By Rebecca Wilder
Current bond market pricing implies a 6.17% yield on a 10-yr Italian government bond, or 430 basis points (%/100) over a like German government bond. I’d call this distressed levels for Italian debt, especially for an economy that is very likely contracting as we speak. Recently Mark Thoma pointed us to Kash Mansori’s article on “Italy’s future.” In the article, Kash points out that the [market] “is worried about Italian debt dynamics simply and purely because of skyrocketing interest rate expenses that the Italian government is now facing thanks to the eurozone debt crisis.”
I disagree and comment that his argument is circular in nature. See, the market is pricing in Italian solvency risk by way of a rising risk premium, which then portends more solvency risk as borrowing costs rise. But the market is not pricing in solvency risk because of the risk premium, rather the risk premium is rising due to (1) terrible growth dynamics in Italy, and (2) heightened political risk in Italy.
The PMI’s illustrate the likely recession in Italy – Roubini Global Economics is pointing to negative growth starting in Q3 2011. Those countries that issue debt in a foreign currency (since Italy does not own the euro rather it uses the euro) are subject to market constraints. And with negative growth comes higher government deficits; but the market is not satisfied with the high Italian public debt levels. Therefore, bond investors push for ‘fiscal discipline’ via a rising risk premium.
Another driver of the increasing Italian risk premium is political risk. You can see this in the spread between Italian 10yr bond yields and the Spanish 10yr bond yields, which has collapsed since the summer and is now trading at -70 bps. That means the Spanish sovereign is borrowing at a 10yr yield that is 70 bps cheap to Italy, where it used to pay a premium. Something idiosyncratic is going on with Italy.
The beginning of July corresponds with the outset of a political rift that brought the credibility of Berlusconi, as it pertains to Tremonti’s deficit targets, into question. Berlusconi now has only a slim majority in the Parliament, so passing future legislation tied to fiscal austerity is fraught with risk. Despite the fact that Italy is forecast to run a 2011 primary surplus (just one of two just G7 economies), the recessionary outlook requires added fiscal discipline and reform. To date, we’ve seen no such legislation, just promises on the reform front. Implementation risk is high in Italy, thus the risk premium rises.
So interest rates are rising as a consequence of the deteriorating economic fundamentals and questionable politics; that’s what the market is worried about. I do agree with Kash, though, that austerity is not the answer. But that’s how the Germans are rolling. This idea of fiscal austerity and gaining competitiveness is the new mantra for Europe - a mantra that will probably make or break the EA. I refer you to an excellent article by Martin Wolf that lays out the Euro area adjustment challenges clearly and succinctly.