Italy - the Sick Patient of Europe

In 2011, at the height of the sovereign debt crisis, the yield spread on Italian Government bonds was 501 basis points as investors fled to the safety of German bunds. The main policy adopted was QE to help stimulate demand in the euro bond market and act as a lender of last resort so that Governments, including Italy, could roll over the national debt without having to default.

Mario Draghi, president of ECB and leading Italian economist, plans to wean financial markets off of the 2.5 trillion QE programme by December this year. This withdrawal of liquidity from the demand side of the bond markets is called quantitative tightening and it is a feature of many central banks world-wide as they reduce their influence in markets. The Federal Reserve refer to it as normalising the market by allowing bonds on their balance sheet to mature without replacing them.

Most of the asset purchases have been on Eurozone government bonds, hence there is expected to be weaker demand in 2019. Italy is the 3rd largest economy within the Eurozone and a net contributor. However, it is heavily reliant on the ECB as a major buyer of its bond; it is the largest single holder of Italian debt with over €400 billion on its balance sheet. The possibility of the ECB cutting back its QE program has long been priced into the market. The yield spread, at the start of 2018, of 140 basis points supports this notion.

The yield spread increased significantly in Q2 2018 due to the new coalition of the populist government between the League and the 5-star movement which began on 1st June 2018. They have pursued fiscal policy which does not put debt levels on a sustainable downwards path as many expected, with the debt to GDP ratio around 130%. The average across the EU is 86%. Government want to run a structural budget deficit to stimulate the economy, with the deficit increasing to 3.1% of GDP in 2020. This is above the 3% limit set by the ECB who believe in expansionary fiscal contraction where reducing government spending will allow for the private sector to grow as resources are not being crowded out by the government.

It was agreed, with the previous Government in Italy that the budget deficit would be 1.8% in 2019. However, under the new proposal that is set to rise to 2.4%. A key element of the budget is that the retirement age will fall from 65, which is the status que across the EU, to 62. This is a significant problem because the “baby boom” generation are now retiring hence pensions are becoming a strain on public expenditure. This measure will cost €7 billion a year and will mean that an extra 400,000 people will be able to retire, according to the Financial Times. This will decrease the number of people in the work force, meaning GDP could fall. In addition, Italy’s population is due to decrease, with an ageing population the burden will be on a diminishing number of working age people. This deadweight debt is worrying for investors because it will not improve Italy’s ability to repay in the future. Consequently, a higher return is demanded increasing the cost of borrowing.

The reaction of the credit ratings agencies to this policy is important. Moody’s rating is currently hovering just above junk at baa3 and S&P has a rating of BBB with a negative outlook. There would be significant implications if Moody’s downgrades Italy further as many investment funds are not allowed to hold speculative grade bonds hence it would result in a large sell off and yields could increase above the 2011 level. This will become a reality if the budget standoff does not lead to the Italian Government backing down. Indeed, structural problems, such as declining manufacturing, an ineffective education system and increasing trade union participation are abundant in Italy but now is not the time for significant expansionary fiscal policy. A rating downgrade to speculative could be the final straw in the crisis as investors would sell off the Italian bonds very quickly. Moody’s does not currently have a negative outlook on Italy so for now the risk of a further downgrade is negligible.

Italy has had a higher gradient yield curve in recent months. This steepening was mainly caused by the large sell off of 2-4 years notes after the coalition, resulting in a large increase in yields on the notes. There was uncertainty around the new budget proposal as investors were concerned about Italy’s ability to repay in the medium term. This forced the Italian treasury to buy back some of the debt to provide investors with liquidity and prevent the sudden downwards price movement triggering stop-loss ceilings which sell a bond if the yield increases above a certain rate, which would exacerbate the price fall further. Nearly €1 billion of government debt with 2-4 years maturity were bought back. The graph below shows that the 2-4 maturity notes increased significantly over the last 6 months, which dragged up the rest of the yield curve.

So where next for Italy? An estimated €260 billion will need to be raised next year. €60 billion to support the deficit and €200 billion to refinance existing paper that is due to mature. With the ECB rolling back on its purchasing and Italian banks already heavily exposed to the debt, it remains to be seen who will step in and buy the bonds. Foreign investors are staying away amid the market jitters of the past six months. This has seen talks in Italy of encouraging Italian citizens to buy the bonds by offering tax incentives. The policy could help to stimulate demand for the Italian bond, but it also shows the desperation within the Populist Government of Italy. Also, the sustained wave of selling that Italy’s bond market has faced since investors first become concerned about the country’s political position, came as the Italian government turned to domestic households to finance its deficit. A change in political stance in the current government would go some way to reversing these effects.

With Mario Draghi set to step down next year, it will be fascinating to see how his successor will handle dealing with Germany’s demand of reducing the crisis-era stimulus and Italy’s fear of being crippled without the monetary support. Investors are not very confident that the Italian Government can resolve the escalating situation and it is up to them to create a sustainable policy solution which does not involve defaults on any bonds. Italy has not officially had a budget surplus since the 1960s, but they would currently be considered to have a surplus if interest payments were removed from the budget; they spend 3.7% of GDP on interest payments. The current Italian administration is suffering from the myopic nature of previous Governments and with no end in sight there seems to be no cure this country can stomach and there does not seem to be any solution within reach.