro area as a whole.
Despite the weakened risk profile, Fitch views Spanish sovereign solvency as secure. Under the agency's baseline scenario, the debt to GDP ratio will peak at 72% of GDP in 2013, well below the forecast euro area average of 89% in 2013.
Spain's 'AA-' rating reflects strong fundamentals: a diversified, high-value-added economy and strong governance. The government's policy response has been credible and aggressive.
The Negative Outlook reflects the risks associated with a further intensification of the euro area financial crisis, as well as possible material fiscal slippage and to a lesser extent contingent liabilities from the financial sector. A material deviation from the government's fiscal targets and failure to stabilise the government debt to GDP ratio from 2013 would place negative pressure on the rating. Substantial progress has been made in the restructuring of the banking sector and Fitch has not revised its estimate of the ultimate fiscal cost which is moderate and is consistent with the current rating.
The amount disbursed by the Fund for Orderly Bank Restructuring (FROB) is estimated at EUR17.3bn by end-2011. Under Fitch's baseline scenario, Fitch assumes that a further EUR30bn (2.8% of GDP) of capital is required from 2012 based on the agency's stress-test exercise. This is to cover additional losses while maintaining a strong core capital ratio of 10% for the system. Fitch views the costs as manageable. Should recapitalisation costs be significantly higher than this figure, the rating could move into the 'A'-range.
On a wide range of economic and fiscal indicators Spain has underlying fundamentals consistent with maintaining its sovereign rating in the 'AA'
category. Success in meeting its fiscal targets and progress on structural reform that would further enhance competitiveness and growth prospects would stabilise the rating, as would resolution of the euro area crisis.
FITCH DOWNGRADES ITALY TO 'A+'; OUTLOOK NEGATIVE
Fitch Ratings-London/Milan-07 October 2011: Fitch Ratings has downgraded the Italian Republic's (Italy) foreign and local currency Long-term Issuer Default Ratings (IDRs) from 'AA-' (AA minus) to 'A+' (A plus) and the short-term rating from 'F1+' to 'F1'. The Outlook on the long-term ratings is Negative. The Country Ceiling of 'AAA' has also been affirmed.
The downgrade reflects the intensification of the Euro zone crisis that constitutes a significant financial and economic shock which has weakened Italy's sovereign risk profile. As Fitch has cautioned previously, a credible and comprehensive solution to the crisis is politically and technically complex and will take time to put in place and to earn the trust of investors. In the meantime, the crisis has adversely impacted financial stability and growth prospects across the region. However, the high level of public debt and fiscal financing requirement along with the low rate of potential growth rendered Italy especially vulnerable to such an external shock.
While the recent supplementary budget substantially strengthened the fiscal consolidation effort, the initially hesitant response by the Italian government to the spread of contagion has also eroded market confidence in its capacity to effectively navigate Italy through the Eurozone crisis.
Italy's sovereign credit profile remains relatively strong and is supported by a budgetary position that compares favourably to several European and high-grade peers. As a sovereign and nation it is solvent. Moreover, as the third largest economy in the euro zone, Italy is a 'core' member of EMU and the rating incorporates Fitch's judgement that, in extremis, the ECB and/or EFSF/IMF will provide support to prevent a self-fulfilling liquidity crisis.
The Italian government is expected to meet this year's deficit target of -3.9% of GDP and a primary (non-interest) budget surplus of close to 1%. Despite the high public debt burden, the budgetary adjustment necessary to stabilise and gradually reduce government debt to GDP ratio is eminently achievable. Moreover, several years of incremental pension reform, including as part of the latest fiscal package, has contained demographic pressures on public spending over the long-term, while contingent liabilities from the financial sector remain low.
Private sector indebtedness is moderate and net foreign debt is not excessive.
The supplementary budget passed by parliament on 14 September underscores the broad political recognition of the necessity of fiscal consolidation and reducing the burden of public debt on the economy, as does support for a constitutional 'balanced budget' amendment that would be effective from 2014.
The supplementary budget implies a cumulative EUR59.8bn (equivalent to around 3.5% of GDP) of additional and largely front-loaded fiscal tightening over the period 2011-2014 with the aim of achieving a balanced budget by 2013, one year earlier than previously targeted. The estimated structural budget tightening is 2.3% of GDP in 2012 compared to the original target of 0.8%. A balanced budget in 2013 implies a primary (non-interest) surplus of 5.4% of GDP that under most macroeconomic scenarios would be consistent with steadily declining government debt to GDP ratio.
Fitch's own fiscal projections reflecting weaker macroeconomic assumptions (see Fitch's latest 'Global Economic Outlook' published 3 October) and potential for slippage imply that the government's target of a balanced budget in 2013 may not be realised, and Fitch's baseline forecast is for a primary surplus of around 4% which, if sustained over several years, would be sufficient to reduce government debt to GDP ratio to below 110% by the end of the decade. Based on government projections to 2014 and assuming a balanced budget over the rest of the decade, debt would fall below 100% of GDP for the first time since 1991.
However, while the near-term budget deficit targets are achievable, the fiscal measures fall short of a more fundamental reform of public finances and imply a shift from expenditure to revenue-led fiscal adjustment. The high tax burden is one of the factors that weighs on long-term growth, but is set to rise further.
Moreover, the expenditure restraint is still largely based on 'cross-the-board' cuts in current spending as well as a further squeeze on investment rather than long-lasting structural reform of public spending. Greater emphasis on structural fiscal reform would strengthen confidence that a large primary surplus can be sustained over several years as well as enhance the productivity and growth potential of the economy.
The structural weaknesses that have constrained economic growth are well-known: high public debt and tax burden; an inefficient public sector; barriers to competition in product markets and services; inflexible labour market; and a pronounced "north-south divide". The government has been gradually introducing measures designed to address these weaknesses. Against the backdrop of reforms across Europe and the higher cost of capital that Italy is likely to face over the medium as well as in the near-term, a more radical and sustained economic reform effort will be necessary to prevent the productivity and competitiveness gap with OECD and high-grade peers from widening further. However, broad public and political support for a comprehensive, far-reaching and credible reform strategy necessary to raise the long-run potential growth rate of the economy has not been sought or secured.
The Negative Outlook reflects the risks associated with a further intensification of the euro zone financial crisis, as well possible fiscal slippage and to a lesser extent, potential for contingent liabilities to arise from the financial sector. A material deviation from the balanced budget target and failure to place government debt firmly on a downward path within the Outlook horizon (ie. within one to two years) would likely prompt a downgrade.
Weaker than forecast economic growth and downward revision to potential output would also place negative pressure on the rating.
A key relative strength of Italy versus several high-grade peers has been its resilient banking system that is not exposed to an excessively leveraged domestic private sector or to the euro zone 'crisis countries' of Greece, Ireland and Portugal. However, the banking sector's recent increased cost of funding will place further pressure on already strained profitability as will some worsening of asset quality in the wake of the weakening of the economy.
Italian banks also need to further raise their capital ratios to bring themselves in line with international peers as well as Basel III regulations and shore up confidence in wholesale markets. Of greater concern to Fitch is the small but no longer negligible tail risk that a further worsening of the euro zone debt crisis and volatility in the value of Italian government bonds will further erode confidence in the banking system. In such a scenario, concerns about the banks would start to weigh on the sovereign credit profile as a contingent liability and a vicious cycle of deteriorating sovereign and bank credit quality could emerge.
On a wide-range of economic and fiscal indicators Italy has underlying fundamentals consistent with a high investment-grade rating. Addressing the current crisis of confidence by meeting its fiscal targets and making progress on reforms necessary to enhance potential growth would stabilise the rating, as would resolution of the euro zone crisis.
