Italy's Underlying—and Underappreciated—Strengths
Yields on the benchmark 10-year Italian government bonds surged to 7.4 percent yesterday, the highest level since the adoption of the euro more than 10 years ago. The situation has unsettled markets around the world, where investors are noting that similar sovereign debt rate levels drove Greece, Ireland, and Portugal to seek bailouts.
The question is whether the onerous borrowing conditions imposed by the markets on Italy are justified by the conditions of the Italian economy and whether these higher rates will make it impossible for Italy to stabilize and achieve fiscal and economic stability.
In my view, the answer is no to both questions.
On the first question, market pressure largely reflects the uncertainties surrounding the Italian political scenario. A recent analysis undertaken by Tito Boeri, professor of economics at Bocconi University in Milan, suggests that this factor has been responsible for the equivalent of 110 basis points in the differential between Spanish and Italian 10-year bond yields in the period July–September 2011. According to such analysis, since the two countries have both been hit by the same external shocks and both benefited from support from the European Central Bank (ECB), the difference in their relative position must be ascribed to political factors.
Such effects have overwhelmed more rational considerations, such as the many strengths of the Italian economy, including its cautious fiscal policy in recent years, the sound financial situation of households and firms, the low level of foreign debt, the absence of imbalances in the real estate sector, and the soundness of the banking system.
According to the most recent issue of the Fiscal Monitor of the International Monetary Fund (IMF), Italy and Germany will be the only countries where the debt-to-GDP ratio will not rise in the next two years. The Financial Stability Report recently issued by the Bank of Italy is helpful for a better assessment of the sustainability of Italian public finances. For example, the Report recalls that, according to the European Commission's estimates, the improvement in the primary budget balance needed to stabilize the debt-to-GDP ratio is 2.3 percentage points for Italy, compared to 6.4 points for the euro area as a whole, and 9.6 for the United Kingdom. A similar indicator calculated by the IMF confirms Italy's favorable position with respect to the United States and Japan as well. Similar results are obtained using an indicator recently developed by the Commission to take into account additional information concerning a country's vulnerability to macroeconomic risks.
The analysis of a country's conditions also entails an assessment of factors not specifically related to public finances, including the debt exposure of the private sector and net international investment position. In Italy, the total financial debt of households and nonfinancial firms amounted to 126 percent of GDP at the end of 2010, compared with 168 percent in the euro area, 166 percent in the United States, and more than 200 percent in the United Kingdom.
In Italy the share of public debt held by nonresidents is 42 percent, against a euro area average of 52 percent. Finally, Italy's net international investment debtor position is equal to 24 percent of GDP, which is higher than the average for the euro area (13 percent) but well below the figures for Portugal (107 percent), Greece (96 percent), Ireland (91 percent), and Spain (89 percent).
The answer to the second question—whether Italy can achieve stability even with higher interest rates on its debt—is consistent with the above and again relies on the analysis carried out in the Stability Report. Indeed, simulations taking the government's latest estimates as a baseline scenario clearly show that even if the interest rates on new issues increase significantly, the debt-to-GDP ratio would still decline or stabilize. According to official estimates, which incorporate the fiscal consolidation measures approved during the summer and the rise in interest rates through September, the debt-to-GDP ratio would be reduced from 120.6 percent in 2011 to 112.6 percent in 2014.
To evaluate the effects of a shock to the cost of financing public debt, starting from January 2012 the yields on all new issues of government bonds are assumed to increase by 2.5 percentage points over the baseline, equivalent to a rate of 8 percent. In an even more unfavorable scenario, the increase in yields is assumed to flatten GDP growth in the three-year period 2012–14; this hypothesis is consistent with the available estimates regarding the economic effects of an increase in spreads. Both scenarios use standard budget elasticities with respect to changes in the macroeconomic picture. In particular, a fall of one percentage point in growth reduces the primary surplus by 0.5 percentage points of GDP; an increase of one percentage point in interest rates increases outlays by 0.2 percent of GDP in the first year, 0.4 percent in the second, and 0.5 percent in the third.1
The results of the two simulation exercises indicate that in the first of these unfavorable scenarios, the debt-to-GDP ratio would still fall to 115.5 percent in 2014. In the second, despite the prolonged stagnation of the real economy, Italian public debt would stabilize at just over 120 percent of GDP.
The quantitative exercise depicted above carries the crucial assumption that all fiscal consolidation measures approved during the summer will be fully implemented. The implication is that if a balanced budget is pursued, even such high rates as 8 percent are not incompatible with a debt-to-GDP reduction.
It is worth adding that the implementation of the fiscal package may greatly benefit if it is included within an organic framework of structural measures. While the implementation of such measures may require some time, it is crucial that they start as soon as possible to provide the markets with positive signals lacking in recent months.
1. The gradual nature of the impact reflects the long average residual maturity of outstanding government securities (over 7 years) and the limited proportion of securities at variable rates.