The markets reacted in horror to the Italian government’s budget proposal. Investors are concerned that the already massive Italian debt levels will balloon further, resulting in credit downgrades. Larger debt and higher service costs as rates increases could result in a “debt-spiral” of higher costs and lower growth for Italy. “Markets” worry that that in this scenario Italy could default on its debt, creating another European financial crises which could affect the whole world.
The Italian government announced late last week that its budget deficit for 2019 budget would be 2.4%. This lead the market into a negative tailspin. The FTSE MIB share index declined more than 3.6% while the Italian 10-year bond yield went up to 3.2%. Banks stocks, in particular sold off sharply, with Banco BPM (BAMI IM) down over 10% and Italy’s biggest bank Unicredit (UCG IM) down 8%.
Italy’s public debt is officially estimated to be over 130% of GDP at a total of $2.7trillion. Italy is the 2nd most indebted country in the Euro-area after Greece on a relative basis, and the 3rd most indebted country in the world on an absolute basis (behind US and Japan).
Source: The World Factbook
The high debt/gdp ratio scares the market. Italy is the third biggest Eurozone economy, and potential debt crises there could have severe contagion risks.
Another factor in the big market reaction on Friday is the fact the Italian economy has been rather stagnant since the financial crises and unlike other EU countries has not bounced back. Carmen Reinhart points-out;
Italy’s per capita GDP in 2018 is about 8% below its level in 2007, the year before the global financial crisis triggered the Great Recession. And the International Monetary Fund’s projections for 2023 suggest that Italy will still not have fully recovered from the cumulative output losses of the past decade…Since the crisis erupted a decade ago, economic stagnation and costly banking weaknesses have propelled debt burdens higher still, despite a decade of exceptionally low interest rates.
Source: Macrobond
As the economic growth has been missing, the markets worry that this additional deficit will further trigger increases in Italian debt levels. As a result of this, investors are worried that Italian bonds will be downgraded. MarketWatch writes;
Fears the deficit figure could trigger downgrades by credit-rating firms, push up long-term debt levels and endanger Italy’s compliance with EU budget rules, setting the stage for a fight with Brussels, drove the reaction, said analysts.
Currently, Italy is rated two levels about junk status by S&P, Moody’s and Fitch. Markets fear that the populist coalition government of the League and Five-Star Movement (5SM), will continue on their deficit widening program which could trigger a downgrade to junk. Again MarketWatch notes the fear;
A downgrade into junk status would put the bonds out of reach of the European Central Bank’s asset purchases at a time when investors are leaving en masse. Foreign investors’ holdings of Italian debt slipped by 38 billion euros in June, the second straight month of record outflows, according to the ECB’s data
Furthermore, the Italian banking system stands on rather shaky grounds. Italian banks’ non-performing loans amount to as much as 15% of their balance sheets, while almost a further 10% of their balance sheet are made up of Italian public bonds. This puts further pressure on any adverse economic development. Bloomberg summarizes;
A slump in growth, along with higher interest costs, could seriously impair the government’s ability to pay-off its obligations. Rising bond yields can also make it more difficult for Italian banks to sell their non-performing loans.
All of this is made worse by fact that the average maturity of the Italian debt is around 7-year, which is relative short. In another words, Italy has to roll-over more than half of its debt the next five years. As a result, combining these factors could lead into a “debt-spiral”. AEI writes;
Sadly, all of this heightens the chances that Italy will find itself again in a downward economic spiral. High interest rates caused by political uncertainty will cause the Italian economy to stumble. That in turn will raise further questions about the country’s ability to service its debt, which will drive interest rates even higher leading to a further leg down in the economy.
In a worst-case scenario with the risk of Italy defaulting on their debt, the result would be a European-debt crisis, similar to the one that rattled the market with Greece. But, unlike with Greece, EU does not have enough capital to bail-out Italy. An Italian default would have reverberations around the world, contagion risk and another global financial crises.
It is therefore important to continue following Italy and the developments there. The government needs to win back investors trust. The markets are already jittery about the recent budget proposal. Any further development that would reduce the markets faith in the Italian economy, its government and its ability to service its debt can be detrimental.
Italian 10 year yield spiking.
Source: Bloomberg
