Too big to fail and too big to bail?

In terms of the scale of public debt, Italy has been the elephant in Europe’s room for a long time. The Italian national debt is now €2.5tn which is 132% of Italy’s GDP and making Italy highly vulnerable to economic shocks and loss of investor confidence. While Greece still holds the title of the most indebted nation in the Eurozone, Italy is not far behind. But it is Italy’s economic size that makes it both too big to fail and too big to bail.

Despite this fragility, past governments have kept the show on the road and contained the problem. Now, the newly elected populist coalition government of the Northern League, ‘Lega’, and the Five Star Movement (M5S) are threatening to follow through on their manifesto promises to cut taxes and increase spending on unemployment benefits, introducing a guaranteed basic income to poor families of €780, lower retirement ages and scrap VAT increases.

The government’s budget was published in late September with a target deficit of 2.4% of GDP in order to pay for their campaign promises. The EU wants a deficit target of under 2% and has told Rome to revise their budget. This is an unprecedented move from the EU to a member state. The EU has the right to reject a Eurozone member’s budget and impose fines if ignored. The proposed budget deficit of 2.4% falls short of the 3% default limit currently allowed under EU rules but it is Italy’s high level of debt at €2.5tn that alarms the EU. Italy now pays €93bn per year in interest payments which is more than they invest into education.

Economic forecasts are predicting that the Italian deficit will hit 2.9% of GDP in 2019 and 3.1% in 2020. The Italian economy is flat lining and the stand-off between Rome and Brussels is having dangerous implications for bond yields and credit. The northern block of EU countries are seeking debt restructuring and structural reforms prior to any further assistance.

For Italy to service this debt it must sell government bonds to investors. The interest rates on Italian 10-year bonds rose to 3.78%, as compared to 0.44% yields on German 10-year bonds, indicating that investors are concerned by the political risks and fragile public finances. Higher bond yields mean that Italy will be paying higher rates of interest to service its public finances as they are renewed. Fortunately, the average renewal rate for Italian debt is seven years. Bond yields have risen in other Eurozone countries with high public finance debt such as Spain, Portugal and France. The Italian situation is one of the pressures the ECB has in rising interest rates.

Markets were relieved that the M5S Lega coalition has only partially followed through on its full manifesto pledges. The cost of which would have taken the deficit to 5.5% of GDP. For this reason, investors are likely to see Italian bond prices as attractive at the current yield of 3.25%. Analysts are expecting Italian debt as a percentage of GDP to fall in 2019 and spreads are likely to narrow. For now, the issues of debt, structural reform, and productivity can be deferred but no one should underestimate the determination of the M5S Lega government desire to implement their budget. If the difference between German and Italian bond rates rises over 4%, this could cause a credit squeeze that hits the balance sheets of European banks and requires state intervention. The exposure that French banks alone have to Italian debt amounts to 11% of French GDP. The stakes are high for all involved and the markets will discipline weakness.

If the M5S Lega sticks to their tax and spending plans the EU may then activate its ‘excessive deficit procedure’. They will find this difficult as the political impact of the EU fining a net contributor member nation would be historic. However, the standoff has been defused when the Deputy Prime Minister Luigi Di Maio stated that Rome may be willing to reduce the deficit target to 2.2% or even down to the EU target of 2%. This news prompted European stock markets to rise and bond spreads to fall from 3.34% to 2.91%. Italian 10-year bond yields stand at 3.25% while the exact German equivalent offers 0.34%.

ECB’s €30bn per month QE programme is due to come to an end in December but as Eurozone economies are slowing the programme may continue into 2019. We shall wait to see but what is clear is that the Eurozone still needs the support of QE to depress the cost of borrowing.

It is Italy’s economic size that makes it both too big to fail and too big to bail.

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