Financial instability has returned in the Eurozone, with Italy taking the center stage. Interest rates on Italian public bonds have been rearing up, peaking on June 8. Are worries well founded?
Italy’s fundamentals are better than you think. In December 2017 Gross Public Debt was 131.9% of GDP, down from 132.0% a year earlier. This means it has now stabilized… albeit at rather high levels by international standards… or are they?
Japan has both a higher (and growing) Debt/GDP ratio (198%) and a higher deficit ratio: 4.4% in 2017, when the Italian deficit was 1.9%, and will be 2.3% in 2018 if the government does nothing to curb it.
Considering Net debt instead does not change the broad picture.
Net debt trends are better in Italy than in Japan.
Net debt ratios in selected countries
Furthermore rising inflation in Europe (1.9% in May) is a long awaited good news for Italy’s Debt ratio (inflates denominator), and for its competitiveness (as Italy’s rising inflation rate at 1.1% is significantly lower than its EU trading partners).
American economists Carmen Reinhart, Stephen Cecchetti, and Desmond Lachman are among those who believe Italian finances are in worse shape than they appear. They cite: a Government Debt average maturity of “only” 7 years; a high level of bank “non-performing loans”, implying that “the likely cost of government support for the country's troubled banking system… could be large…”; and a high level of “central bank’s debts (Target2 balances)” that “must be added to those of the general government… increasing the ratio of public-sector debt to GDP by 26%”, “to 160%”.
However, the average maturity of the Italian debt is longer now than in any of the past 6 year; is not substantially different from that of Belgium, France, Portugal, Spain; and is markedly higher than in Canada, Finland, Sweden and the US.
NPLs (as a share of total loans) have come down to 11.1% in 2017 from 16.8% in 2015, and according to the ECB they are now lower in Italy than in countries such as Portugal (16.6%) and Ireland (11.2%). Here is what 5 major banks did last year:
All Italian banks are making further progress this year, by selling or winding down loans. They are very unlikely to become a liability for public finances.
As for Target2 balances, it is surprising how often they are misunderstood. For example Carmen Reinhart’s adds Target2 balance to gross public debt (as in the graph below) to derive the "true" Italian debt ratio. This is a serious conceptual mistake.
Target2 is a double entry accounting system where a new debt/liability (-) is always matched by a new and equivalent credit/asset (+). This can be seen in the Bank of Italy’s (BI) balance. When there is capital flight towards Germany, Italian commercial banks loose reserves to the Bank of Italy [BI: +100 (+reserves), -100 (+debt to the Bundesbank)], then restore their reserves by providing in return collateral (Gov’ bonds) to the Bank of Italy (BI: -100 (-reserves), +100 (+Gov’ bonds)]. The Bank of Italy ends up with [BI: +100 (+Government bonds), -100 (+debt to the Bundesbank)]. Thus the public sector net debt has not increased. With Target2, central banks only facilitate transactions among private agents. Ultimately, net credits and debts can be traced up to these agents. So what is important is to establish whether the Italian private sector is accumulating debts at an unsustainable pace. Is it?
In fact Italy has a trade surplus (2.8% of GDP), which implies that the Net International Investment Position is improving: it was -28% of GDP in 2011 but is almost turning positive (-6.7% in 2017).
If Italian fundamentals are at least no worse than Japanese, why are Italian bond prices unstable whereas Japanese aren’t? You may think: “It’s the economic policies, stupid!” Let me tell you: not so fast! Like Italy, Japan is ruled by a so-called “populist” government, who is applying unorthodox, growth-enhancing policies unimaginable in Italy (devaluation, huge fiscal expansion, etc.). The only relevant difference between the two countries (and of course the “fiscal space” in Japan is greater…) is the BoJ unambiguous role as a lender of last resort (RLOLR). In contrast, the ECB RLOLR is discretionary and subject to political majorities. When a member country diverges from EU neoliberal orthodoxy, markets start to price in the risk of an ECB withdrawal from its RLOLR. But, as Draghi once famously said, markets often “underestimate the amount of political capital that is being invested in the euro”. To assess whether market worries are valid, one has to check the political outlook.
In Italy, the “new” parties in power want to consolidate their recent predominance by proving that they are ‘fit’ to rule the country. That’s why they named two top economists – Giovanni Tria and Paolo Savona – as economic Ministers. Their goal is the same as ever: to reduce the Debt/Gdp ratio. And read my lips, they have a Plan in 3 steps that - although “Keynesian” in its logic – is palatable to the ECB:
- In 2019: change the budget composition and boost public investment, while keeping the deficit ratio at 2% of GDP;
- In 2020-21: accelerate growth and thus lower the debt ratio
- In 2022: use the new fiscal space, but no more, to implement a mildly expansionary fiscal policy, and keep some of the promises that ruling parties made to their constituencies (higher pensions and unemployment benefits, lower income taxes).
They know that in order to be successful (in bolstering growth) they need to generate positive expectations in both financial and real markets: thus an agreement with Europe is a key ingredient.
Europe too - Germany in particular – is signaling it wants to find an accommodation with Italy, even on possible improvements of the sick Eurozone architecture, in order to avoid unpleasant outcomes. And the “Draghi put” is still there (as Draghi may remind you one day if needed: beware shorts!). By the way, it is also understood that, in the unlikely event of an Italexit from the Eurozone (nobody really wants it, so why should it occur?), there would be no currency redenomination of Italian assets, but a serious anti-cyclical rigorous long term OMT agreement between Italy and the EU/ECB that would maintain financial stability, an integer EU, and a friendly cooperative climate in Europe. So markets are wrong in panicking and in raising Italian spreads, and by the end of the summer at the latest, when dust will settle, it will be clear that speculators have burned their fingers.
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