The Markets’ Favorable Response to Italy’s Major Steps Ahead
Since December, Premier Mario Monti of Italy has taken several steps that appear to have improved market confidence in the country’s ability to repay its debt, thereby raising hopes that Italy can recover from its financial and economic crisis. Parliamentary approval of an additional public finance adjustment package for 2012–14 in December (the third since July) was the first sign of the bold leadership of his Government’s new policy course. A few days ago, a measure to increase competition in various sectors of the Italian economy followed.
Markets are starting to realize that something has changed. The spread between ten-year Italian government bonds (BTP) and German government (Bund) rates recorded 373.5 basis points on February 2, 2012 the lowest since early December.
Nonetheless, the degree of uncertainty over the course of the sovereign debt crisis is still exceptional, and is reflected also in interest rates, banks’ balance sheets, and lending volumes. Funding difficulties might involve a tightening of lending policies, hampering the spending capacity of households and firms. These difficulties are being mitigated by the euro system’s aggressive interventions in support of the banking industry.
On the optimistic side, a restored confidence in Italy’s ability to repay its debt would reduce the cost of credit to households and firms. It is worth keeping in mind, though, that interest rates and credit trends also depend on developments in the international financial markets and decisions taken at the European level.
The current economic and financial situation, with its potential impact on financial stabilization, is assessed in the latest Economic Bulletin of the Bank of Italy with the help of a rigorous analytical exercise. A baseline scenario is presented, based on the assumption that the interest rates on government securities reflect the shape of the yield curve at the time of the exercise (the second week of January). The scenario includes a spread between ten-year BTP and Bund rates of about 500 basis points throughout 2012–13. In this context Italy’s GDP is projected to contract by 1.5 percent this year; it would rebound in 2013, but on a year-average basis, the growth rate would nonetheless be nil.
A second scenario is presented, based on a partial normalization of conditions in the financial and credit markets, owing to the restoration of investors’ confidence in Italy’s debt-repayment ability and to the implementation of the measures decided at the European level. In this context, starting in the first quarter of 2012, the yield on ten-year BTPs is assumed to be 200 basis points lower than that embodied in the first scenario. This puts them at around last summer’s levels. As a consequence, banks’ funding difficulties are reduced and the credit supply strains that emerged in the second half of 2011 are attenuated. Restored confidence improves the outlook quite substantially. Indeed, economic activity would contract significantly only in the first quarter of 2012 in this scenario, and would stabilize in the latter part of the year and return to expansion in 2013. On average, GDP declines by 1.2 percent in 2012 and increases by 0.8 percent in 2013. This puts GDP in 2013 more than 1 percentage point higher than in the baseline scenario.
The Bank of Italy’s bulletin points out that in both scenarios the very large public finance adjustments enacted from July to December leads in 2013 to a primary surplus of about 5 percent of GDP and to a reduction in the debt-to-GDP ratio. The reduction is larger in the second scenario, however. In 2013 the ratio comes back down to the level recorded in 2010. Moreover, in that scenario a budget balance is approximately achieved.
The Economic Bulletin stresses that the degree of uncertainty surrounding the medium-term outlook for the Italian economy is extraordinarily high and is closely connected to the euro area sovereign debt crisis. Moreover, serious additional downside risks for economic activity cannot be excluded. They may arise from a further deterioration in confidence in the European governments’ ability to cope with the debt crisis or from a more pronounced world economic slowdown.
However, the bulletin indicates that a boost to growth could come from the approval of structural measures for economic growth by the Government. Such measures were not incorporated into the forecast. As mentioned at the beginning of this article, a first set of measures, focusing on competition, has already been approved a few days after the publication of the bulletin.
In conclusion, the second scenario in the bulletin was originally meant for illustrative purposes, “to evaluate the sensitivity of the baseline forecast to financial and credit market developments.” As spreads are getting near to those assumed in that scenario, it may well instead become the most likely projection, a focus point for expectations and markets.