Italian bond yields have been on a dangerous path since late summer with yields on 10-year benchmark securities increasing from just under 5% in mid-August to 7.45% early in the trading day on November 9th before falling back to 7.25% at day end.
Italy has a projected 2011 budget deficit of 3.9% after running a deficit of 4.6% in 2010, leaving year-end 2011 debt to GDP at an estimated 120.6%. The country also suffered from a current account deficit of about 3.4% in 2010 and based on a slight worsening through the first seven months of 2011 versus the prior year it is likely that the deficit will tick up to about 3.7% in 2011, in my view. Taken together, these facts suggest that Italy is dependent on external funding to support its public finances.
In looking at the sustainability of Italian public deficits, creditors are likely paying close attention to the economic performance of Italy coming out of the financial crisis. In evaluating the sustainability of public debt, nominal GDP is important since debts are compared current dollar GDP and are paid in nominal, not real terms. However, looking at real GDP is also important since it gives a sense of the underlying performance of the economy.
Coming out the recession, the first quarter of positive GDP growth for Italy was 3Q09 when the country grew at a 2.3% nominal and 1.3% real quarterly annualized growth rate. Since that time, average quarterly annualized nominal GDP has averaged 1.9% while real GDP has averaged 1.1%. In the most recently reported quarter 2Q11, nominal and real GDP were both up 1.4%. Public debt is therefore growing at a greater rate than the nominal economy and the ECB expects the overall European economy to enter a recession further exasperating the differential between GDP and public debt.
The Italian government has responded with a series of measures aimed at increasing revenue and decreasing expenditures. Even prior to austerity measures currently under debate, the government introduced a series of new taxes, including a surtax on the energy sector, a one percentage point increase in VAT, new taxes on financial assets and new gaming taxes amongst others which collectively are projected to raise EUR 21 billion in 2012 and greater amounts in 2013-14. On the expenditure side, reductions in public spending are targeted at about EUR 8 billion in 2012 with similar additional decreases in 2013-14.
Taken together, these measures are predicted to decrease the budget deficit to 1.6% in 2012 with balance being achieved in 2013. However, as Greece, Portugal, Ireland and Spain have shown, austerity measures have a tendency to produce weak economic growth, so while Italy expects these measures to improve its position, the actual improvement will likely be less than anticipated.
Turning back to Italy’s current public funding crisis, many commentators paint 7% as the level at which Italy would begin needing some type of external support. Once crossing this level Ireland, Portugal and Greece saw yields deteriorate rapidly before accessing external support. In a bit of irony, 19% of that external support is pledged from Italy, opening up deep questions about the sustainability of support for smaller European countries in distress not to mention questioning where Italy will get support from itself. What the rise in yields certainly means is that Italy has lost the confidence of external private investors – which as evidenced by its current account position, it certainly needs.
While it is possible that the market turns around, given the experience in other stressed eurozone countries, the magnitude of Italy’s debt and its continued borrowing needs, the likelihood of a new recession and the fact that the prior eurozone bailouts are reliant on Italy’s borrowing capacity, it seems a remote possibility that private lenders will materially change their opinions on Italy’s borrowing capacity. Add to this the fact that even today’s bond yields exist only in part due to ECB support and the situation seems increasingly dire.
The question now turns to how the present situation will develop over time. Italy and the European Community, including the eurozone have options. Italy could embark on a very serious structural reform whereby it enacted policies and budgetary decisions aimed at increasing international competitiveness. It is questionable whether even the most ambitious of plans would soothe investors because such plans would lead to a significant short-term contraction in the economy. From a political perspective, this option does not seem to be on the table.
Another option is to muddle through. Assuming rates stabilize around 8-10%, it is likely that Italy could continue to borrow such that its budget deficit did not increase much over 5%, at least for several years until interest costs caught up with them. A gradual reduction in external imbalances would increase Italy’s ability to fund itself from domestic markets, which together with continued levels of ECB funding could avert an immediate crisis. How the situation would materialize three to five years from now would continue to be a problem but there are many examples in history of countries muddling through with high debt levels for many decades; however, interest rates would need to stabilize soon for this scenario to work.
Public intervention is the scenario most often discussed as a solution to the current problem and indeed, it is likely necessary, if not in strict economic terms than in political ones. Italy does not have the political will for deep reforms and global policy makers see a stagnant Italy that takes a decade or more to resolve through market forces as unacceptable. Furthermore it is far from clear that private investors, even domestic will continue to fund Italy even at interest rates several points higher than today.
I believe public stakeholders will absolutely wait to see where the markets go from here and will not intervene before the crisis becomes greater for a myriad of reasons. First, it will take a real and visible crisis for electorates to bow to the costs of an intervention. Second, policymakers will want firm proof that muddling through is not an option – at 7.25% the 10-year Italian yield is not there yet. Third, the authorities would benefit from seeing a crisis develop further if commodity prices receded thus reducing inflationary pressures – similar to 2008, energy prices are very high and a reduction would prove a boon to not only economic growth but current account deficits. Fourth, a consensus must be built on how to intervene – will it be through the ECB, the German state, the IMF or through an enlarged role of the federal eurozone apparatus with dedicated tax revenues. Lastly, will all the countries in the eurozone continue to be in the eurozone in the future?
That last question is perhaps the biggest stumbling block because simply ejecting Greece at this point may not be enough to solve the problem and the environment does not seem ripe for a more significant restructuring. However, a year ago ejecting Greece was not on the table, and failing to do so may have led to the current situation. The eurozone therefore finds itself in a trap where it cannot get ahead the problems it is facing – in trying to defend Italy will it end up sacrificing itself? A recent Reuters article shows that some discussion has taken place about a radical restructuring of the eurozone. In order for this or any other solution to become politically feasible the crisis will need to become worse, but so much worse that the solution no longer solves the problem. Finding this equilibrium is policymaker’s most pressing task.
- Bank of Italy: Economic Bulletin No. 62, October 2011 (Pg. 39)
- Ibid. (Pg. 26)
- Reuters: ECB surprises with rate cut, sees "mild recession"
- Bank of Italy: Economic Bulletin No. 62, October 2011 (Pg. 37)
- Ibid. (Pg. 39)
- Reuters: French, Germans explore idea of core euro zone
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.