6 June 2019

Talk of Italy being the site of Europe’s next debt crisis has increased since the country slid into a technical recession earlier this year. With a ruling populist coalition willing to flout EU spending rules, soaring public debt and deep-rooted economic issues, cause for concern is warranted. But is Italy really heading towards a full-blown debt crisis?

 

The fundamentals of the Italian economy are troubling

In its April survey, the OECD described the Italian economy as “weakening.” The country’s real GDP growth has been revised down to 0% this year, compared with 1.2% for the Eurozone as a whole. Its unemployment rate in March was 10.2%, compared with 7.7% for the currency bloc, and its public debt-to-GDP ratio stands at 132.2%, second only to Greece in the Eurozone. The economy has struggled to grow since the early 2000s and failed to rebound after the global financial and the European debt crises.

GDP per capita (USD, constant prices, 2010 PPPs)

Behind the headline figures, the story is no better. A host of supply-side issues, including a failure to invest in technology, a tradition of family-owned businesses limiting growth potential, general distrust in economic institutions, and unsound economic reforms have all contributed to Italy’s sluggish growth.

The European Central Bank’s fiscal sustainability report, published last week, made no secret of its concern for the Italian economy, stating, “A lack of fiscal discipline, the delay of fiscal and structural reforms, or even the reversal of past reforms, may reignite pressures on more vulnerable sovereigns. In fact, if weaker economic growth prospects were to be coupled with an interest rate shock stemming from a sovereign risk repricing, that would increase debt sustainability concerns in highly indebted countries and amplify the adverse feedback loop between debt levels and underlying macroeconomic dynamics.”

Italy’s economic policy meets every one of these concerns: the governing coalition is expected to run a budget deficit of 2% this year, and 3.5% next year, it has not addressed supply-side issues, and has proposed revoking pension reforms whilst Italy’s projected growth has slowed drastically. Adding insult to injury, Italian banks are over-burdened with a large share of non-performing loans, limiting their ability to lend.

 

For a debt crisis to be on the horizon, the cost of borrowing will need to increase significantly

Though the causes of debt crises are complex, when a country has a large amount of public debt its ability to stay solvent relies heavily on its access to affordable credit. A rapid increase in the cost of borrowing for the Italian government could increase its interest expenditure, which is already at the excessive rate of 3.7% of GDP, to unsustainable levels. If this were to happen, Italy could find itself at risk of a debt crisis. But how close is Italy to this prospect?

In 2017, economists at the OECD modelling government debt limits estimated that for Italy, a debt-to-GDP ratio of 180% (at current market rate of interest) would constitute the point at which spurs a “vicious cycle of loss of market confidence, rising interest rates on government debt, and difficulties to serve the debt, and eventually default or restructuring.” At present, Italy’s debt-to-GDP ratio (132.2%) is still some way from this limit. However, changes in macroeconomic conditions and the reaction of markets could potentially leave Italy vulnerable to spikes in the cost of borrowing.

 

Markets appear to have confidence in Italy for now

In light of recent gloomy data from the European Commission suggesting a slowdown in the Italian economy, previous forecasts that the country’s debt-to-GDP ratio would remain stable between late 2018 and 2020 can no longer be relied upon. Italy’s 10-year government bond yield, a key factor in a country’s access to credit, has increased to 2.5%. This signals that investors perceive lending to the government as riskier now than they have over the last five years. However, this yield suggests the markets are confident in the government’s ability to service its debt and will continue to lend. For context, during the high of the European debt crisis, Greece’s 10-year government bond reached a yield of 48%, whilst their Portuguese and Irish equivalents reached over 17% and 12% respectively according to Trading Economics.

Italian government 10-year bonds yield (2014-present)

Another reason why Italy is likely to be more resilient to changes in market sentiment is because much of its sovereign debt is held within Italy. Last year, 47% of Italy’s sovereign bonds were held by domestic banks and residents, compared with just 26.4% for France and 15.1% for Germany. Because residential investors are considered a more stable source of credit, the fact that a relatively high proportion of Italian sovereign debt is held in Italy makes the country’s public finances far more resilient than other countries highly dependent on international investors.

So long as Italy remains able to borrow on reasonable terms, it is highly unlikely it will experience a debt crisis. However, financial market sentiment can change rapidly and some commentators have suggested the market has failed to price in a shift towards populist politics.

 

A long-term trend towards populist fiscal policy could undermine this confidence

As mentioned earlier, Italy’s populist leaders have openly disparaged EU budget rules, pledging to continue with its spending projects, with Deputy Prime Minister Matteo Salvini describing EU spending rules as “defeated by evidence, history and the popular vote.” As John Plender of the Financial Times writes, “The difficulty for investors lies in the way Mr Salvini has discovered that picking a fight with EU fiscal rules plays brilliantly with Italian voters.” What is yet to be determined is whether Italian populists are simply using anti-EU rhetoric for political gain, or whether we are witnessing a shift towards sustained expansionary fiscal policy, at a time when Italy’s public debt is already worryingly large. Either way, with Salvini’s League increasing its seats from five to 28 in the recent European Parliament elections, his anti-EU rhetoric appears to have struck a chord with the Italian electorate.