Italy’s debt problem is still the ‘elephant in the room’

Italy’s debt stands at a record 132% of its GDP, higher than every nation in the eurozone except for Greece.

But those following the coverage of this weekend’s general election in Italy would be forgiven for thinking that debt sustainability is no longer a point of concern for the country.

“The issues around public finance and achieving economic growth have been put aside during the election campaign, which is very disappointing,” said Lorenzo Codogno, founder at LC Macro Advisors and former chief economist in the Italian Treasury.

Few can take seriously the economic policies that have been touted by the prospective candidates.

Within Italy’s right-wing coalition, for example, Silvio Berlusconi’s Forza Italia wants to impose a 23% flat rate of tax and the Northern League wants it at 15% — either of which would be hugely costly and difficult to implement.

The Democratic Party, meanwhile, which is effectively the government leading into the election, has different economic targets in its electoral manifesto to the ones it’s pursuing while already in power.

But that won’t stop investors from asking difficult questions about Italy’s debt-to-GDP ratio, which could face further scrutiny as interest rates rise in the coming years.

“The debt problem hasn’t been ignored by the market,” said a chief economist at a European bank. “The impact the election could have on government policy, and what that would mean for the debt numbers, is always the elephant in the room.”

Even the country’s central bankers have started to weigh in on the debate on Italy’s economic policy.

Fabio Panetta, deputy governor of the Bank of Italy, said in a recent speech in London that “the opportunity offered by the ongoing [economic] recovery must be seized to reduce the debt-to-GDP ratio with increasing determination”.

But the March 4 vote is not expected to deliver a strong and reform-heavy government. By most estimates, Italy will end up with a hung parliament or some form of grand coalition between the different competing parties, which will operate with a weak political mandate.

This not the sort of scenario in which politicians would be able to fulfil their rather ambitious pre-election promises on debt reduction — 30% in five years according to Forza Italia and 40% in 10 years according to the Five Star Movement.

“Italy is not that far away from achieving a sustainable, steady decline in the debt-to-GDP ratio,” said Codogno. “But you still need about 1.5% of fiscal consolidation, which is difficult and politically demanding.” 

Codogno says that Italy is simply not in the right place to confront some of these issues properly.

A parliamentary commission of inquiry that was set up in September 2017 to look into recent problems within the Italian banking sector published a report this year in which it reintroduced a number of findings from a controversial Italian court investigation in Trani.

The Trani court was probing for market manipulation following the European sovereign debt crisis in 2011, when concerns about debt sustainability heaped pressure on Italian government bonds and raised fears that the country might default.

It questioned the integrity of Deutsche Bank’s sale of Italian BTPs during this period, and suggested that rating agencies had acted with prejudice against Italy.

“The findings were being used as a political tool,” said Codogno. “How can you address Italy’s problems now if the narrative around the 2011 crisis is yet to have been fully formed? Some people are arguing in favour of a kind of international conspiracy against the country, which is just nonsense.”

But not all market participants are particularly concerned about how an incoming government might disrupt the state of Italy’s public finances.

“In Rome and in Italy there is too big a proportion of influential people thinking that fiscal policy is a solution to Italy’s low growth,” said the chief economist. “What Italy needs is structural reform to get more people into the labour force.

“But the market should not be too worried about Italy’s debt problem at this stage. Under any conceivable scenario, given the maturity structure of Italy’s debt, this is not really an issue.”

The average maturity of Italy’s outstanding debt has risen to close to seven years, just as yields have fallen with the introduction of quantitative easing measures from the European Central Bank.

And the country is finally starting to see the beginnings of an economic turnaround. It recorded annual GDP growth of 1.6% last year — its fastest pace since 2010 — and both the Bank of Italy and the European Commission think that it will grow by another 1.5% in 2018.

“The recovery in Italy has only been underway for less than a year or so but it is very robust,” the chief economist said. “Export growth is strong, Italian companies are gaining market share around the world, and the growth rate of fixed investment in Italy has been stronger than the eurozone average — albeit from a lower base.

“It would take quite a lot to disrupt those underlying economics in the next couple of years.”

But in every corner of the market, participants are certainly concerned about the risk that the anti-establishment Five Star Movement or the right-wing Northern League could gain a significant share of the power in Rome.

Few observers would assign a great deal of probability to either of these outcomes. “There will just be a different premier, somebody you’ve probably never heard of,” said the fixed income investor.

But the risk of an electoral upset is not zero. Italy goes to vote at the weekend with a new and as yet untested electoral system, which combines elements of proportional representation and first-past-the-post.

The new voting system makes it harder to predict with any precision how public opinion may translate into seats.

“The biggest risk to the European project from an Italian angle looks increasingly like it is sitting with the Northern League more than the Five Star Movement,” said the chief economist. “Many politicians have actually moved away from anti-European rhetoric. Renzi has mused about being a being an Italian version of Emmanuel Macron [the French president] and Berlusconi has held back, having been quite critical of Europe in the past.

“Even the Five Star Movement no longer wants a referendum on EU membership.

The market certainly seems to believe that it is more or less positioned correctly already.

There has been very little volatility in Italian credit. The spread between 10 year Italian BTPs and the equivalent German Bunds has declined since the beginning of the year, and additional tier one bonds issued by UniCredit and Intesa Sanpaolo have moved two to three cash points higher in value in the last two months.

“International investors are positioned quite lightly in the Italian market at the moment,” Codogno noted. “But many investors will be unwilling to go short on the country because they have been burned in the past. Before the 2016 referendum there were plenty of unsuccessful short positions on Italy.”

“There is no point being too bearish or too bullish on Italy right now,” said a fixed income investor based in London. “The fiscal path signalled in the election, the flat tax, is simply unachievable and it will never happen. So there is no risk of Italy having a 10% deficit.

“But equally, this isn’t a Macron moment. There is nothing that is going to trade up 10% on the day of the election.”