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2018-05-23Macro `n Cheese

A Grim Outlook for Italy’s Debt Ratio

This week Roger steps aside so Sebastian, an esteemed Macrobond intern, can run his forecast model on what seems to be the topic on everybody’s lips - Italy. He takes a look at the recent developments there, and what the new administration might mean for the indebtedness of their struggling economy.

The Political Situation

The Italian elections held in early March left two big winners, the Five Star Movement and the League. Five-star gained 32% of the votes and the League got 18% outstripping its center-right coalition partner Forza Italy! As the center-right coalition gained 37% of the votes, a coalition between them and Five-star seemed the probable way forward.

Since the election, uncertainty has characterized the political situation as several rounds of coalition talks failed to produce a government. The president, Sergio Mattarella, deemed the talks a futile endeavor and was ready to appoint a neutral caretaker government. However, soon after, the seemingly impossible union started finding common ground.

On Monday, the parties might have resolved one of their most contentious points, their choice of prime minister. Giuseppe Conte, a lawyer and university professor with limited political experience is the front runner. While Mr. Conte has yet to be officially endorsed by the parties and accepted by Mr. Mattarella, it seems probable that an anti-establishment government will wield power in Europe’s 4th largest economy. The recent development has rattled markets and reinforced worries about the stability of the monetary union and Italy’s struggling economy.

Italy & the Euro

Italy has been part of the EMU since 1999. The economy has showed lackluster growth compared to other euro countries. This can partly be explained by low productivity growth.

 

The Italian economy was hit hard by the 2008 financial crisis and the subsequent recovery has been slow. With debt to GDP quickly rising after the crisis, austerity measures were introduced by the government. The weak economy and its impact on households has, together with the recent migrant crisis, helped pave the way for the anti-establishment parties.

 

Despite the austerity measures, the debt continued to increase before stabilizing at a debt to GDP ratio of between 130% and 135%. While the debt burden has been stable at these levels over the past four years, it shows no sign of decreasing. Because Italy is the second most indebted country in the Eurozone after Greece and the third largest economy in the monetary union, this is of course cause for concern in Brussels. Should the recent European economic upswing turn sour, a member the size of Italy, with the world’s fourth largest government debt, poses a risk for the stability of the union. The EU would like to see austerity measures and fiscal discipline in accordance with the fiscal rules to bring the debt to a more manageable level. Early interventions from EU-countries and bodies have so far been met with disdain and brushed aside by both Salvini and di Maio.

 

Fiscal policy

Both the League and the Five Star Movement went to the polls promising reforms characterized by anything but fiscal restraint. On Friday, the parties published a coalition agreement with policy pledges. Notable and expensive promises are Five-star’s flagship policy, the introduction of a universal basic income, as well as the League’s ditto, a flat tax with two brackets at 15 and 20 percent. Estimates for what the policies might cost if implemented vary significantly. For the universal basic income, representatives from Five-star claim the reform would cost 17 billion Euro. Public policy analysts have gone out with estimates of around 29 billion Euro. The tax plan is thought to be even more expensive, with estimates ranging from 50 billion Euro to 85 billion Euro.


In conjunction with plans to get rid of the unpopular pension reform of 2011 (the Fornero reforms), the Italian deficit would increase substantially from today’s 2.4% exceeding the EU maximum of 3%. While it is not likely that all pledges are enforced to their full extent, this is an unwelcome development for Brussels. The previous administration was aiming to reduce the overall budget deficit to 1.8% of GDP this year. For the new parties, breaking fiscally-lavish campaign promises citing EU rules as the reason would probably not sit well with the general populous or voters, as the skepticism toward EU institutions is strong.

 

Market reaction

It is hardly a recent revelation that markets have shown a significant resistance and a “glass half full” mentality in the face of political upsets over the past few years. The Italian general election was no exception and markets took the election results in its stride. Both the CDS spread and the spread between Italian bonds and bunds fell to comparably modest levels after slight upsets following the election. This cool attitude remained intact, much due to the prospect of a caretaker government. When a coalition became more probable the bond spread started to increase but the strong market reactions came on Monday when the coalition agreement had been published. The bond spread spiked as the risk premium was revised. The stock market was also affected, especially the banking sector which is still harboring a substantial amount of bad loans. Also on Monday, Fitch, the credit agency, said that the new coalition in Italy posed a risk to Italy’s credit profile. Italy was downgraded by Fitch to BBB last year with political risk being one of the main reasons. As this risk has now materialized, fiscal loosening and deteriorating confidence could lead to further downgrades.

 
 

Economic Prospects

The market volatility over the past few days shows that investors are not indifferent to the political risk circling back to the government debt situation. An increased real interest rate as the result of a higher risk premium would make it tougher to service debt. This would be especially problematic if GDP growth started to fall.


At the beginning of the year there were high hopes for European growth to finally pick up having trailed that of the US for years. Of course, that is quite a sweeping statement considering the divergence in growth within the Euro area, with our country of interest being one of those that are worse off. In recent years, Italy’s GDP growth has started to increase, albeit from arguably low levels, and before the election the Bank of Italy predicted a growth of 1.5% in 2018.


Unfortunately, while unorthodox monetary policy obscures the view, there has been some time since the financial crisis and an economic slowdown on the back of rising rates would not come as a big surprise at this point.


The last ECB press conference on the 26th of April was conducted with the backdrop of disappointing European data. PMI numbers for large European countries came in weaker than expected sowing fear in markets that the euro area economic expansion would come to a swift, and for many countries premature, end. This trend is ongoing as the latest PMI numbers published on Tuesday also came in below expectations. Depending on the underlying growth in the Eurozone going forward, the ECB stimulus program might come to an end later this year. This might bring problems for Italy as the tightening of policy would mean their substantial debt burden is less subsidized.

 

Impact on Debt

In July last year the IMF published the Article IV consultation of Italy, a report containing predictions for the economy. The forecasts are based on the assumption that structural reforms were to be implemented, continued growth and responsible fiscal policy. With the benefit of hindsight, we would like to make our own estimates.


When studying government-debt dynamics, components of importance are the difference between real interest rates and GDP growth and the primary budget balance. The latter is defined as government income less its spending, excluding interest paid on government debt. In an attempt to model trajectory of the debt burden give forecasts of the above parameters, the change in Debt/GDP is defined as:

Δdt = (i − ∏  − g)dt−1 − b

ddebt/GDP,  i = 10y Italian bond, ∏ = GDP deflator,  g = GDP growth,  b = Primary surplus/GDP   
 

After years of austerity measures there is little reason to believe that there would be a massive public uproar if the already abstract debt levels notched up a few steps. The new government will surely meet strong resistance against their policy proposals from the EU. As such, they might have exaggerated their policy goals in the coalition agreement to be able to soften their stance later. In these two scenarios the simplified model estimates the debt to GDP for varying commitments in fiscal policy and for changes in economic growth.


Assuming little to no fiscal restraint and that policy measures to a value of 100 billion Euro are implemented. Such a move would wipe out the primary surplus and Italy would end up with a primary deficit of about 2.1% of GDP. The markets would most likely deem this a risky move and borrowing costs are thus increased by 30 bps each year until 2022. The somewhat optimistic GDP growth rate as in the IMF example is kept in scenario 1.


In scenario 2, only half of the 100 billion Euro increase in expenditures materialize in actual policy. Markets are slightly more lenient, and Italy experiences an annual increase in rates of 20 bps over the period. However, it turns out that weak PMI data was the writing on the wall and despite the new government’s efforts, GDP growth decreases by 25 bps annually over the period. In both scenarios inflation is assumed to remain stable.

Note: The divergence between the scenarios highlights the sensitivity of such analysis and the difficulty of forecasting. Macrobond users may download the document and add their own forecast. I suggest downloading this document as it does not contain the redundant code for adding three forecasts in one document.
 

What it all comes down to

A number of diverging outcomes are of course possible, and the scenarios described above are only indicative. The main takeaway is nonetheless that in less than five years Italy’s debt ratio could easily be ten percentage points higher than what has been generally acknowledged. Worse still, we have not assumed any major moves in interest rates which would be a game-changer at Italy’s debt levels.


Therefore, ECB remains Italy’s foremost ally, but we deem it highly unlikely that ECB can continue to support the Italian government bond market should a new Italian government take decisions that run counter to agreed EU rules and policies. The fate of Italy is therefore not in the hands of Conte, nor Salvino or di Maio. It is not even in the hands of the President, Mattarella. The man holding Italy’s fate in his hands is Mario Draghi.

 

Thank you to Sebastian Svensson Bromert for his contribution to this week's Macro n Cheese. 

 

 

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